Tanzania - Industrial Rehabilitation and Trade Adjustment Program

Docunent of The World Bank FOR OFFMCIAL USE ONLY C4a /q6YF?1 Repot No. P-4944-TA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT IN AN AMOUNT EQUIVALENT TO US$135 MILLION TO THE UNITED REPUBLIC OF TANZANIA FOR AN INDUSTRIAL REHABILITATION AND TRADE ADJUSTMENT PROGRAM November 22, 1988 This document has a restricted 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.  CURRENCY EQIVALENTS Currency Unit - The Tanzanian Shilling (T Sh) EXCHANGE RATES December 1983 US$1 = TSh 12 December 1985 US$1 - TSh 17 June 1986 US$1 - TSh 40 June 1987 US$1 = TSh 63 June 1988 US$1 - TSh 96 No-vember 1988 US$1 - TSh 120 GOVERNKENT FISCAL YEAR July-1 -.June 30 GLOSSARY OF ABBREVIATIONS BOT = Bank of Tanzania ERP = Economic Recovery Program GDP - Gross Domestic Product IRTAC = Industrial Rehabilitation and Trade Adjustment Credit MRC - Multi-Sector Rehabilitation Credit NBC National Bank of Commerce NMC = National Milling Corporation OGL Open General License QRs = Quantitative Restrictions SAF = Structural Adjustment Facility TPL = Tanganyika Packers Limited PIP Public Investment Program SGR Strategic Grain Reserve BIS = Basic Industrial Strategy  FOR OFFICIUL USE ONLY TANZANI INDUSTRIAL RERABILITATION AND TRADE ADJUSTMENT PROGRAM TABLE OF CONTENTS Page No. CREDIT AND PROGRAM SUMOARY i-i PART I - THE ECONOMY Background . .......... .......... 1 The Economic Recovery Program (ERP) ... ...... 2 Recent Economic Developments and the Impact of the ERP ....... 4 Macroeconomic Prospects ... ........... ............ .. 6 External Financing Requirements ........... 7 Collaboration with the DMP ......... O..** ..................... 7 The Bauk's Country Assistance Strategy ............... 7 PART II - TIE PROGRAM OF TRADE POLICY REFORM Introduction .............................................. 8 The Exchange Rate and Trade Policy Framework ................. 9 Trade Policy in the Early 19809 . .. 9 Trade Policy During 1986-87 ................................. . 10 The Program of Trade Reforms 1988-1989 .................... 10 Trade Liberalization and Foreign Exchange Allocation ...... 10 Tariffs and Sales Taxes ......... * ......................... 13 Pricing Reforms ....... ...................... . ...... . 15 Deconfinement Policy ...................... . . ...... ...... . 15 Export Incentives ........................................ . 16 Export Retention Schemes ................................ 16 Export Duty Drawback ... ... .. ............................. 17 Fiscal and Monetary Policies ................................. 17 Fiscal Policy .......................................... 17 Monetary Policy ... ....................................... 18 Agricultural Policies ........................................ 19 The Financial Sector ............... * ............. 20 PART III - THE INDUSTRIAL SECTOR Overview .......................................... 21 Industrial Restructuring and Rehabilitation ......... 23 Leather ........................................... 24 Textiles .... ...................................... 24 Agroprocessing ............ 25 Edible Oil ..... 25 Meat Packing ............. 25 Ths document has a nrstricted distrution and may be used by ecipients only in the orformance of their offlcial duties. Its contents may not otherwise be discbsed without Wori Bank v. ithorizatom.  PLA IV - TIM PROPOS8D OPERATION Pae No. Background . .. ............. ............. 25 Objectives . . . . . . . . . . . . . . . . . . . . . 26 Program Description and Financing ........................................... 27 Industrial Restructuring Component ........................ 27 Disbursements, Procurement and Auditing ..... ........... 28 Tranche Release and Monitoring ..................* ....... ..... 29 Social and Economic Aspects of Adjustment ........... ......... 31 General ...................................................... 31 Industry ........... , 33 Project Risks .. . .. ....... . 34 PART V - BANK GROUP OPERATIONS 34 PART VI R KOM92MTION 36 ANNEXES Annex I : Economic Indicators: Key Macroeconomic Indicators ....... ........... 37 Balance of Payments . ......................... . 38 Foreign Exchange Requirements and Debt Service ..................................... 39 External Financing Requirements: 1989-1993 ... 40 Selected Macroeconomic Variables: Graphs ..... 41 Annex II : Letter of Government Policies ................... 42 Annex III : IRTAC Policy Reform Matrix ..... . ............ .. ... 53 Annex IV : OGL Facility List Under Initial Liberalization Step, February 1988 ........................... 57 Annex V : Summary Matrix of Main Bottlenecks and Policy Issues in Industry ............................ 58 Annex VI : Subsectoral Efficiency Indicators in Industry,: 1984 ........ .................... 59 Annex VII : Status of Bank Group Operations ................. 60 Annex VIII: Supplementatry Data Sheet .. ..................... 62 Annex IX : Social Indicators ....... i ....................... 63 Map... ... ...................  