Madagascar - Industrial Assistance Project

Documof The World Bank FOR OFMCIAL USE ONLY C /Z. ,/ q/-kkc Respt No. P-3262-M&G REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATIGN TO TEE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT IN AN AMOUNT OF SDR 40.2 MILLION TO THE DEMOCRATIC REPUBLIC OF MADAGASCAR FOR AN INDUSTRIAL ASSISTANCE PROJECT December 28, 1984 This docmen ba a resricted distrilatsad may be used by recipius emy in the peIformance of thdr oficd dutesL Its cnteomt my om utewwse be dised wihout Wodi BDk atdmatim.  DI(OCRATIC REPUBLIC OF ASCAR CURRENCY EQUIVALENTS Currency Unit = Malagasy Franc (FMG) 1 US$ = FfG 1 FMG US$ 1983 430.45 0.0023 1984 (Dec.) 621.88 0.0016 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System GLOSSARY OF ABBREVIATIONS BCRM Central Bank of Madagascar BFV National Bank for Trade BNI National Bank for Industry BTM National Bank for Agriculture MIEM Ministry of Industry, Energy and Mining  FOR OMCIAL USE ONLY NADAGAkSCAR LWUSTRI AS:SISTANCE PROJECr CREDIT AND PROJECT SIEARY Bcrrower: Democratic Republic of Madagascar Beneficiaries: Priority enterprises in the industrial sector, the Ministry of Industry, Energy and Mining. and the National Bank for Industry (BNI). Amount: SDR 40.2 million (US$40.0 million equivalent). Terms: Standard IDA terms Project Description: Objectives The purpose of this credit is to support important policy reforms designed to increase the efficiency and productivity of the industrial sector and to increase the capacity utilization of selected efficient industrial enterprises so as to enable them to produce incentive goods for the domestic market and to produce products for export. Components (a) Financing imports of spare parts and raw materials for selected efficient, private and public industrial enterprises. The funds (US$33.5 million equivalent) would be sold to approved industrial enterprises through the existing commercial bank network. The banks would receive a commission of 0.5 percent of the amount of the transactions. (b) Financing equipment for the rehabilitation of a selected group of enterprises; and (c) Technical assistance to the Ministry of Industry. Energy and Mining. Tis document bas a icted dis6rlaon and may be used by cpients only 11 the performa of their ofdicial dutis Its contents may not otberwe be dislsd without Wod Bak authorizau  - ii - Relefding Terms: For the rehabilitation component (US$5.0 million equivalent) the Government would pass on to BNI the funds at the rate for World Bank loans prevailing at tim of Board approval. The loan to BNI would have a composite amortization schedule conforming to the aggregate amortization schedule on BNI's subloans. Onlending to enterprises would be at 2.0 percent per annum above the rate to BNI for a maximum period of fifteen years. Benefits: Through its support of policy changes the credit is expected to lead to increased efficiency and to an improved allocation of resources in the industrial sector. By relaxing the foreign exchange constraint that prevents priority efficieat enterprises from operating at full capacitv, the credit is also expected to promote the production of incentive goods and exports. Risks: The main risk facing the project is that of possible internal resistance to the timely implementation of the policy reforms which this Credit supports. The risk is limited by: First, a consensus has been building within Madagascar on the need for industrial reform and the Government has adopted a carefully designed package of measures which this Credit supports and which enjoys growing acceptance within Madagascar. Second, important parts of the policy package have already been implemented, demonstrating Government's commitment. Third, the industrial import component of the credit will be disbursed in two tranches of SDR17.2 million and SDR16.5 million with release of each tranche linked to satisfactory implementation of subsequent stages of the policy package. Fourth and finally, the Credit is expected to result in quick, tangible benefits--4n the form of a rapid increase in industrial capacity utilization, thus adding momentum and credibility to the operation and its policy package. Estimated Disbursement: US$ Million FY85 FY86 FY87 FY88 Annual 5.3 27.4 6.6 0.7 Cumulative 5.3 32.7 39.3 40.0 Appraisal Report: This is a combined President's and Appraisal Report. IBRD 14160  CONTENrS PART I - THE ECONOKY 1 PART II - THE INDUSTRIAL SECTOR 6 Sector Background and Recent Performance 6 Structure of Manufacturing 6 The Financial Sector 11 Past Industrial Policies 12 PART III - THE GOVERNMENT ADJUSTMENT PROGRAH IN INDUSTRY 14 The Adjustment Process 14 Towards a New Industrial Strategy I5 PART IV - TEE PROPOSED CREDrT 21 Credit History and Rationale 21 Previous Bank Group Support for Industry 21 Credit Objectives 22 Credit Components and Timing 22 Disbursement and Procurement 27 Expected Impact and Risks 28 PART V - BANK GROUP OPERATIONS IN MADAGASCAR 29 PART VI - LEGAL INSTRUMENTS AND AUTHORITY 33 PART VII -RECOMMENDATION 33 ANNEX I - Madagascar - Social Indicators Data Sheet ANNEX II - Status of Bank Group Operations in the Democratic Republic of Madagascar ANNEX III - Government Statement on Industrial Policy and Goals ANNEX IV - Note on the National Bank for Industry ANNEX V - Supplementary Credit Data Sheet ANNEX VI - Industrial Assistance Credit - Estimated Disbursement Schedule  INTERNATIONAL DEVELOPMENT ASSOCIAIION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEMOCRATIC REPUBLIC OF MADAGLA1CAR FOR AN INDUSTRIAL ASSISTANCE PROJECT 1. I submit the following report and recommendation on a proposed Development Credit to the Democratic Republic of Madagascar for SDR 40.2 million (US$40.0 million equivalent) on standard IDA terms to help finance an industrial assistance project. The equivalent of US$33.5 million, from the Credit for spare parts and raw materials, would be sold to eligible industrial enterprises through the existing commercial bank network with the banks receiving a 0.5 percent commission on these transactions. Covernment would on-lend US$5 million equivalent to the National Bank for Industry (BNI), for the industrial rehabilitation component, at the rate for World Bank loans at the time of the proposed Credit's approval and with a composite amortization schedule conforming to the zggregate amortization schedule of BNI's subloans. PART I - THE ECONOMY 2. A report entitled -Current Economic Situation and Prospects' dated October 25, 1984, was distributed on November 6, 1984 to the Executive Directors and to participants of the Madagascar Consultative Group Meeting, and is available as document 5154-MAG. Country data sheets are provided in Annex I to this report. Main Features of the Economy 3. Madagascar, with a population of 9.4 million and a GNP per capita of about US$300 in 1983, is among the poorest countries in the world. It is a sparsely settled country, with a population density of about 15 persons per square kilometer. Although generally well endowed with natural resources and a variety of soils, there are considerable regional variations in ecology and climate. The central plateau, the most economically advanced region, has a subtropical to temperate climate. The South is the poorest region with an arid climate and infertile soils. The eastern region has a tropical climate and, although rich agriculturally, crops are frequently devastated by cyclones. Agriculture accounts for about 35 percent of GDP; about 85 percent of the population lives in rural areas, and agricultural products account for about 80 percent of the country's export earnings.  - 2- Economic Developments in the 1970s 4. During the past twenty five years, Madagascar's development has been sluggish and erratic. For about a decade following independence in 1960, the economy grew at an average annual rate of 3 percent. Agriculture was responsible for much of this GDP growth while manufacturing, under increased protection, gained in relative importance. For the period 1970-1983, however, there was, on average, virtually no growth in real GDP. With an average population growth of about 2.8 percent per annum, per capita real income in 1983 was about 28 percent below its 1973 level. 5. This slow development was true for all sectors of the economy. Agricultural output lagged conspicuously, and yields tended to stagnate or decline; the country became increasingly dependent on imports, especially of rice, to meet food requirements; and the volume of agricultural exports virtually stagnated. Manufacturing output showed a modest expansion. The sector remained heavily dependent on imported inputs, however, and operated at low levels of capacity utilization. There was little expansion in the country's transport network and indeed the existing transport facilities (road and rail) were subject to increasingly serious deterioration. 6. The poor economic performance stemmed in large measure from inappropriate economic policies. These policies can be summarized along three main themes. First, the Government undertook a widespread nationalization of economic activity. This policy was initiated following the 1972 military coup and was intensified after 1975, when the present Government came into power. A second but related theme was the adoption of an interventionist attitude towards the economy. Most of the decade of the 1970s was thus marked by the vigorous pursuit of official policies which sought to reduce foreign involvement in the economy and, through nationalizations and various economic controls, to extend the Government's role in economic activity. Under these political and economic conditions, private sector initiative was discouraged. Third, the Government embarked on a strategy which accorded high priority to the development of industry with protective policies that neglected agriculture and, in effect, fostered the growth of an inward-looking and sometimes uneconomic manufacturing sector. The adverse effects of these policies were compounded by the deterioration of the terms of trade following the world oil price increases. 