Tunisia - Export Industries Project

Document of The World Bank FOR OFmFCIAL USE ONLY ,< ,X SEZ- 7vuA/ Report No. P-3996-TUN REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN THE AMOUNT EQUIVALENT TO US$50.0 MILLION TO THE REPUBLIC OF TUNISIA FOR AN EXPORT INDUSTRIES PROJECT April 2, 1985 This document hs a restricted distribution and my be used by recipients only in the perfornmnce of their official duties. Its contents -y not odwewise be disclosed without World Bank authorization. .  CURRENCY EQUIVALENTS December ;983 December 1984 Currency Unit = Tunisian Dinar (TD) TD US $ 1 TD 0.7302 TD 0.8344 TD 1 US $1.3695 US $1.1985 Exchange rate used in the Appraisal Report is TD 0.8344. Fiscal year = Calendar year List oE Abbreviations BCT Banque Centrale de Tunisie BDET Banque de Developpement Economique de Tunisie BNDT Banque Nationale de Developpement Touristique BTEI Banque de Tunisie et des Emirates d'investissements BTKD Banque Tuniso-Koweitifqne de Developpement BTQI Banque Tuniso-Qatari 2.Investissements CEPEX Centre de Promotion des Exportations COTUNACE Compagnie Tunisienne d'Assurance de Commerce Exterieur EMI Electro-Mechanical Industries ERR Economic Rate of Return FRR Financial Rate of Return SSI Small-Scale Industries STUSID Societe Tuniso-Seoudienne d'Investissement et de D6veloppement UTICA Union Tunisienne de l'Industrie, du Commerce et de l'Artisanat (Chamber of Commerce)  FOR OMCIAL USE ONLY REPUBLIC OF TUNISIA EXPORT INDUSTRIES PROJECT LOAN AND PROJECT SUMMARY Borrower: Republic of Tunisia. Beneficiaries: Banque de Developpement Economique de Tunisie (BDET), Banque Tuniso-Koweitienne de D6veloppement (BTKD). and Societe Tuniso-Seoudienne d'Investissement et de Developpement (STUSID). Amount: US$50 million equivalent. Terms: 17 years, including 4 years of grace, at the standard variable interest rate. Onlending Terms: The Government would onlend $50.0 million equivalent in Dinars of the Bank loan to BDET ($20 million equivalent), BTKD ($15 million equivalent) and STUSID ($15 million equivalent) at the Bank's standard variable interest rate. BDET, BTKD and STUSID would repay their loans to the Government according to a composite amortization schedule of the sub-loans financed out of the proceeds of the loan. The Government would bear the foreign exchange risk. Sub-borrowers would be charged an effective interest rate of at Least 11 percent per annum. Proiect Description: The project would assist the Government of Tunisia in developing Tunisia's export industries through a line of credit to BDET, BTKD and STUSID. The Project also includes the establishment of an Export Promotion Fund and technical assistance to Compagnie Tunisienne d'Assurance de Commerce Exterieur (COTUNACE), the Government's newly established export credit insurance company. The project consists of a line of credit of US $50 million equivalent to BDET, BTKD and STUSID to enable these banks to make sub-loans for eligible export projects. This document has a stricted distribution and may be used by recipients only in the performance of their official duties Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Assistance from bilateral sources and UNDP will finance a $0.15 million equivalent technical assistance package to COTUNACE. The Government is financing from its own resources the Export Promotion Fund. The project will increase export earnings and job availability, strengthen three development banks and COTUNACE, and, through the Export Promotion Fund, encourage such marketing aud promotion. The project involves no special risks, though some risk is attached to external factors which could depress export possibilities. Estimated Disbursements: (in $'000) Bank FY FY86 FY87 FY88 FY89 FY90 FY91 Annual 2550 11075 17000 11250 5525 2600 Cumulative 2550 13625 30625 41875 47400 50000 Appraisal Report: No. 5251-TUN of March 20, 1985 Map: No. IBRD 18707 .  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF TUNISIA FOR AN EXPORT INDUSTRIES PROJECT 1. I submit the following report and recomendation on a proposed loan for the equivalent of US$50.0 million to the Republic of Tunisia to help finance an Export Industries Project. The loan would have a term of 17 years, incl-uding 4 years of grace, at the standard variable interest rate. Twenty million dollars of the proceeds of the Loan would be onlent to the Banque de D6veloppement Economique de Tunisie (BDET), $15 million to Banque Tuniso-Koweitienne de Developpement (BTKD), and $15 million to Societe Tuniso-Seoudienne d'Investissement et de Developpement (STUSID) for a term of 17 years, at the Bank's standard variable interest rate. The Government would bear the foreign exchange risk. PART I - THE ECONOMY -' 2. A special economic report entitled "Tunisia - Review of the Sixth Development Plan (1982-86)" (No. 4137-TUN), in two volumes, was distributed to the Executive Directors on March 16, 1983 and June 29, 1983. An economic mission to review the performance of Plan implementation at mid-term visited Tunisia in April 1984; its findings are reflected in this part and the country data sheets, attached in Annex I. 3. Tunisia is a medium-size, middle-income country with a population of 7 million and a per capita income of $1200.-' Much of Tunisia is arid or semi-arid. Only three percent of arable land is irrigated, and areas where rainfed agriculture is possible are subject to severe year-to-year fluctuation in rainfall. Nevertheless, agriculture still occupies nearly one out of every three Tunisians in the labor force. Tunisia's most important raw materials are phosphates, petroleum and natural gas. Known exploitable reserves of oil and gas are approaching depletion, and new hydrocarbon reserves are limited and require costly off-shore drilling; priority is now given to slowing down the growth of domestic consumption by - conservation and pricing measures. The low quality of phosphate deposits constrains the expansion of the highly efficient Tunisian phosphate processing industry. The country also has considerable tourism potential, but after a period of rapid expansion, the sector is experiencing difficulties in maintaining competitive prices and quality standards. 4. Tunisia has undertaken a massive effort to develop its human resources, 1/ Part I is substantially the same as Part I of the President's Report No. P-3954-TUN of February 20, 1985 for a Northwest Agricultural Production Project. 2/ 1984 preliminary figure at current prices and current exchange rates.  - 2 - paying special attention to family welfare, education, and technical and vocational training. As a result, between the early 1960s and the early 1980s, the infant mortality rate declined from almost 160 to 65, the expectation of life at birth rose from 48 to 61 years, the adult literacy rate increased from about 15 to about 62 percent, and average caloric supply per capita increased from 83 to 116 percent of minimum standard requirements. An active family planning policy pursued by the Government led to a decrease in fertility and birth rates. Even though mortality rates also decreased, the gross reproduction rate decreased markedly from 3.5 to 2.1 percent over the same period. However, since net emigration of Tunisians abroad was sharply reduced by restrictive measures taken in the EEC countries and Libya, the growth rate of the labor force accelerated, a main reason for the rapidly growing, serious unemployment problem. Open unemployment reached 14 percent in 1983 and underemployment is extensive. These problems are particularly serious among young school dropouts. 