7. Through 1977, the poor growth and development performance and the extensive institutional changes which were being effected were nevertheless accompanied by continued cautious policies regarding the balance of payments, public finances and external debt. The external resource gap was kept at low levels (about 3 percent of GDP from 1970-78), the overall Government budget deficit fluctuated around 2.5 percent of GDP and recourse to external borrowing was strictly limited. Total external public debt (outstanding and disbursed) at end 1977 was equivalent to about 13 percent of GDP, compared to an average of about 22 percent for low income developing countries, and the ratio of debt service payments to export earnings at end 1977 was only about 3 percent. The Public Investment Boom of 1978-81 and its Impact 8. In 1978 the Government adopted a significantly different economic policy orientation, undertaking a large expansion in public sector  -3- investment with greatly increased reliance on external sources for its financing. Investment outlays increased by about 13 percent per annum between 1978-80 and the share of investment in GDP, which had been about 14 percent since the early 1970s, rose to around 25 percent in 1979 and 1980. The increased investment resulted in increased imports and coincided with virtually stagnant export earnings and a further deterioration in the terms of trade. As a result, Madagascar's balance of payments deteriorated sharply in 1979 and 1980 and the resource gap reached almost 17 percent of GDP. Madagascar began to run into difficulties in meeeting its external debt obligations in 1980 and foreign exchange shortages grew increasingly severe through 1981 and 1982, largely as a result of the rapidly growing burden of external debt service. 9. With the rapid expansion in external borrowing and a hardening of average terms, Madagascar's public external debt service obligations increased dramatically from about US$19 million in 1978 (equivalent to about 4 percent of exports of goods and non-factor services in that year) to about US$265 million in 1982 (equivalent to about 72 percent of exports of goods and NFS). In 1981 and again in 1982 Madagascar sought and obtained a rescheduling of a part of debt service obligations due. These reschedulings reduced payments due in 1981 and 1982 by over 50 percent so that actual service payments on external public debt made in 1982 were equivalent to about 35 percent of export receipts. In April 1984 a further rescheduling was accorded by the Paris Club and reduced debt service due in 1984 from the equivalent of 80 percent of export earnings to around 38 percent . 10. The Central Government's finances in 1978-83 clearly reflect the investment boom and the subsequent efforts to restore equilibrium. Total expenditures virtually doubled between 1978 and 1980 and declined slightly in 1981 and 1982, when the inflation rate was much higher. The overall public sector deficit swung from 4 percent of GDP in 1978 to a peak of 17 percent in 1980 and then decreased to 6 percent in 1982 and 5 percent in 1983. The recurrent budget contributed little to the swings since expenditures and revenues moved roughly in line. The main cause of the deficits was the capital budget, which more than quadrupled between 1978 and 1980 and then declined by 57 percent from 1980 to 1982, with only a modest increase in 1983. Although showing some growth in nominal terms, both revenues and recurrent expenditures generally declined in real terms after 1980. The growth of revenues has been slowed by the cut in imports and by the low level of economic activity, despite additional tax measures introduced in 1982 and 1983. 11. The investment boom and the ensuing stabilization policies are also reflected in the money and credit figures as well as in the rate of inflation for the years 1978-83. Net domestic credit expansion, due overwhelmingly to net Government borrowing from the Central Bank, stood at 58 percent of total net domestic credit at end 1982, as compared to 31 percent at end-1978. The official cost of living index for Antananarivo, Madagascar's capital and largest city, which is likely to understate the actual price rises, showed an 18 percent increase in 1980, about 31 percent in 1981 and 1982, and an estimated 20 percent increase in 1983. The implicit GDP deflator shows a parallel development: a 15 percent increase in 1980, a 25 percent increase in 1981, a 34 percent increase in 1982, and a 22 percent increase in 1983.  -4- 12. The balance of payments has also been affected by the investment spending of 1978-80, but the sluggishness of exports and the difficulties in reducing imports have made restoration of external equilibrium especially difficult. The current account deficit began to rise rapidly from less than 2 percent of GDP in 1978 to over 18 percent in 1980. Transactions with the rest of the world were financed by a total exhaustion of reserves, an unprecedented degree of foreign borrowing, and by incurring substantial arrears on external payments obligations. The Government began to take somr measures to restore equilibrium in 1981 and took stronger actions in 1982 and 1983, notably by tightly restricting imports and by negotiating arrangements with the DMF and the Paris Club. The current account deficit was reduced in each of the years 1981, 1982 and 1983, and in 1982 it was about 10 percent of GDP compared to 18 percent in 1980. 13. One factor which impeded further improvement in the current account was that capital goods imports, which were tied to the existing financing arrangements and on-going projects, continued at very high levels through 1981 and 1982. The total volume of imports grew by 33 percent in this period, and import price increases were also substantial, increasing at roughly the same rate. The foreign exchange shortages that began in 1980 and grew much worse in 1981-82 obliged the Government to restrict imports where it could. The categories of raw materials and spare parts and of non-food consumer goods suffered most, though the Government ensured that energy imports covered essential needs. Food imports increased because of bad weather, including serious floods, that reduced the rice ..arvests. The sluggish export performance aggravated difficulties. During 1978-1983 the volume of exports stagnated. Coffee, the main export, was seriously affected by the international market situation, first by a drop in prices in 1981 and then by the ICO quota restrictions. Recent Developments 14. Since 1979 the drop in industrial production, including mining. has been especially sharp. Production at end 1982 had dropped to 70 percent of the level in 1979, lower Laan in any year of the 1970s. Output in every branch of production was lower in 1982 than in 1979. A particularly serious aspect was that the output of some basic consumption items (soap, shoes, matches, batteries) had dropped by well over one half since 1979. Preliminary figures for 1983 indicate a modest pick-up of about 1.5 percent in manufacturing output. 15. The performance of the agricultural sector since 1979 was less disappointing than in the immediately preceding years, but was nevertheless unsatisfactory. Output grew by 7 percent in 1979, fell by 4.5 percent in 1981 but resumed growth by 4.0 percent in 1982 and 2.5 percent in 1983. In addition to poor weather, there have been shortages of inputs such as fertilizers, pesticides and improved varieties of seeds. Rice production did not increase between 1979 and 1982 but most export crops had somewhat higher outputs in 1982 than in 1979. In the case of coffee the increase was only about 2.5 percent. but output reached the highest level so far obtained. Clove production almost tripled between 1979 and 1980 and declined slightly thereafter. Vanilla also picked up from a low level in  - 5 - 1979 and almost doubled by 1982. These three crops accounted for over 70 percent of merchandise exports. 16. Over the last couple of years, the Government has shown its willingness to take a number of significant stabilization and recovery policy measures. These measures and their first results are summarized in para. 51 and Annex III to this report. The measures represent a major reversal in the thrust of policies and, therefore, were politically very difficult. The fact that the Government has been willing to undertake them shows that a significant reassessment has taken place. The Malagasy Government's stabilization and recovery efforts have been supported by successive IMF stand-by arrangements. The latest arrangement, in addition to establishing performance targets for external borrowing, domestic credit, reduction in external arrears and maintenance of exchange rate adjustment, requires increases in the prices of major agricultural products, further measures to liberalize the marketing of these products and progress towards a market-determined system of interest rates. Madagascar has met the June 1984 [MF stand-by target. In November 1984 a Consultative Group Meeting was informed of the Government stabilization efforts and endorsed the Government adjustment program in industry. 17. Until April 1982, the Malagasy Franc was pegged to the French Franc. As domestic inflation rates substantially exceeded those of Madagascar's major trading partners since about 1979, this led to the overvaluation of the currency. The overvaluation accentuated Madagascar's strong dependence on foreign inputs and discouraged exports further. In April 1982 the Malagasy Franc was floated on the basis of a basket of currencies. Furthermore, it was devalued by 15 percent in May 1982, by 6 percent in February 1983, by a further 2 percent in July, by 10.5 percent in September and by 15 percent in March 1984. These devaluations were in keeping with an understanding with the IMF which calls for the adoption of a flexible exchange rate policy aimed at restoring the competitiveness of the Malagasy Franc against the currencies of its trading partners. 18. The cumulative effect of exchange rate movements since mid-1982 has been that the Malagasy Franc has been devalued by 58 percent against the currencies of Madagascar's major trading partners. When relative inflation in Madagascar and in those countries is taken into account, the real exchange rate has depreciated by 22 percent over the same period. As a result of these adjustments, it now stands at about the same level as in 1978, a year of reasonable external balance for the country. It should, of course, be noted again that in the period since 1978 there have been a significant deterioration in Madagascar's terms of trade and a dramatic increase in its debt service ratio. Further real devaluations may be required. An exchange rate strategy for the immediate future has thus been developed with the help of Fund staff. For the remainder of 1984 and for 1985, the authorities have decided to depreciate the Malagasy Franc at a pace equal to domestic inflation. Nonetheless, the exchange rate adjustments already made and the country's current exchange rate policy constitute an important step towards the reestablishment of external balance in Madagascar.  -6 - PART II - THE INDUSTRIAL SECTOR A. Sector Background and Recent Performance 19. Manufacturing, which in 1960 accounted for about 4 percent of GDP. tripled its GDP share to about 13 percent by 1970. From 1970 to 1979 manufacturing value added grew at a rate of about 2.5 percent per annum, falling thereafter by a total of about 35 percent, a drop far greater than in any other sector. As a result, the sector's contribution grew to only a 14 percent share of GDP at the end of the decade, dropping to an estimated 10 percent by 1983. 20. Manufacturing growth proceeded along the path of import substitution. In contrast to mining and some agricultural products such as coffee, cloves and vanilla which were oriented towards exports, manufacturing was developed mainly in order to meet the consumption requirements of the domestic market. Under a high level of protection from foreign competition, the domestic manufacturing sector quickly became the supplier of many final consumer goods. The growth performance of Madagascar's manufacturing sector, measured in domestic prices, was rapid when compared to that of 19 other African countries at similar levels of development. Madagascar's share of manufacturing in GDP was amongst the lowest in this group in 1960 and by 1980 it was the second highest, surpassed only by Senegal. Thereafter, the deteriorating macroeconomic situation and the emergence of a severe foreign exchange constraint brought to the surface the structural inefficiencies of the sector, many of them caused by the industrial policies described in paras. 42 to 50, and showed that development along the lines of the recent past was unsustainable. 21. The rapid deterioration of the manufacturing sector over the past few years was partly caused by acute shortages of imported inputs and spare parts and a sharp decline in the supply of domestic agricultural inputs. As a result of these shortages, a great number of enterprises were forced to stop or slow down production. Average capacity utilization in selected enterprises accounting for about three-quarters of manufacturing value added dropped from about 75 percent in 1979 to 57 percent in 1981 and to 47 percent in 1982. At the subsector level, capacity utilization in 1982 was estimated at about 40 percent for beer and other beverages, about 20 percent for batteries, concentrated milk, wood panels, soap, candles, metallic packing materials and paints; about 30 percent for paper products, leather, matches and pens; about 25 percent for glass bottles; about 15 percent for edible oils; and only about 10 percent for insecticides, corrugated sheet metals and nails. Only a few industries operated at above average capacity utilization: clothing (60 percent), cement (75 percent), sugar, salt and cigarettes (65 percent) and textiles (90 percent). B. Structure of Manufacturing Composition of Output 22. Manufacturing now accounts for about two-thirds of industrial value added and is dominated by two main subsectors, food processing and textiles. These two branches account for about 50 percent of manufacturing value added. When beverages, cigarettes, garments and leather goods are  also included, their share increases to close to 70 percent. This represents a relatively low level of manufacturing diversification. The 30 percent share of the textile subsector in value added, for example. represents a level of conceotration in this subsector more than twice the average concentration recorded for countries of a similar size and level of resource endowment. Other important subsectors include household chemicals (10 percent of value added), intermediate goods such as metal and paper products (9 percent), and construction materials and petroleum refining (8 percent). 23. At the product level, the manufacturing sector is still heavily dominated by final consumption goods, a feature typical of an early stage of industrializat'on through import substitution. Thus, of 33 major products manufactured in Madagascar, 22 are consumer goods (such as food and tobacco products, garments and footwear) and simple household chemicals (such as soap, matches, batteries and candles); five are petroleum products (e.g. kerosene, butane, fuel oil) and only six can be considered as intermediate goods (pulp, paper, metal sheets, cement, nails and paints). Capital goods production is practically non-existent in Madagascar. Manufacturing Inputs 24. Because of the emphasis on the production of consumer goods, the manuifacturing sector is still characterized by a low level of integration. Inter-industry linkages are weak as there is little production of intermediate goods, and manufacturers have little opportunity to take advantage of domestic inputs. The high protection afforded to producers of final consumer goods and liberal exemptions from tariffs and import taxes on investment and intermediate goods, have not encouraged either the use of, or investment in, domestic inputs. Even linkages to agriculture have not always worked well, mainly because of the poor performance of agriculture. 25. Reflecting weak domestic integration, many manufacturing enterprises are dependent upon imported inputs. Import substitution may have thus reduced Madagascar's dependence of imported consumer goods but it has increased its reliance on imports of intermediate and capital goods. In 1983, imports of intermediate goods (excluding petroleum) amounted to US$115 million or 24 percent of total imports. According to a survey of about 200 manufacturing enterprises, they imported close to 60 percent of their total raw material needs between 1981 and 1983. Import dependence was more than 50 percent of total raw material requirements in house'lold chemical iadustries, textiles and clothing, wood, paper and furniture. This dependence was lower in food, beverage and leather industries, but still relatively high at about 35 percent of these industries' total raw materials needs. These survey results must be interpreted with caution as enterprises may tend to inflate the requirements for foreign inputs in order to obtain higher allocations of scarce foreign exchange. Nonetheless, the overall tendency underscores the fact that relatively high dependence on imported inputs makes Malagasy manufacturing highly vulnerable to foreign exchange shortages.  Manufacturing Exports 26. The orientation of Malagasy manufacturing towards meeting the consumption requirements of the domestic market has meant that little attention has been paid to exports. Exports of manufactures have ranged between five and 10 percent of the sector's output. In 1983, for example, they amounted to an estilated US$25 million compared to a sectoral output of almost US$550 million. Apart from a few export-oriented activities based on the processing of agricultural products, only the textile industry exported more than 10 percent of its output, manly to France and Germany. In addition to exports of surplus petroleum products from the refinery, major goods exported by the manufacturing sector are: sugar and molasses, cotton fabrics, essential oils, canned meat and garments. 