5. During the 1970s, the Tunisian economy did extremely well. Rapid growth in the range of 7-8 percent was accompanied by substantial structural transformation as manufacturing and tourism became more diversified, and their share in total exports increased. Economic performance benefitted from substantial terms of trade gains due to the rapid price increase of oil, allowing both consumption and domestic savings to increase and investment to remain high (over 30 percent of GDP). It also benefitted from improved economic management with a cautious shift toward a more liberal, market-oriented economy. The current account deficit, averaging 5 to 6 percent of CDP over the period, was easily financed, much of it by direct foreign investment. The only major problem was a high rate of unemployment and underemployment. 6. To accelerate job creation, more than half of total investments of the Fifth Plan (1977-81) was allocated to directly productive sectors, but the direct employment effects of the leading sectors (petroleum, phosphate mining and processing, and tourism) were small and unemployment continued to increase. These sectors, however, made a vital contribution to GDP, public savings and exports. They provided 52 percent of the country's fGre-ign exchange earnings in 1983, while manufacturing activities, except phosphate-based chemicals, provided 19 percent. 7. The Sixth Plan (1982-86) proposes a number of policy reforms to face the consequences of rising unemployment and the progressive decline in net energy exports. Its main objectives were employment generation, export promotion, regional development and public sector efficiency. Investment priority was given to agriculture, engineering industries and tourism. The overall rate of investment was projected to decline during the Plan period. To minimize the effects on economic growth and employment, measures were proposed to increase the efficiency of existing investments and to encourage a shift to labor-intensive activities. These measures were to be accompanied by a substantially tightened incomes policy, in particular cautious wage and salary policies and a considerable slowdown in the growth of recurrent budget expenditures.  -3- 8. The Sixth Plan started poorly. In 1982, a prolonged drought depressed agricultural output and agro-industrial production, technical problems plagued the phosphate and cement industries, and tourism and exports of manufactured goods were adversely affected by the recession in Europe. The economy recovered in 1983 and 1984 due to buoyant growth in manufacturing output, stimulated by rapidly growing local demand. This brought the average annual growth of GDP in the first three years of the Plan to 3.5 percent, compared to 5.3 percent targeted. This performance is nonetheless commendable in view of the world recession and compared with other countries. 9. More worrisome than the slowdown in economic growth are the macroeconomic imbalances, which have worsened over the last years. In contradiction to the Plan's macroeconomic scenario, the investment rate remained high rather than declined, mainly due to high public enterprise investments in energy and transportation, and consumption expanded rapidly, fuelled by sharp increases in wages and salaries. The corresponding strong demand pressure, facilitated by rather liberal credit policies, was reflected in rising inflation: 13.6 percent in 1982, compared to a 7.8 percent average over 1977-81; it was slowed to 9 percent in 1983 through increased price controls. Lower than planned overall economic growth, higher capital intensity of new investments, and the sharp increase in labor costs combined to keep employment creation below Plan goals, and unemployment further increased. 10. Despite a virtual stagnation of imports (in constant prices) due to tightened import control, the current account deficit of the balance of payments deteriorated to 8.2, percent of GDP by 1984. A fall in exports of petroleum and of agricultural products, and a slowdown in tourism, depressed export receipts. Direct foreign investment (mainly in the oil and gas sector) stagnated in 1983-84. Nevertheless, Tunisia's net foreign exchange reserves increased substantially to reach 1.7 months of imports at end-1983, as compared to 1.4 at end-1980. This reflects, inter alia, a revaluation of the Central Bank's foreign exchange assets, as well as the Government's drawing down part of a syndicated Eurodollar loan contracted in 1982. In mid-1984, reserves were some 13 percent above the mid-1983 level. 11. The budgetary situation has also deteriorated since 1981; the Central v Government's overall budget deficit jumped from 1.7 to 7 percent of GDP between 1981-84. This reflected increases in public investments and in recurrent expenditures due to wage and salary increases, higher subsidy payments to households and public enterprises, and growing dollar-denominated debt service payments caused by the 30 percent dollar appreciation vis-a-vis the Tunisian dinar batween 1981-84. On the other hand, this latter factor helped keep petroleum revenues from falling, and total revenues showed a continuous growth despite the recession. In 1983-84, recurrent expenditure growth slowed considerably, however, as a result of a freeze in Government salaries and wages and of lower consumer subsidies.  - 4 - 12. Medium-term prospects depend on two main factors: future developments in the hydrocarbon sector; and the speed with which the Government implemen:ts the far-reaching macroeconomic policy changes outlined in the Sixth Plan. Oil and gas exploration programs under way have not been encouraging. Based on known reserves, and with the possible exploitation of smaller fields that recently became profitable, it is generally expected that domestic oil and gas production could be stabilized at abo,; its present annual level of 5-6 million tons of oil equivalent until the end of the decade. Barring large new oil or gas discoveries, and given the rise in domestic demand for energy, Tunisia would turn into a net importer of oil in the early 1990s. 13. Making the necessary adjustments to prepare the economy for the post- hydrocarbon era is made more difficult by increasing financial and balance of payments constraints. While there is little disagreement about the desirability or objectives of economic reform, the appropriate implementation measures and particularly the speed of reform are more controversial. While undeniable progress has been made since the early 1980s in several respects, other factors have worked in the opposite direction (para. 14). Over the last years, the Government has focussed with some success on administrative type measures. Legitimately concerned with the immediate economic and social problems, it resorted to short-term measures and direct, quantitative controls such as mandatory price reductions and import restrictions. Among longer-term policies, only export promotion was addressed by a sufficiently broad approach (tax rebates, foreign exchange risk insurance, special credit, trade companies). The price liberalization process has moved slowly, with some reductions in price subsidies (particularly for agricultural inputs, transportation and energy) and some liberalization in the price regimes for manufactured goods. Economic incentives have been modified to promote regional development and stimulate smaller firms, but the existing bias in favor of capital-intensive investment rather than employment has little changed. Finally, fiscal reform has been initiated. 14. Policy reforms to address the root causes of the structural imbalances identified by the Sixth Plan have been less actively pursued. Specifically, major areas that need greater attention are: (a) wage and salary policies, which should become more restrictive, so as to slow down growth of public and private consumption and stimulate savings, labor-intensive investments and exports and, thus, increase employment creation. As mentioned before, recent trends have been in the opposite direction; (b) subsidy policies, with consumer subsidies to be reduced so as to dampen private consumption and stimulate public savings. Some encouraging first steps have been taken in this respect, but more action is needed; (c) interest policies, to make interest rates positive in real terms, so as to stimulate savings and labor-intensive investments. A thorough reassessment of these policies is underway; {d) public enterprise reform, to stop the drain of public enterprise deficits on the Government budget. First steps have been taken in this direction, and a number of enterprises have been closed; (e) public investments, which should be reduced to decrease the budget deficit, but made more efficient and reoriented so as to increase their contribution to economic growth and employment creation. A particularly careful screening of projects will be necessary in the future; (f) domestic protection and pricing policies so as to create more incentives for exports, particularly for manufactured products; and {g) exchange rate policies, so as to ensure that exports (including tourism) become more competitive.  15. Even if the Government moves more rapidly in implementing all or most of the above measures, the delays incurred so far in meeting the Sixth Plan macroeconomic targets and in implementing its policy recommendations will probably not be recovered by 1986. It is unlikely therefore that medium-term GDP annual growth will match the 6 to 8 percent rate achieved in the past. A growth rate not exceeding 4 percent would be more commensurate with the need to control current account deficits without a systematic recourse to quantitative protection measures or excessive external borrowing. This 4 * percent growth rate takes account of the projected stagnation or even decline of hydrocarbon production. It also assumes that while agriculture will remain sensitive to weather conditions, manufacturing will perform well as the full impact of the export promotion policies is felt. 16. Social Issues. Since independence, the country has gone a long way towards meeting the basic needs of its population. Over 16 percent of GDP is now devoted to social programs, and the number of absolute poor declined from 17 percent of total population in 1975 to 13 percent in 1980. This improvement was largely concentrated, however, in urban areas. Since 1981, social issues have faced a different context than in the 1970s. when an easy financial situation seemed to allow a relatively unconstrained expansion of social services. On one hand, the Tunisian population has become incre;isingly aware of and sensitive to thp issues of income distribution ar.d the Government's responsibility for redistribution. Furthermore, the beneficial effects of past rapid expansion in social services, reflected in the improvement of the country social data (see Annex I), have created a demand for improved standards in social services delivery. On the other hand, the provision of adequate social services - education, health, town infrastructure, housing - is being increasingly hampered by budgetary constraints. Attempts to -espond to protect the workers by raising the levels of minimum legal wages and social insurance has discouraged private business from increasing employaent. 17. To reduce internal differ-nces, in parcicular between rural and urban areas and among workers in the modern sector and those precariously employed in informal activities, the Covernment is channelling more resources into regional development and youtch employment. Integrated rural programs are being developed to stimulate productive job creation and grassroots participation. Subsidses an-d credit facilities are granted for young technicians to create tieir own enterprises and for entrepreneurs to create new projects in underdeveloped regions. More efforts are needed, however, to strengthen the coo-dination of vocational and on-the-job training with market demand. To reduce the financial burden of social services, the administration is reviewing the cost structure of the various types of social services, including free or below-cost delivery and the introduction of some user fees. Special efforts are needed to improve social infrastructure mAnagement, in particular as regards hospitals. Also, decentralization of social facilities in deprived zones will have to be assessed carefully because costs for servicing and maintaining them could become rapidly prohibitive. 18. External Assistance and Foreign Debt. During the second half of the 1970s, foreign borrowing was modest and a large share of foreign funds was  -6- provided by public sources at relatively soft terms. At the end of 1979, debt outstanding and disbursed was estimated at $3 billion, or 42 percent of GDP; debt service was 10 percent of export revenues. For reasons mentioned earlier (para. 10), the balance of payments deficit has increased substantially since then, as has foreign indebtedness. Total public foreign debt outstanding and disbursed at the end of 1983 is estimated at $3.9 billion, equivalent to about 48 percent of GDP; according to preliminary estimates, it reached about $4.3 billion (52 percent of GDP) at the end of 1984. The relative burden of debt servicing reached 18-20 percent in 1983-84. However, a relatively cautious debt management policy has been followed by the Tunisian authorities. While the share of short-term borrowings has increased slightly since 1980, Tunisia's overall foreign debt remains overwhelmingly long and mediumr-term, and debt service requirements are projected to increase only slowly. During 1978-82, 65 percent of foreign loan commitments were from official sources and about 30 percent on concessional terms. Just over half of official commitments came from bilateral sources (mainly France, Japan, the Federal Republic of Germany and some Arab oil-producing countries), and about 24 percent each from the Bank Group and from other multilateral sources. Overall borrowing terms were favorable, averaging 7.4 percent interest and 15.8 years maturity, including a grace period of 4.2 years. 19. In the medium-term, external capital requirements will clearly remain manageable. In the longer-term, much will depend on the policy changes to be initiated during the next few years, and on developments in the hydrocarbon sector. The Government's medium-term objective is to maintain the present level of indebtedness; this prospect strongly depends on a timely implementation of policy measures to accelerate exports, reduce public investments, lower domestic demand growth, and liberalize regulation and controls. On this basis, the current account deficit is projected to fluctuate around 0700 million until 1986, but decline thereafter. New loan commitments from abroad could be kept below $1.2 billion per year on average (in current prices at the 1984 exchange rate), while net foreign borrowing might average about $450 million between now and the early 1990s. 20. Tunisia, after a decade of outstanding performance, is facing the major challenge of adapting its economic structure at a time of external and internal financial constraints. A strategy of demand restraint combined with more liberal economic policies is called for to preserve the country's financial stability and creditworthiness and, thus, its considerable long-term growth potential. Considering its long record of prudent and skillful balance of payments and external debt management, there are good grounds to assume that Tunisia will implement the necessary policy changes, and remain creditworthy for a continued high volume of Bank lending.  