27. In recent years, exports of manufactures declined as a percentage of total exports. Between 1975 and 1983, the share of manufactures to total exports declined from just over 20 percent to about 10 percent. Petro'eum product exports were responsible for a large part of this decline because of a production shift towards domestic uses. There were other reasons for the relative decline in export industries which are related to agriculture's inability to produce surpluses for industrial processing and to a policy bias towards import substitution. Particularly at times of scarcity, the Government has put emphasis on raising industrial output destined for the domestic market, at the expense of potential exports. These factors are discussed further in the sections on recent sectoral developments and on past industrial policies. Enterprise Characteristics 28. Most manufacturing firms were established in the sixties. According to a recent survey (1982). there are 362 manufacturing enterprises. In addition, there are some 2,000 artisanal enterprises, the vast majority of which employ less than 5 wor'kers. There is a high level of concentration in manufacturing as about 100 firms account for almost 80 percent of output and 14 'irms account for about 90 percent of manufacturing exports. The most recent information on enterprises indicates that about 80 percent of manufacturing employment was provided by enterprises employing more than 100 persons while only 23 firms employed more than 500 people. The largest firms are in the food and beverage industries, the textile industry and the clothing and footwear industries. Many of the large enterprises enjoy a monopoly position in the market. Some 55 percent of manufacturing enterprises are located in Antananarivo. 29. Many industrial firms, particularly the large ones, were owned b, foreign private interests at the time of their establishment. The Government's attitude towards the productive sectors during the sixties was conducive to the development of private sector enterprises. Local entrepreneurs were particularly active in small and medium enterprises. This environment changed in the early seventies with the adoption by successive Governments of a more interventionist attitude towards the whole economy. Banks, insurance companies and large trading concerns were all nationalized and the GDvernment took over the marketing of key agricultural products.  -9- 30_ Throughout the seventies, the Government pursued a policy of nationalization of the industrial sector. At the beginning, this policy was aimed at eliminating foreign control over the sector and was, therefore, confined to taking over foreign owned firms. Later on, the Government sought to bring under its control most of the industrial sector either by nationalization or by equity participation. As a result of this widespread nationalization of existing enterprises as well as a large public investment effort, by the late 1970s a large part of industry had come under Government control. At present, out of a total of 362 industrial enterprises, 40 are entirely state owned. The Government has a majority interest in a further 17 firms and a minority holding of at least 33 percent in another 14. These include most large scale operations; mediuar- and small-scale firms have remained mainly in private hands. Enterprises in which the Government has an interest of more than 50 percent account for an estfaated 65 percent of sectoral output and a similar share of employment. Another 15 percent of output is contributed by firms in which the Government has a substantial minority interest. Government control over public sector enterprises is exercised primarily through appointments to the boards of directors and through the supervision of the Ministry of Industry. 31. In 1978, the Government set out the objectives as well as the organisation and management of state enterprises in the -Charter of Socialist enterprises.- In theory, the socialist enterprise is the model to which all firms with at least a 51 percent state share were intended to conform. Such enterprises are intended to be run by a management committee with worker representation, which is responsible to a policy council. The objectives of these enterprises include employment creation and the provision of goods and ser-ices at low cost. The Government, however, has been cautious and pragmatic in applying the Charter. Of 57 enterprises with majority state ownership only 13 are socialist enterprises, many of them new projects. Moreover, in practice socialist enterprises operate much like private firms. Indeed, many of the existing firms that were nationalized have retained their managers and senior staff, thus providing continuity. The Government has also been receptive to joint ventures with private concerns and has also often made arrangements for sound management provided by expatriates, as in the case of the fishing industry. 32. Preliminary analysis of a sample of firms indicates that the financial results of state-owned industries vary greatly between individual firms. The net financial impact on the Government's budget of all state enterprises together is estimated to be negative and about half the companies are operating at a loss. These include some of the largest fully state owned firms. On the other hand, several state enterprises are financially healthy and consistently make satisfactory profits. These include particularly those firms where the previous owners, now minority shareholders, have continued to manage them. 33. Because a number of investment decisions have been taken without proper analysis since 1978, the overall condition of the public enterprise sector is likely to worsen as new projects become operational. However, for existing firms, the Government's policies and the economik downturn in Madagascar have probably been more important in influencing financial  - 10 - results than public ownership in itself. Industry has been facing rising costs due to low capacity utilization. The slump in demand and the system of price controls have made it increasingly difficult to pass on these higher costs despite the fact that most enterprises generally enjoy a high level of protection from foreign and domestic competition. Price controls have been particularly damaging for certain goods--sugar, vegetable oil, cement, jute bags--whose prices are fixed close to, or even below, average production costs. Industrial Investment 34. Between 1975 and 1983, annual industrial investment by both the private and public sectors ranged from 4.1 to 9.3 percent of GDP and it averaged about 6 percent. In the three-year period 1979-81, industrial investment averaged 8.4 percent of GDP as compared to an annual average of 4.6 percent in the previous three-year period. The lion's share of this investment was made by the state. After rapid growth in the sixties, private sector investment in industry has remained low since 1982. Medium and longer term loans from banks to private manufacturing enterprises. for example, dropped by more than half between 1972 and 1975. The private sector, discouraged by a political and economic environment that was not conducive to private sector initiative, invested very little in fixed assets both for the expansion of existing concerns and for the establishment of new enterprises. 35. As noted above, public sector industrial investment accelerated, particularly in the late seventies. More than 70 percent of investment in manufacturing between 1979 and 1983 was undertaken by the public sector. Much of this investment was in new activities (metal products, machinery, cement) and was aimed at broadening import substitution into areas where the private sector had not ventured. A significant part of these investments was undertaken without adequate analysis and the financial and/or economic viability of some investments is questionable. Industrial Employment 36. Industrial employment in Madagascar accounts for a small percentage of the total labor force. In 1983, the industrial sector employed about 120,000 persons, or only about 2.6 percent of the labor force. In the same year, this relatively small part of the economically active population accounted for about 15 percent of GDP-about half the contribution of agriculture which employed, however, close to 90 percent of the labor force. The manufacturing sector employed about 70,000 persons. Included in this total is an estimated 10,000 persons employed in the informal handicrafts sector (tailoring, basket weaving, food, leather, wool and metal working). Manufacturing employment grew at an annual rate of about 6.5 percent in the sixties but this growth rate dropped to about one percent a year in the seventies while there appears to have been no growth in the early eighties. 37. Wages in manufacturing in 1983 averaged about 24,000 FMG (or US$56) per month. Wage costs were 20 pev-:.t higher because of social security and other charges. The minimum monthly wage for nonagricultural  - 11 - employment in 1983 was FMG 17,000 (or US$39). In earlier years, nominal wages for unskilled and semi-skilled labor in Madagascar were higher than in other African countries. Madagascar's relatively rich natural endowments and a profitable agricultural sector were largely responsible for this phenomenon up to the early 1970s. Thereafter, nominal wage increases lagged behind the rapid inflation rate of the late seventies and early eighties, and as the exchange rate began to depreciate, wage rates, measured in US dollars, dropped. Manufacturing monthly earnings in Madagascar are now significantly lower than in some African countries at comparable levels of development for which information is available (e.g. Burundi, Malawi, Zambia and Kenya), but considerably higher than earnings in some low-income Asian countries (e.g. Sri Lanka and Bangladesh). 