PART II - BANK GROUP OPERATIONS IN TUNISIA 21. Since 1962, the Bank has committed to Tunisia sixty-five loans and ten IDA credits amounting respectively to $1,341.0 million and $75.2 million (net of cancellations) of which forty-one loans and credits have been fully disbursed. Annex II contains a summary statement of Bank loans, IDA credits and IFC investments as of September 30, 1984. Project implementation is generally satisfactory. As of September 30, 1984, overall disbursements amounted to 50 percent of appraisal estimates, which is in line with experience in other countries in the region. Disbursement performance for irrigation, industrial finance and port projects has generally been above the country average, while longer than average disbursement delays have been experienced for agricultural credit, education, highway, urban and fisheries projects, due to project-specific problems that are being addressed through supervision missions and sector discussions. In a number of sectors, important institutional improvements have been achieved, and autonomous agencies have been created or strengthened to ensure the efficient management of the related sectors or subsectors. 22. The Bank's lending strategy in Tunisia aims at supporting the country's transition from a si.tuatinn nf reliance on petroleum exports to a sectorally-balanced post-hydrocarbon era through appropriate changes in economic policies and programs. This a&justment process, as outlined in the Sixth Development Plan, will require.further diversification of exports, greater savings efforts, reduction in consumer subsidies, gradual liberalization of all sectors of the economy, and stronger incentives to the private sector particularly in agriculture and industry, while taking measures to increase employment and tarnet.d-vlopnent to low-income groups. In support of the above, the overall objective of Bank lending is to emphasize projects which have a direct and rapid impact on production, employment and exports (or import savings) and-w'"ch minimize Government net contributions. The focus of lending for agriculture and industry meets this objective. In addition te the above, pro'osed Rank lending would focus on improvement of public enterprise performance, development and conservation of energy resources, and continued support to the social sectors and operations targeted to low-income groups. For the latter, attention would be given to increased efficiency and cost-effectiveness of institutions and investments and to linkages with directly productive sectors (e.g., education reforms stressing vocational training). We envisage only marginal lending for basic economic infrastructure, focussed in areas where Bank guidance would still be useful, such as rural water supply and highways maintenance. 23. Past Bank lending emphasized support for long-term investments in infrastructure and social development, each of which accounted for about one-third of Bank/IDA commitments since 1971. The rest of the commitments were almost equally distributed between agriculture and industrial financing. In addition, the Bank has made two loans for technical assistance. Within the broad framework noted in para. 22, we expect a significant shift in our lending, with well over half going to agriculture and industry. In addition to the already approved Northwest Agricultural Production Project and this project, proposed lending in the next couple of years would include projects for irrigation, grain storage, credit lines for electromechanical and small-scale industry, textile rehabilitation, urban development, energy, and sector loans for agriculture and industry.  - 8 - 24. The Bank's economic and sector work will continue to focus on strengthening the macroeconomic and sector base for our lending program. It will be centered on the analysis of economic issues and policies, related to the necessary adaptation process from a petroleum-exportingpto importing country. This analysis, which was included in ial economic report entitled "Tunisia - Review of the Sixth Developme Plan (1982-86)" (No. 4137-TUN), dated March 16, 1983 and June 29, 1983, is being pursued through a number of studies. A mid-term performance review of the Sixth Plan is being discussed with the Government, as are studies on industrial employment creation and on the financial sector. A number of key studies resulted from provisions in Bank loans, for example on the institutional and incentive framework for electromechanical industries and for exports in general. In time, the recommendations of these studies, and of those currently in progress (industrial policy study, agricultural strategy paper) will provide the basis for policy action programs. Further economic and sector work includes studies of educational finance and administration, housing finance, and a review of public enterprise performance. 25. The Bank and IDA accounted for about 19 percent of total public commitments to Tunisia during 1982-1984. Their share in total debt outstanding and disbursed at the end of 1984 (including loans from private sources) was an estimated 14 percent, and their share in debt service during 1984 was 13 percent. The share of the Bank and IDA in Tunisia's disbursed external debt is expected to increase to 15 percent and their share in the debt service to about 13.5 percent through 1986. 26. As of September 30, 1984, IFC's net commitment in Tunisia totalled $14.0 million. IFC has invested in the Economic Development Bank of Tunisia (BDET), in 1966, 1970, and 1978; in the National Bank for Tourism Development (BINDT) to promote and invest in tourism projects; in the Societe Touristique et Hoteliere (RYM), a large hotel development; in the Industries Chimiques du Fluor (ICF), a producer of aluminum fluoride from local fluorspar for export; and in the Societe d'Etudes et de D4veloppement de Sousse-Nord for an integrated tnurism development project. In FY84, IFC approved two new equity investments in Tunisia: (i) Fluobar, a project to privatize, rehabilitate and expand an existing fluorspar mine; and (ii) Tunisia Leasing Company, the first leasing company in Tunisia to provide financing to the industrial sector. IFC is considering the following activities: (i) participation in an expansion program under study by ICF; (ii) purchase of additional share capital under expansion programs planned by BNDT and BDET; and (iii) at the Government's request, privatization of certain state-owned industrial projects. PART III - THE MANUFACTURING SECTOR AND EXPORTS OF MANUFACTURED PRODUCTS 27. The role of the sector in the economy. Manufacturing industry has been a relatively fast-growing sector. It is well diversified and has contributed successfully to the Government's main economic objectives of employment creation, attracting foreign investments and know-how, and generating foreign exchange earnings to offset the decline in oil revenues. In the long term, traditional exports, such as phosphate-based industries and agricultural products, will offer only modest growth prospects. Also, the  - 9 - size of the domestic market will provide only limited opportunities for further import substitution. Manufacturing exports, therefore, will be the principal instrument for creating additional employment. stimulating growth and alleviating balance-of-payments problems. 28. Structure and Pprformance. Manufacturing industry's share in GDP increased from an average of 7.5 percent per annum in the 1960s to 10 n percent in the 1970s and 14.2 percent in 1980-83. The average annual grjwth rate of the industry was about 11.5 percent during the period 1971-81. Following a year of stagnation in 1982, growth resumed in 1983 and reached an annual rate of 12.0 percent in real terms. Starting in the 1970s, and due largely to the Government's strong support, the private sector became a major factor in fostering this growth. Investment in manufacturing grew at an average rate of 21.1 percent in real terms during the period 1980-83 and represented 19.7 percent of total investments. The public sector accounted for over half of all investments in the sector and has concentrated its involvement in chemicals (fertilizers), construction materials (cement) and agro-industries (sugar). The private sector dominates textile and miscellaneous manufacturing industries. Employment creation has been one of the main objectives of industrial policy and close to one-fifth of the labor force is engaged in Tunisia's manufacturing industries. 