3s. In recent years, the Government has followed a policy of wage restraint for public sector employees and has also encouraged wage reduction as an alternative to lay-cffs in parastatal and private sector enterprises. At the same time, however, the Government has instituted a policy of not permitting the lay-off of industrial labor without its prior authorization. This authorization has been rarely granted and industrial employment has not fallen significantly despite substantial reductions in industrial output. As a result of this policy, however, labor productivity has declined. C. The Financial Sector 39. Madagascar's financial system was reorganized in 1977, when the then existing co mercial and development banks (all of which had been nationalized in 1975) were merged to create three new national banks specialized by sector: the National Bank for Industry (BNI), the National Bank for Agriculture (BTM), and the National Bank for Trade (BFV). The state is the sole shareholder in all three banks. These three banks, together with the Central Bank of Madagascar (BCRM), a postal checking system, two insurance companies and an investment fund, constitute the country's financial sector. 40. The Central Bank is responsible for regulating all the financial institutions in the country and for establishing and administering national monetary and credit policies as well as managing international reserves. Each of the three banks is expected to concentrate on its prescribed sector, and to lend outside that sector only as a cofinancier with the appropriate lead bank. In practice, however, the three compete for both deposits and loans. Further details on the activities of BNI, which is expected to play an active role in the proposed Credit, are provided in Annex IV. 41. The three national banks have generally been able to provide an adequate service to depositors and to industrial clients. The recent deterioration in the Central Bank's net foreign asset position, however, has put limits to the banks' lending capacity. Although in 1982-83 about half of the total short-term credit went to private sector enterprises, larger, mostly state-owned enterprises absorbed an increasing share of the limited credit. The precarious financial situation of some of these enterprises presents a potential threat to the health of the banking system.  - 12 - D. Past Industrial Policies 42. The main objective of industrial policy in Madagascar after independence was to diversify the structure of national production through the encouragement of industry. This objective was based on the desire to reduce the economy's vulnerability to adverse movements in international agricultural prices and on the perception that industry promoted faster economic growth and increased employment opportunities. Import substitution offered the easiest road to rapid growth in manufacturing output and was achieved through policies protecting domestic production from external competition. Tariffs and import taxes were the early means of protection during the 1960s. In the late 1970s, however, import prohibitions, strict import licencing practices and foreign exchange rationing, dictated by the Government's attempt to maintain an overvalued exchange rate in the face of rapid inflation, were the main sources of the high level of effective protection to domestic industry. 43. Following the military coup in 1972. two other main themes of Madagascar's industrial policy emerged. First, the Government undertook a widespread nationalization of economic activity. With regard to industry, public ownership of the most important enterprises was the means through which national control replaced foreign interests in a priority sector. Beyond the desire to reduce foreign influence, nationalization also reflected impatience with the pace of industrialization which the private sector, whether domestic or foreign, was able to achieve. Particularly towards the ead of the 1970s, this led to substantial public sector investment in industry in sub-sectors where the private sector had not ventured. 44. A second but related main theme was the adoption by the Government of an interventionist attitude towards the economy, characterized by the strengthening and extension of central regulation and a corresponding reduction in the role of prices in allocating resources. Thus, price controls were generalized and enforced with greater vigor than before and import restrictions and exchange controls were tightened. The following six paragraphs discuss in greater detail the various aspects of Madagascar's industrial policy. Trade Regime 45. Industry in Madagascar is highly protected. Up to 1976, protection was granted mainly through custom duties and import taxes. While duties are generally low and uniform with orly four rates (0, 5, 10 and 15 percent), taxes are relatively high and vary over a wide range of up to 100-150 percent. In many instances finished industrial products have the same or even lower duty rates than raw materials and/or intermediate goods used in their production. Import taxes, however, are generally low on raw materials, higher on intermediate goods and in the upper range for most finished products. 46. More recently, the level of protection has increased further as imports have been subject to increasingly tight quantitative restrictions because of the increasing foreign exchange shortages. Currently, all goods  - 13 - are subject to import restrictions and are classified into two categories: (i) those whose import is prohibited and (ii) those which can be imported but only under a detailed annual licensing program. This system of import controls and quantitative restrictions, combined with the structwre of import taxes described above, provides a high level of effective protection to import substitution industries. Preliminary estimates undertaken during the preparation of the Credit proposed in this report, show high and fairly dispersed levels of effective protection among subsectors: protection rates of between 50 and 100 percent were estimated for cement, food processing, plastics and leather and rates in excess of 100 percent were encountered in textiles, paints, edible oil and paper. Price Controls 47. Price controls have existed in Magadascar since before independence. In the late 1970s, in an attempt to control the pricing behavior of protected local industry and, more recently, to protect consumers from the impact of increasing scarcities, the use of Government price controls was intensified and generalized to apply to all industrial goods. Under this rigid and cumbersome system, any price increase had to be authorized by the Government. This was done on the basis of cost plus a set margin for each subsector. Up to 1982, authorizations, when granted, were given with a delay of several months, and often only in part. On the advice of IDA staff, Government has recently reduced delays in responding to price increase requests. Authorizations for price increases are now given in many cases within one month from the time of application. Despite this improvement, the system remains unnecessarily complex, it impedes industrial efficiency, discourages output increases, and has in some cases adversely affected the financial health of manufacturing firms. Similarly, the Government's policy of holding down the prices of agricultural products to provide cheap inputs to industry is a major factor in the declining availability of these products. Extensive price liberalization is a major objective of the Credit proposed in this report and has already begun (paras. 54-56). Investment Incentives 48. In 1973, the Government enacted an Investment Code which provides fiscal and other incentives to investors, including reduction of customs duties and taxes on imported equipment, protection from competing imports, corporate tax relief for up to five years and priority in the allocation of foreign exchange. The Code, however, lacks precision and is open to widely different interpretations. Eligibility criteria are vague and the nature and extent of benefits are decided upon by Government without apparent consistency. The significance of several of the main incentives is more apparent than real because they are made redundant by other Government regulations. For example, the general tax law offers to all investments accelerated depreciation schedules for 50 to 100 percent of the investment, which is equivalent to the corporate tax relief offered by the Code. Similarly, higa protection through import taxes makes some investments profitable even without tax relief which means that the Government may be unnecessarily foregoing fiscal revenues.  - 14 - 49. The Investment Code makes a distinction between three categories of activities: those reserved to the state, those calling for joint ventures between the state and private investors and those open to private initiative. However, the content of each category is not defined. The Code gives greater advantages to new Credits as against investments for expansion, rehabilitation or modernization. This has not proven appropriate during recent times when consolidation of existing capacity should have been the correct policy objective. Also, generous accelerated depreciation provisions and easy access to tax-free imported equipment favor capital intensive techniques, which is not consistent with the employment-creation objectives of the Government. Export Incentives and Regulations 50. Additional incentives to those granted to all investors are, in principle, available to exporters under an ordinance enacted in 1973. which also regulates export procedures. On the incentives side, it has never become operational for lack of specific legislation required for its implementation. According to the dormant provisions of the ordinance, export enterprises would benefit from partial or total exoneration of import taxes on capital goods and from partial or total income tax relief. In addition, exports would benefit from a number of other provisions such as access to special credit windows, insurance, technical assistance, and duty free imports of inputs. On the other hand, until recently the regulatory side of the ordinance had restricted freedom of exporting. Each exporter had to hold an exporter's card, which was valid for specific goods only and had to be renewed every year. In addition, each export shipment had to be authorized, such authorization being given only when the Government was satisfied that the proposed operation did not contravene existing regulations and the invoiced price was adequate. Delays in granting authorizations had sometimes resulted in cancellations of orders. Under the proposed operation, these procedures have been simplified and streamlined (para. 61). P4RT III - THE GOVERNMENT ADJUSTMENT PROGRAM IN INDUSTRY A. The Adjustment Process 51. The economic crisis of the early 1980s has prompted the Government to reconsider many of its past policies and to appreciate that a sustained improvement In the economy's performance requires policy reforms. In 1981, in the face of the deteriorating economic situation, the Malagasy Government began implementing stabilization measures aimed at containing aggregate demand. The thrust of Madagascar's stabilization efforts, supported by the IMF through several stand-by arrangements, included tax measures, an improved expenditure control system, increases in tariffs charged by public enterprises and a reduction in consumer subsidies. As a result of austerity measures, the overall public sector deficit was reduced from 18.4 percent of GDP in 1980 to 8.7 percent in 1982 and to 6.7 percent in 1983. The resource gap was also reduced from about 17 percent of GDP in 1980 to 9.5 percent in 1982 and to 8 percent in 1983. Fiscal restraint and tight money played a significant role in reducing  - 15 - annual inflation to an estimated 22 percent rate in 1983. compared to over 30 percent in both 1981 and 1982. 52. Given the fiscal adjustment already achieved, further deficit reductions are likely to be slower and their balance of payments impact sma7ler than in 1982 and 1983. As a result, the Government, supported by a fourth IMF stand-by arrangement, has recently begun to emphasize the liberalization of pricing and marketing arrangements in agriculture aimed at improving production and export performance. Government also recognizes that the revitalization of industry on an efficient basis would make an important contribution to overall economic recovery. B. Towards a New Industrial Strategy 53. The Government, operating in a difficult short-term setting, has either taken, or is considering, measures to reestablish an economic environment conducive to efficiency. The country's economic team is attempting to strike a balance in the pace of policy reforms in order to achieve greater efficiency in the industrial sector without causing severe economic dislocation and possible social unrest. An immediate objective of the Government's industrial strategy is, therefore, to raise the level of capacity utilization of the sector so as to promote the production of consumer goods and exports. Increased availability of basic industrial goods would provide incentives to farmers to raise agricultural production. Increased industrial exports would also contribute towards regaining external equilibrium. Through the reactivation of the industrial sector, the Government also wishes to avoid reductions of employment opportunities for the country's growing labor force. Building on important initiatives already undertaken in the areas of economic stabilization and agricultural pricing, the Government has already begun moving to decontrol the prices of a large majority of manufactured goods, to adopt a more rational public investment program, to introduce measures to encourage industrial exports, to remove some import restrictions and to implement an investment code tha. encourages private sector initiative. Major aspects of the Government's new industrial policies are summarized below. 54. (a) Price Controls: Extensive use of price controls with the stated objective of defusing inflationary pressures and guarding against the possibility of excessive price increases in the absence of competitive markets, has aggravated shortages and distortions and has also inflicted financial hardship on enterprises (para. 47). Consistent with Bank Group advice, the Government has already taken some steps to render the price control system more responsive, such as acting within one month on requests for price increases. Under the proposed Credit the price liberalization process would be significantly advanced. 55. The Government has decided to free prices of manufactured goods representing 70 percent of value added in manufacturing before the release of the second tranche of the proposed credit. Specifically, prices of manufactured goods representing about 35 percent of manufacturing value added have already been freed and another 35 percent will be freed between effectiveness and the release of the second tranche (Schedule 4 of Development Credit. Major products whose prices will be decontrolled  - 16 - decontrolled include textiles, cigarettes, shoes and cement. A list of 31 goods representing approximately 30 percent of manufacturing value added would not be decontrolled during the life of the proposed Credit. The Government wishes to continue controlling for the meantime prices of certain basic necessities and of certain goods which are produced by monopolies. These include sugar, bread, flour, paper, soap, school materials, medicine and candles. 56. The Government's strategy, as spelled out in its development policy statement (Annex III), is to ultimately phase out price controls on most of the remaining 31 goods. In the meantime, price control procedures for these goods would be made more flexible by allowing enterprises to put price increases into effect if the Government has not objected within thirty days from the submission of the application. To the extent possible, prices of controlled goods would also be set at levels prevailing in competitive markets for the same goods in comparable countries and in no case would an efficient manufacturer be forced to price his output below the average cost of production. The Government has already begun moving in this direction by recently authorizing a 50 percent increase in the ex-factory price of sugar and a 40 percent increase in the price of paper. 57. (b) Public Investment Program in Industry (PIP): The appraisal mission reviewed 21 industrial projects under execution. Sixteen of these projects have been inadequately prepared, and are likely to face significant technical, financial or economic problems and their viability is doubtful. For most of these projects Government plans no further investments unless and until their viability (either in their present or some restructured forms) is established. In order to assess the viability of these projects and make specific recommendations, specialized consultants will carry out a full analysis of their economic, financial and technical aspects. Terms of reference for the study of these projects, financed under a PPF of US$500,000, have already been approved by IDA. As the studies for these projects are completed, Government and IDA would reach agreement as to their future. 58. For 1984, an understanding on the industrial investment program has been reached with the Government. An appropriate level of investment, consistent with available resources and the implementation capacity of the Government providing for a total 1984 public sector investment in industry of FMG 10.4 billion (about US$17 million) was agreed. This contrasts with an annual average in excess of FMG 50 billion (US$80 million) since 1979. 59. A major issue facing the Government in the area of public investment is what to do about the economically dubious Zeren urea plant which is by far the single most important industrial public investment in Madagascar. With total cost estimated at about US$80 million, Zeren is the largest of the 21 projects under implementation in the industrial sector and accounts for 28 percent of the expected total investment cost of these  - 17 - projects. Construction of the project is 95 percent complete and investment of only about US$3 million remains to be made. Because of doubts regarding the Zeren project, Government has agreed not to start-up its operation--except on a limited pilot basis--until a consultants'study, satisfactory to the Association, has established that its operation (either as originally conceived or through appropriate redesign) would be economically justified, treating existing investments as a sunk cost. Government has also agreed not to start-up the largely completed Hamisoa vegetable oil factory, another large scheme whose viability is questionable, unless a satisfactory study establishes that it, too, is or can be rendered (through modifications) economically justified (Development Credit Agreement, Section 3.06). 60. In addition, the understandings reached between IDA and Gjovernment include: (i) the PIP in industry for 1985 would be agreed upon as a condition of effectiveness (Development Credit Agreement, Section 6.01 (c)); and (ii) agreement on the PIP in industry for 1986 would be a condition of release of the second tranche (Schedule 4 of Development Credit Agreement). As a further safeguard against the launching of greenfield projects of dubious economic merit, the government would consult with IDA before starting any major new industrial projects (Development Credit Agreement, Section 3.07). Agreement has been confirmed that this consultation will take place for all new projects for which total investment is in excess of US$4 million. 61. (c) Export Promotion: The encouragement of exports is one way to eventually break out of the foreign exchange constraints holding back the recovery and longer term development of the industrial sector in Madagascar. Until recently, however, Government policies had created an export climate characterized more by procedural impediments than by encouragement (para. 50). This is beginning to change. The recently enacted devaluations of the Malagasy franc can be expected to provide a stimulus to exports and the Government is now allowing manufacturers to import goods needed for the production of exports. Moreover, in the course of preparing the proposed Credit, the Malagasy authorities have simplified export procedures. Exporters are now licensed to export a range of goods rather than only specific items as was previously the case. Export cards are now renewed automatically, and the requirement for Government clearance prior to each consignment has been dropped for all exporters with a previous export record and has been replaced by selective ex-post checks. 62. Because of the severe shortage of foreign exchange, exporters have to apply to the Ministry of Industry, like all industrial enterprises, for the allocation of a foreign exchange quota. It is, however, not uncommon for foreign exchange not to be available in the banking system to honor this quota. As a step towards easing the difficult environment in which exporters have to operate, a ministerial decree of March 1983 established a scheme known as the EPI account (export, parts, inputs), whereby exporters are assured access to part of their net export receipts to pay for their spare parts and inputs used in the production of exports. In June 1983 about a dozen firms in mining, fishing, textiles and leather were guaranteed access to foreign exchange ranging from 10 percent (mining) to 30 percent (leather) of their net export receipts for their own import  - 18 - requirements. More recently, other firms have been able to negotiate retention rates sufficiently high to cover their needs for imported goods. The Government has indicated its willingness to apply the EPI account to all manufacturing exporters. Satisfactory implementation of the EPI system for all exporters will be a condition for the release of the second tranche (Schedule 4 of the Development Credit Agreement). 63. Preliminary agreement has also been reached with the Government on the following practical measures which are designed to increase further the incentive to export: (i) export taxes for all manufactured goods would be eliminated and (ii) exporters of manufactured goods would be exonerated from all indirect taxes on raw materials and spare parts used as inputs in export production. Beyond these measures, which should be in place as a condition of the Credit's effectiveness (Development Credit Agreement, Section 6.01 (e)), the Government has indicated its willingness to prepare a program of actions designed to further increase the profitability of exports. This could include, for example, an improved export earnings retention scheme, an effective duty drawback system and the creation of a special unit in the Ministry of Commerce that would provide a "one-stop- service to assist exporters in all aspects of the export activity. The terms of reference for consultants to help with the preparation of this program were agreed at negotiations and the consultants' hiring would be made a condition of effectiveness of the proposed Credit (Development Credit Agreement, Section 6.01 (b)). The actual enactment of a satisfactory program would be a condition for the release of the second tranche (Schedule 4 of the Development Credit Agreement). 64. (d) Import Restrictions: All Madagascar imports--except those needed by manufacturers to produce exports--are subject to either quantitative restrictions or prohibitions (para. 46). In order to move towards opening up the economy and promoting greater efficiency, the Government has also undertaken to prepare an action program for import liberalization. This would initially involve removing prohibitions on the imports of some goods and replacing them by tariffs. A list of goods satisfactory to the Association would be established with priority given to permitting imports of goods that are currently produced by local monopolies and/or which are basic necessities. As a first step, prohibitions would be lifted before the Credit's effectiveness on five percent of the goods whose importation is currently prohibited and on another 15 percent before the release of the Credit's second tranche. Import licences and some foreign exchange would be made available for the importation of these goods (Development Credit Agreement, Section 6.01 (d), and Schedule 4 of the Development Credit Agreement). In addition, the Government has agreed with the IMF that products accounting for five percent of the 1984 import program will be put on an Open General License system. Thereafter, the Government's action program will spell out the details of further progressive relaxation of import restrictions and prohibitions. The program will be prepared with the help of consultants financed under the Technical Assistance Component of the proposed Credit (para. 94 (iii)) and the terms of reference for this technical assistance were agreed at negotiations. The hiring of the consultants who would assist Government in drawing up this action program would be a condition of credit effectiveness (Development Credit Agreement, Section 6.01 (b)).  - 19 - 65. (e) Investment Code/Charter of Socialist Enterprises: The Investment Code, enacted in 1973, has some significant defects (paras. 48 and 49). The Investment Code has an impact on the size, nature and direction of investment, along with the overall stability of the economic and political environment. Policies such as those contained in the package outlined in this report would contribute to economic recovery and efficient growth and should encourage private investors. Further encouragement could be provided as the degree of regulation and bureaucratic requirements, some of them dictated by the current economic and financial crisis, are reduced. 66. At the request of the Government, the European Development Fund sent in January 1984 an expert from SEMA, a French consulting firm, to review the Code with the authorities and prepare the draft of an improved Investment Code. The Government has agreed to consult with the Association on a final version to be submitted to Parliament before the release of the second tranche of the proposed Credit (Schedule 4 of the Development Credit Agreement). 67. The Charter of Socialist Enterprises, a law enacted in 1978, stipulates that any enterprise in which the State has 51 percent of the share capital will be converted to a socialist enterprise, to be managed by committees with worker participation. The Government recognizes that this constitutes an obstacle to attracting foreign partners in industrial ventures. As indicated above, the Government has been flexible in the application of this Charter. The Government confirmed that it will continue to apply the Charter in a flexible manner (e.g., that the provisions of the Charter would be waived when so agreed between the Government and private investors at the time of company establishment). This is confirmed in the Government's Statement on Industrial Policy (Annex III). 68. In addition to the specific program for the industrial sector outlined above, the Government is also undertaking several initiatives designed to improve efficiency and resource allocation in the public sector. These are outlined below: 69. (a) Industrial Public Enterprises: In the area of industrial public enterprises, wherever financial performance has been particularly poor the Government has taken action. Five companies have been recently shut down and further closings are under consideration. The Government is also negotiating the sale of equity participations in 10 public enterprises to private sector shareholders who will also assume responsibility for management. Supported by the Credit recommended in this report, the Government is starting to improve the policy environment in which public enterprises operate and this, together with efforts to improve their management, should have a positive impact on their performance. 