29. Exports of Manufactured Products. Until the early 1970s, Tunisia's industrialization policy was based essentially on import substitution. As a result, the country's exports consisted of foodstuffs, phosphates and petroleum products. In 1972, the country initiated a major export drive. Law 72-38 instituted a generous incentive system for export industries and favorable treatment to exporters with regards to taxes, exchange controls and customs regulations; this has attracted both foreign and domestic investments into "off-shore" manufacturing operations (enterprises that export all of their output) and by 1981 provided employment for 30,000 workers. As a result, the real value of manufacturing exports increased more than four-fold in real terms during the 1971-1983 period. The vigorous growth compensated for the decrease in e'rnrte nf petroleum prodiwrtc znd, in 1983, manufactured products surpassed petroleum as the main contributor to total exports (52.5 percent, including processed foods, versus 42.8 percent). 30. Traditional exports will be insufficient to offset the projected decline in oil-export revenues. The Sixth Development Plan (1982-86) therefore puts major emphasis on the stimulation and diversification of manufactured exports. Past export performance, based on the country's comparative advantage, suggests that the Plan's emphasis is appropriate. Tunisia has a well-trained labor force whose wages are still well below European levels; it has liberal investment policies with regard to foreign and private investments, is close to Europe and the Arab countries, and has preferential access to the EEC market. This gives the country a comparative advantage in efficient production of capital, intermediate and consumer goods for exports, particularly in sub-sectors using labor-intensive ani simple or intermediate technologies. However, to realize this export potential, Tunisia would have to further improve its sectoral policies (para. 31) and also meet the long-term financial and institutional support needs of investors in a time'Jy and efficient manner. In this respect, its established development banking system would have a major role to play, and this project supports this role.  - 10 - 31. Industrial Sector Constraints. To attain the full development and export potential in the sector, the Government would need to further address imbalances in the relative factor costs of labor and capital and in the protection/incentives structure on three major fronts. First, due to strong unions, the cost of labor is rigidly determined and has been raised beyond productivity increases in recent years. At the same time, negative deposit rates and marginally positive lending rates have understated the economic cost of capital. In certain instances, this imbalance has encouraged capital intensive industries despite the considerable unemployment prevailing in the country. Second, administered prices, import restrictions, tariff policy and investment licensing practices have together encouraged uncompetitive production in the domestic market and detracted from the export potential of that segment of the industry. Third, the present highly regulated industrial environment has not been conducive to proper sectoral planning and intersectoral linkages. The Government is now focussing on these issues which are expected to be addressed in 1985-1986 in light of the preparation of the next Plan (1987-1992). 32. The Financial Environment. Tunisia's monetary system consists of the Banque Centrale de Tunisie (BCT), ten commercial banks and the postal check system. The other financial institutions consist of eight operating development banks, two savings organizations, eight portfolio management companies, eight off-shore banks and five foreign bank representative offices. The stock and bond exchange is in the early stages of development. The commercial banks, which are -essentially deposit-retail banks, are small by internationa'l standards. In 1982, the total assets oi the ten commercial banks did not exceed about $5.0 billion. Comnercial banks can provide short and medium-term loans up to a maximum of seven years. Loans over seven years are exceptional and can only be provided by commercial banks from special resources (i.e., non-deposits), which have a maturity of more than seven years. However, credits over seven years can be authorized for public enterprises from regular commercial bank resources as long as these credits do not surpass 3 percent of total deposits of the bank in question. 33. Until 1980, the Banque de D6veloppement Economique de Tunisie (BDET) and the Banque Nationale de Developpement Touristique (BNDT) were the only institutions specialized in long-term financing of industry and tourism. Since then, several new development banks have been created. Three of these are special-purpose banks (agriculture, bilateral ventures). Five others, namely Banque Tuniso-Koweitienne de Developpement (BTKD), the Societe Tuniso- Seoudienne d'Investissement et de Developpement (STUSID), the Banque de Tunisie et des Emirates d'Investissements (BTEI), the Banque Tuniso-Qatari dlInvestissements (BTQI), and a Tuniso-Bahraini bank about to be established are joint-ventures between Tunisia and other Arab countries. A Tuniso-Senegalese and Tuniso-Italian develcoment bank are also being established. In comparison with the commercial banks, these banks have relatively large share capitals, which have been subscribed equally between Tunisia and the respective foreign parties. Long-term lending to industry is provided essentially by the development banks, which have been created for this purpose. They have or are developing the capability to appraise, supervise and promote industrial ventures in all industrial sub-sectors. Commercial banks do not have the incentive and resource base to enter into long-term lending. They provide mostly short- and medium-term credit and only  - 11 - under exceptional arrangements long-term credit. There is thus a clear division of focus between commercial banks and development banks. This project addresses the main resource need in Tunisia, related to long-term lending by development banks. The inclusion of BTKD and STUSID in the project will significantly add to the number of viable export projects. The two development banks have given priority to export projects in the past and the proposed Bank loan has already led them to identify additional viable export projects. The two institutions are financially viable and well managed. 34. Export/Imyort Financing. The financing of export and import transactions is strictly controlled by BCT. Exporters must repatriate the proceeds of their exports and are allowed a maximum amount (4 percent of the proceeds) in convertible Dinars to pay for incidental expenditures related to their export business. On the basis of agreed import allocations, which have been liberalized progressively, commercial banks provide pre-financing credit for imported goods and services required by the prospective exporter. These credits, as well as those to finance claims originating from realized exports, are subject to favorable interest rates (6.5 percent), unlimited rediscount facility (at 4.75 percent) and are not subject to prior approval for rediscounting. In the future, these credits will be insured by Compagnie Tunisienne d'Assurance de Commerce Exterieur (COTUNACE), which will be a significant improvement since, in the past, credit was often restricted because of insufficient collateral provided by exporters. Medium-term export credit is provided by the BCT through the commercial banks on a case-by-case basis and is tailored to the particular needs of the very few manufacturers who export capital equipment (transformers, railway wagons, metal structures) A medium-term export-credit scheme to finance exports of capital goods is under study. 