70. (b) Foreign Exchange Allocation: Import programs have been established under IMF stand-by agreements for the past few years but the foreign exchange availability has not been adequate to meet the needs of even a minimum import program. A Technical Committee on External Payments was established about 18 months ago. The Committee meets weekly under the chairmanship of the Minister of Finance and includes high-level  - 20 - representatives of the Central Bank, the Planning Directorate, the commercial banks and main economic ministries. The Comuittee's main function has been to establish short-term schedules and priorities for meeting foreign exchange payments falling due. 71. More recently, the Committee has begun to address problems of assessing the foreign exchange needs of the economy, to establish a system of foreign exchange budgeting and to develop criteria for foreign exchange allocation which could become more automatic as the foreign exchange situation eases. This committee operates effectively. It is, however, desirable to progress from the current 'emergency and short-term' procedures for foreign exchange allocation to a more systematic approach. Bank Group staff have discussed with the Central Bank and the Planning Directorate staff the formalization of a foreign exchange allocation system which establishes priority criteria, ensures a more automatic and less administratively controlled system, and a more adequate allocation to the private sector. 72. (c) National Public Investment Program: The Government has recently begun to take steps to improve the process of public investment programming and control. This initiative, apart from bringing Government investments in line with projected resource availabilities and ensuring a degree of coordination between ministries and agencies that has been lacking in the past, emphasizes rehabilitation and maintenance rather than new investments. Proposed reforms in the area of public investment in which Bank Group Staff have actively assisted the Government include: a) establishment of institutional and administrati%e procedures which ensure an effective inter-ministerial coordination of investment decisions; b) establishment of a rolling three year public investment program geared to resources economically available, in line with priority activities in the economy and closely integrated into the annual Government budget; and c) improvement in investment project preparation capability in the main economic ministries and in the Planning Directorate. An Investment Coordinating Committee has been established and its composition, objectives and terms of reference have been reviewed by Bank Group staff. The proposals cover, in detail, procedures for review and decision-taking for all phases of the project cycle. The Committee's decisions on investment selection will be governed by agreed selection criteria. The establishment of these procedures represents considerable strengthening of public investment management. The Government has requested assistance from the World Bank and from France to further improve its public investment planning system. The Bank has decided to second a staff member to assist in this task. 73. (d) External Debt Management: Procedures for decision taking on the contracting of new external loans for Madagascar require further improvement. Considerable progress in reporting, recording and processing data on external debt has already taken place and the Government has prepared proposals for the establishment of an Investment Financing Committee. Proposals on the compcsition, role and terms of reference of this committee have been reviewed by Bank Group staff and they represent considerably improved safeguards for the contracting and monitoring of external debt. The Investment Coordinating Committee and the Investment  - 21 - Financing Committee would be jointly responsible for submitting Public Investment Program proposals to Government. 74. In parallel to the introduction of the industrial policy measures described in paras. 53 to 67 and the national resource allocation measures outlined in paras. 69 to 73, the Government's other main priority is to provide foreign exchange to efficient enterprises so that raw material inputs necessary for a higher level of industrial production can be imported. This would be consistent with the Government's demand management objectives. The 1984 import program agreed with the IMF provides for a 17 percent increase in raw materials for the purpose of reactivating industrial production despite a 7 percent reduction in the overall import program. For 1985, imports of raw materials are programmed to increase by a further 21 percent over the 1984 level. The credit recommended in this report, whose main component consists of providing foreign exchange for raw material and spare parts imports for efficient industrial enterprises, supports this objective as well as the measures the Government has taken--or is considering--as it moves towards a new industrial strategy. PART IV. THE PROPOSED CREDIT A. Credit History and Rationale 75. In 1981 the Government raised with the Bank Group the possibility of balance of payments assistance and opened discussions with the Bank on a broad program of sectoral reforms. In the following year, a mission visited Madagascar and determined that the situation of industry had deteriorated seriously and that extensive policy reform was required. In June of 1983 a mission discussed a program for the rehabilitation of the industrial sector. 76. The proposed Credit was appraised by an IDA mission in January 1984. A post-appraisal mission visited Madagascar in June 1984. Negotiations were held in Washington from November 5 to 16 and in Paris from November 26 to 30. The Malagasy team was headed by Mr. Leon Rajaobelina, the Malagasy Ambassador to the U.S.A. 77. The preparation of the proposed Credit has served as a useful vehicle for the dialogue between Government and the Bank Group on a number of far-reaching policy changes affecting a variety of macro and industrial sector issues. These policy changes constitute important first steps towards transforming Madagascar's industrial sector into a more efficient, open, export-oriented one which can make an increasingly important contribution to the country's balance of payments and to the growth of employment and output. B. Previous Bank Group Support for Industry 78. Previous Bank Group assistance to the industrial sector has been through a DFC line of credit of US$5.0 million to BNI (No. 977-MAG).- This Credit was approved in January 1980. At the end of November 1984, the Credit was about 98 percent committed, while disbursements amounted to US$3.2 million. The Credit was committed more slowly than expected at approval mainly because the economic recession in Madagascar resulted in  - 22 - the delaying or cancellation of several new investment proposals whlch were envisaged by BNI. Instead, several smaller rehabilitation proposals were approved. In addition, the demand for foreign exchange has been far greater for spare parts and raw materials than for fixed investment. C. Credit Objectives 79. The basic purpose of the proposed Credit of SDR 40.2 million ($40 million equivalent) is to bring about significant policy changes in the industrial sector designed to increase its efficiency and, at the same time, to help Increase the capacity utilization of the industrial sector and promote the production of exports and consumer goods. Good possibilities exist in the sector for both efficient import substitution and some export promotion. Production capacity already exists in local industry and, by increasing capacity utilization levels, output could be revived without any significant increase in new investment. In the context of the proposed Project's preparation, the Government and the Association have reached agreement on development objectives for the sector and on the most appropriate strategy to achieve them. These understandings are reflected in the Goverament's Statement on Industrial Goals, which is presented in Annex III of this report. This Credit is a first step in an effort aimed at eliminating distortions in the sector and the economy and it is anticipated that further reforms will be achieved through subsequent IDA Credits in the sector. The main features of the policy reforms which this Credit supports were discussed in paras. 53 to 67 above and are summarized below in the form of a matrix on page 22 (i) - (iv). D. Credit Components and Timing 80. The proposed IDA Credit of SDR 40.2 million would include the following three components: a) Financing for the importation of spare parts, raw materials and other inputs for priority enterprises; SDR 33.7 million b) Financing of equipment for rehabilitation of selected enterprises; and 5.0 c) Technical assistance to the Ministry of Industry, Energy and Mining. 1.5 SDR 40.2 million The proposed Credit would be made to the Government. The SDR 33.7 million of foreign exchange assistance for spare parts and raw materials would be sold by the Central Bank to eligible enterprises through the commercial bank network while SDR 5 million would be onlent to BNI, the Bank for Industry, and SDR 1.5 million would be made available to the Ministry of Industry, Energy and Mining.  SUMMY OF aMovNr MhiM FRW IMRl WM TDbUMI OF MPMNrATION Before Board Prentatton Firt Year Pnvgran CondMotin of Rleie4we - ium Tem , ~~~~~~of Seod Tvach I - Price Ulberaliwation Objective: lb mwa the KakIsy Peice of w