35. Financial Policy Issues. Interest rates on term deposits (7.75 percent after tax on deposits over two years) and savings accounts (8.75 percent) have either been negative or barely positive in real terms in the last three years (percentage changes in the consumer price index were 10.0 in 1980, 9.0 in 1981, 13.6 in 1982, 9.0 in 1983 and about 8.3 in 1984 (estimate)). Also, Tunisia's interest rates have been relatively low in comparison with interest rates abroad, particularly those prevailing in the international market. That savings as a percentage of GDP have remained relatively stable is attributed mainly to income effects arising from substantial wage increases in the last few years. The relatively low interest rates on commercial-bank deposits have kept the average cost of funds for these banks at about 6 percent, taking into account that sight deposits, which constitute between 55 percent and 60 percent of banks' resources, are remunerated at the rate of 1 percent for enterprises and 2 percent for individuals. Development banks on the other hand cannnt accept deposits and depend mainly on the international market for raising resources. BDET has raised $60 million in 1983 from the international market, and its average cost of borrowing has increased to about 8.4 percent p.a. from 7.4 percent in 1980. 36. Commercial banks make medium-term loans to industry at the rate of about 10 percent, which allows them a financial spread of about 4 percent. BDET has increased the interest rates on its loans, e.g., from 9.0 percent p.a. in 1981 to about 11.0 percent p.a. for SSI, to 12.5 percent p.a. for tourism projects and to 13 percent p.a. for large (over TD 1.5 million)  - 12 - projects. However, given the small proportion of new higher interest loans in the total portfolio, the average rate on lending remains about 10 percent p.a. The difference between BDET's average borrowing and lending costs attains 2 percent when taking into consideration the amounts of Government reimbursements for foreign currency losses on borrowings. The Government is focussing on the overall effective interest rate of development banks in the context of a financial sector study, which will be discussed with the Government before June 1985. This study proposes an overall upward adjustment in the structure of interest rates together with a simplification and harmonization of the complex existing structure. It also proposes the introductior. of a more flexible rate adjustment system to allow rates to be adjusted more frequently to changes in the liquidity situation, the domestic inflation rate and interest rates abroad. These recommendations will be discussed with the Government in the context of the above-mentioned study. It wps agreed during negotiations that the Bank will review annually with BDET, BTKD and STUSID their interest rates and structure in the light of their average cost of capital, administrative costs and the general evolution of i'tIerest rates, and, after such reviews, all necessary measures shall be taken by the development banks to achieve a reasonable spread (2 percent), permitting the establishment of sufficient reserves and provisions and a reasonable return on capital (Project Agreement, Section 4.10). The Government agreed that the development banks be allowed to take the measures to attain such objectives (Loan Agreement, Section 4.03). The Government and BDET, BTKD and STUSID shall also review with the Bank at the same time as the interest rate review the resource needs of the banks for the following year (Loan Agreement, Section 4.07; Project Agreement, Section 4.11). For 1985, undertakings have been reached, on the basis of agreed plans, to meet the resource needs. 37. Foreign Exchange Risk. In the past, the Government carried the foreign currency risk on the foreign borrowings of BDET. Until 1981, the Dinar appreciated in relation to the basket of currencies used for evaluat4-n and over a period of ten years, the overall result has been positive. Since 1981, however, the situstion. of the Tunisian Dinar has changed, particularly vis4--vis the dollar. In the period 1981-19Y2, BDET had incurred foreign currency losses on its foreign borrowings totalling about $23.3 million ($6.2 on account of interest and $17.1 on account of principal) of which as of December 31, 1984, the Government had reimbursed BDET $10.1 million ($6.2 million for interest and $3.9 million for principal). During negotiations the Government has committed itself to reimburse the balance ($13.2 million) before the end of 1985. In 1984, it is estimated that BDET incurred additional foreign currency losses of $10.6 million ($3.5 million on account of interest and $7.1 million on account of principal). The Goverment has committed itself to reimburse BDET for these losses before the end of 1986. The Government will continue to cover the foreign exchange risk of the development banks (Loan Agreement, Section 4.05) until agreement has been reached on the results of a study, to be undertaken by the Government and to be reviewed by the Bank by March 31, 1986, on alternative mechanisms to cover the foreign exchange risk (Loan Agreement, Section 4.04). The results of the recommendations of the study will be applied by the development banks to subborrowers (Loan Agreement, Schedule 4; Project Agreement, Schedule 1). 38. Bank Role in Export Promotion. Export incentives, provided by existing legislation and regulations in the form of tax holidays, exemption  - 13 - from duties and liberal foreign exchange provisions, are generous. Further improvements in the export climate have been introduced over the last three years within the framework of the Bank's dialogue with the Government, including increasing: (i) the availability of export credit, (ii) the foreign exchange allocation for exporters, and (iii) the ceiling of pre-financing of exports and including the lengthening of the duration of claims abroad. Subsequently, the Government has set up COTUNACE and, under new legislation, has allowed the establishment of export trading companies which will benefit from customs, foreign exchange and tax facilities. Whereas export and import procedures for the offshore firms are simple, other firms are subject to import content checks and cumbersome procedures for drawback, temporary admission and foreign exchange allocation. In view of the complexity of procedures which exporters face and considering that many regulations are either unclear or unknown to exporters, the Government will, in the context of this project, prepare before December 31, 1985 a comprehensive guidebook describing the procedures for exporters. The Government has also become aware that the procedures themselves require simplification, harmonization and general improvement in their application to assure that they do not stand in the way of promoting exports and integrating domestic industries which supply the needs of exporters, and a number of simplification measures have been taken as a result of recommendations made during this project's preparation. In addition, the customs authorities have set up a service department for aiding exporters in regard to administrative procedures. 39. Bank Role in the Manufacturing Sector. Through its loans to the manufacturing industries, the Bank aims at promoting industrial decentral- ization, export diversification and labor-intensive industries in support of the Government's high priority objectives. Bank assistance was channeled mostly through BDET, which benefitted, to date, from eight operations totalling $129.2 million (net of cancellations), of which $14.48 million remained undisbursed as of December 31, 1984. These Bank loans have contributed to BDET's institutional growth and have confirmed BDET's role as a catalyst in mobilizing resources for private investment, specifically in the manufacturing sector. Through its representative on BDET's Board, IFC has offered a substantial contribution in this regard. The Project Performance Audit Report of September 1981 on Loans 648, 798, and 881, covering the third (1969), fourth (1972) and fifth (1973) loans to BDET, concluded that considerable progress had been made in terms of institution building and management performance, and that these loans had contributed to changing * BDET's role from a supplier of equity funds for public sector industries, to that of financier and advisor of private investors. The seventh loan to BDET (Loan 1504 of 1978) included a credit line for a pilot Small-Scale Industries (SSI) scheme (Loan 1505 of 1978) which prepared the ground for a $30 million loan to SSI through commercial banks and BDET as intermediaries (Loan 1969 of 1981). BDET has since channelled a Bank loan (Loan 2113 of 1982) to EMI. The Bank has also made two direct loans to industry: Loan 2012 of 1981 helps improving public sector textile operations and Loan 2301 of 1983 helps moderaize and expand a large foundry. Implementation of ongoing projects is proceedilxg satisfactorily.  - 14 - 40. Important measures have been undertaken by the Tunisian authorities in recent years to strengthen fiscal and financial incentives to exporters, to simplify administrative procedures and to set up and strengthen institutions to foster export growth. Several of these measures were taken in the context of the continuing dialogue between the Bank and the Government of Tunisia and this project builds up on and continues to support many of these initiatives. A financial sector study has been undertaken and will be discussed with the Tunisian Government before June 1985. The study concludes that the Tunisian financial sector, as regards the export sector, is basically efficient. Hence, this high-priority project does not need to await further improvements that may be recommendcd under this study. At the same time, the protection framework encourages inefficiencies and production for the domestic market rather than for exports. The Tunisian Government is aware of this situation and has undertaken an in-depth study of the protection framework. The results of this work have been recently reviewed with a Bank industrial sector mission and this review is expected to initiate a dialogue with the Tunisian authorities on how best to rationalise the protection system in the coming years. At the same time, Tunisia's record of export growth in recent years, and the priority accorded to exports in the current Five Year Plan, as well as the availability of a substanttal pipeline ot viable export projects and the need to further strengthen export institutions, argues in favor of a project that will support the Government's efforts in th-s critical area at this time. PART IV - rHE PROJLCT Background 41. The proposed project was identified li- October 1983 and prepared by the Government with Bank assistance during '983/84. It was appraised in April 1984. Negotiations were held in Washington, ".C. from February 25 to March 1. The Tunisian Delegation was .ed by the Director-General of Projects in the Ministry of Planning and inciuier. representatives of the Banque de D6veloppement Economique de Tunisie (BDET), Banque Tuniso-Koweitienne de D6veloppement (BTKD), the Societe Tuniso-Seoudienne d'Investissement et de ID6veloppement (STUSID), the Central Bank and the Ministries of Finance and National Economy. The Staff Appraisal Report entitled Tunisia - Export Industries Project (No. 5251-TUN dated March 20, 1985) is being distributed separately to the Executive Directors. The main features of the loan and the project are listed in the Loan and Project Summary at the beginning of this Report and in Annex III. A map of Tunisia is attached. Project Objectives and Content 42. The objective of the proposed project is to assist the Government in developing Tunisia's industries engaged in exports through a line of credit to BDET, BTKD and STUSID. The project also provides for the improvement of the institutional environment for exporters through the establishment of an Export Promotion Fund and t'rough assistance to COTUNACE.  - 15 - The Development Banks 43. Three institutions will be financial intermediaries for the proposed project: BDET, BTKD and STUSID. BDET is the country's leading development bank. BTKD and STUSID were chosen as intermediaries under this project in response to the Government's request. BTKD and STUSID have already given priority to Export Industries projects in the past, and the proposed Bank loan has led them to identify additional viable projects. BTKD and STUSID attach great importance to a relation with the Bank because of the support it provides on overall banking policies and practices, and more specifically, on appropriate project appraisal/supervision methodology and standards. Detailed descriptions and analyses of the organization, operations, financial position and resource requirements of BDET, BTKD and STUSID are presented below. A. Banque de Developpement Economigue de Tunisie (BDET) 44. BDET is well known to the Bank Group since its creation in 1959. The Bank has provided altogether $129.2 million (net of cancellations) in eight operations. IFC is a shareholder and has a representative on the Board. The institution is well managed and has a competent staff. 45. Operations and Portfolio. BDET's approvals almost doubled between 1980 and 1982. In the 1980-1983 period, 73 percent of BDET's approvals were for new projects; 88 percent of thes'e new projects were in the private sector. Operations are well-distributed over the several sectors and regions of the country. As of December 31, 1983, BDET's portfolio comprised loans for about $202 million and equity participations for about $28 million. About seventy percent of the loans went to industries, with agro-industries, construction materials, EMI, textiles and chemicals being the most important sectors. As of December 31, 1984 BDET's arrears over three months amounted to about $14.2 million equivalent, or about 6.1 percent of the outstanding loan portfolio against 4.2 percent on Decemter 31, 1983. Forty-six percent of the total arrears (arrears over TnI 100,000) are concentrated in 22 companies, most of which are public, the remainder being primarily in the tourism industry. Forty-four percent of arrears is being pursued in court. BDET has begun an action program to address the arrears of these companies. The Bank will closely monitor BDET's overall arrears position and quarterly reporting was agreed to permit the Bank to stay abreast of future developments. 46. Financial Position. During the 1980-1984 period, assets increased by an average rate of 21.3 percent per year, reflecting the general growth of industrial investments in Tunisia. BDET's share capital was increased from TD 10 million to TD 20 million in 1982/83, partly by incorporating reserves. BDET's debt-equity ratio of 5:1 on December 31, 1983 remains well below the maximum 8:1 allowed under previous Loan Agreements. BDET expects to consolidate its short-term debt in 1985 through a medium-term loan in the international market (see para. 49). The 1980-84 period has witnessed a decline in the profitability of BDET, as measured by return on net worth, due to the high cost of foreign resources and the large capital increase during this period.  - 16 - 47. Organization and Staffing. BDET employs 73 professional staff, 27 of which are in project promotion and appraisal. While a large number of staff are employed in administrative departments, it is expected that in a pending reorganization many administrative staff will be shifted to operational departments. BDET has been recruiting new professional staff to replenish its ranks after losing staff to the new development banks and industrial enterprises. Nevertheless, on the basis of its experience, the availability of a large number of project files, knowledge of the economy and its technical and financial know-how, BDET is able to process a relatively large number of project applications quickly. Weaknesses, however, remain in project supervision. To overcome these weaknesses, BDET has implemented in 1984 a satisfactory supervision and reporting program with Bank assistance. During negotiations, understandings have been reached to maintain satisfactory supervision and reporting in the future, especially as regards arrears and rescheduling. 48. Projected Operations and Finance. Based on its pipeline of applications, BDET should be able to meet its target of about $60 million lending per annum during 1985-1987. These projections are conservative and reflect BDET's intention to scale down its exposure in tourism. During this period, interest income is projected to increase by about 11.0 percent on average per year reflecting the increases in interest rates already effected and planned for the next years. The average interest rate on outstanding loan portfolio was 8.4 percent in 1981 and 8.9 percent in 1983; it is projected to increase to 10.3 percent in 1986. Borrowing costs are expected to increase less: the average cost of new borrowing is projected at about 9.5 percent while the cost of existing debt will remain at about 8.5 percent. The average return on net worth over the last six years has been 10.7 percent, permitting BDET payment of reasonail'c (8 percent) dividends, and the build-up of adequate reserves and provisions, while permitting the phasing out of the Government compensation by 1986. BDET is planning further increases in share capital from TD 20 million inr 195 Lca TD 30 million by 1986. Long-term debt will increase by about $ 90 million but the debt-equity ratio will remain at the reasonable level of about 6:1, well below t-he maximum permitted ratio of 8:1 (Project Agreement, Section 4.04), and the debt service coverage ratio would be satisfactory at around 1.1. 49. Resource Requirements. At the end of 1983, IBRD loans constituted about 25 percent of total foreign currency borrowings and about 19 percent of BDET's total resources. For the 1985-1987 period, resource requirements are forecast at about $172 million of which about $103 million would be in foreign currency. Part of these new borrowings would replace short-term debt. The foreign currency requirements would be covered by borrowing in the international market and from bilateral and multilateral sources. BDET's local resource gap would be covered by internally generated cash, from a share capital increase, net loan collections and access to the local market.  - 17 - B. Banque Tuniso-Koweitienne de Developpement (BTKD) 50. BTKD was created in 1981. It aims to identify, promote and finance economically and financially viable projects in all sectors of economic activity in Tunisia and abroad, and to develop economic and financial relations between Tunisia and Kuwait and other Arab and African countries. Its share capital of TD 100 million (about $120 million at the present exchange rate) is equally divided between the two countries. BTKD can take *L equity participations, make loans, give guarantees and provide all types of banking services including the acceptance of deposits from abroad. However, it cannot accept domestic deposits. 51. Organization and Staffing. BTKD has a 10-member Board of Directors. A General Manager who is an experienced development banker is in charge of operations. BTKD is organized in five departments: Promotion, Appraisal/ Follow-up, Equity Participation/Representation, Controllers/Treasury and Administration. As of December 31, 1984, BTKD had a staff-of 74, 30 of whom being professional staff. BTKD is well managed and its staff is competent. 52. Operations. BTKD generally finances projects with an investment cost of at least about $1.2 million. As a general principle, it intends to invest about 60 percent of its operations in industry, 20 percent in agriculture, 15 percent in tourism and 5 percent in other sectors. BTKD is particularly interested in technologically-advanced projects. Its equity participations are limited to 50 percent of BTKD's net worth. It cannot normally take more than 15 percent of a firm's share capital, unless BTKD is the promoter of a company and lead financier, in which case its participation can go up to 30 percent. Its maximum exposure in a single company is limited to 15 percent of its own, npt worth. BTKD charges 12 percent per year for loans up to 11 years, rising to 13 percent for loans with maximum durations of 15 years. These rates are revised from time to time. The financial, technical and market analysis under BTKD appraisals is of satisfactory quality; however, in the first years, BTKD has relied on reports of other institutions for a comprehensive assessment of thp ennnmir returns. Also, efforts with respeet to supervision have been modest. To strengthen these, BTKD has prepared a satisfactory plan and understandings have been reached as to satisfactory procedures for future supervision and reporting. 53. Portfolio. As of December 31, 1983, BTKD had approved loan and equity operations for 118 projects for a total amount of about $265 million, of which about 18 percent is in equity participations. Commitments amounted to about $141 million, while disbursements totalled about $70 million. BTKD is making adequate provision for future portfolio losses.  - 18 - 54. Financial Position. BTKD's financial position is sound. Seventy-five percent of its share capital has been paid in, and the remainder is to be paid in during 1985. The company made a net profit of about i5.9 million in 1983 and about $8.0 million for 1984, which is considered satisfactory. The return on average equity in 1983 and 1984 was 8 and 8.7 percent respectively. In accordance with BTKD's policy statement, a maximum debt-equity ratio of 4;1 would be maintained (Project Agreement, Section 4.06). BTKD's financial policies as stipulated in its Policy Statement are considered satisfactory. 55. Projected Operations and Finance. BTKD's loan and equity approval level was about $60 million in 1984, and loan approvals will grow from 1985 by about 10 percent per year. BTKD's equity investment will correspond to about one fifth of total approvals. On this basis, commitments for the September 1984-1987 period are projected at about $244 million. 56. Resource Requirements. Overall, BTKD's resource requirements for September 1984-1987 are about $291 million of which about $197 million in foreign curreacy. Local currency resource requirements are expected to be covered by cash generation, loan collections and share capital increases. Foreign currency requirements are expected to be covered by share capital increases from foreign partners and through recourse to the international market. The proposed subloan of $15 million equivalent would help cover a relatively small part of the remaining foreign exchange needs. C. Societe Tuniso-Seoudienne d'Investissement et de D