TANZANIA INDufSTRIAL REH&ULITATION AND TRADE ADJUSTMENT PROGRAM CREDIT AND PROGRAM SUMMARY Borrower X United Republic of Tanzania Amount : IDA Credit SDR 97.6 million (US$135 million) African Development Fund FUA 20 million (US$ 24 million) United Kingdom L Stg. 8 million (USS 15 million) Netherlands f. 20 million (USS 10 million) Switzerland Sw F 20 million (US$ 14 million) The operation is supported under the Special Program of Assistance to Low-Income Debt-Distressed Countries in Sub- Saharan Africa. In addition to the cofinancing identified above, some other donors have expressed their intention to participate in the financing of this program at a later stage. _ Standard IDA terms, 40 years maturity. Proaram Obiectives and Descrition - The proposed Credit would support the broadening of the Government's Economic Recovery Program, through the reform in the trade regime and the initiation of restructuring and rehabilitation of the industrial sector. The cornerstone of the proposed policy package is a major trade liberalization program supported by active exchange rate management. The liberalization in import restrictions and foreign exchange allocation is accompanied by progress on price decontrol, rationalization of the tariff and sales tax structures, reforms in export incentives, and liberalization of internal trade (deconfinement). The process of industrial restructuring would be the result of the reform in the trade, pricing and foreign exchange regimes and the specific subsectoral interventions. The quick-disburs&ng proceeds of the Credit would contribute to all sectors in the economy, in the context of a more liberalized import regime. Benefits : The proposed policy reform measures would make a major contribution to the continued economic recovery and towards sustained growth. A more liberalized import and internal trade regime, coupled with an exchange rate and pricing regime better reflecting market forces is expected to result in a reallocation of resources away from unviable and towards productive  - ii - activities, and to provide incentives for currently inefficient, but viable activities to restructure. Structural adjustment is expected to result in additional resources flowing to agriculture and transport, while industrial value added is expected to grow utilizing less resources than previously. Increased industrial value added will result from the reallocation of recurrent resources from low to high value added activities, from the restructuring o' currently inefficient but viable enterprises, and from the retrenchment and phase-out of unviable activities. Ri8sk s The main risk to this proposed operation is that the pace of implementation of the major macroeconomic adjustments could slacken due to protracted decision-making related to political considerations. Setbacks in implementing exchange rate, fiscal and monetary adjustments, and failure to implement important institutional reforms in agricultural marketing and in the financial sector, would reduce the supply response and allocative impact of the trade reform and industrial restructuring measures under the proposed operation. The second important r'sk relates to the Government's ability to implement a restructuring program in industry involving firms' closures and retrenchment, and greater selectivity in resource allocation. These risks are mitigated by the fact that there is consensus within the Government on the need for sustained reform; a commitment to the goals of the Economic Recovery Program as witnessed in the past two and half years in the context of the Bank's Multisector Rehabilitation Credit, the IMF programs and the two Policy Framework Papers; and strong support for the reforms from the donor community. In the past few months, the Government has adopted decisive measures in the areas of exchange rate, financial and foodgrain marketing policies. Estimated Disbursements : The Credit would be released in two tranches, the first tranche amounting to US$62 million and the second tranche to US$70 million. The first tranche would be available for disbursement credit effectiveness; the second would be released upon fulfillment of specified conditions, expected before June 1989. Both tranches will be disbursed through the Open Generalized License (OGL) facility. In addition, US$3 million will be made available upon effectiveness of the Credit for the industrial restructuring technical assistance component. Aggraisal Isuort : This is a combined President's and Staff Appraisal Report.  INTLRNATIONAL DEVELOPHENT ASSOCIATION REPORT AND PECOM%SENDTION OF TUE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED INDUSTRIAL RrEHBILITATION AND TRADE ADJUSTMENT PROGRAM FOR TBE UNITED REPUBLIC OF TANZANIA 1. I submit the following report and recommendation on a proposed Credit of SDR97.6 million (US$135 million) on standard IDA terms wlth 40 years of maturity to the United Republic of Tanzania in support of the Government's Industrial Rehabilitation and Trade Adjustment Program. The African Development Fund, Netherlands, Switzerland and the United Kingdom will also participate in the financing of this program. Other donors have expressed interest in participating in the firancing of this program at a later stage. 2. An Economic Memorandum on Tanzania (Report No. 5019-TA) was distributed to the Executive Directors in August 1984, and a report entitled 'Tanzania: An Agenda for IndusArial Recovery" (Report No. 6357-TA) was distributed to the Executive !-rectors in July, 1987. Their conclusions as well as more recent developments are reviewed below. Furthermore, two Policy Framework Papers (Reports No. SecM87-1077 and SecM88-1234) have been distributed to the Executive Directors in October 1987 and November 1988, respectively. PART I - THE ECONOMY Backaround 3. Several years of rapid economic growth followed Tanzania's Independence in 1961, when the country was almost solely dependent on subsistence agriculture and a few estate crops, with a very small industrial and human capital base. In spite of this growth, the country continued to depend on external funding, made few improvements in income distribution, and did not diversify its economic structure. Disappointed with this outcome, Tanzania's leadership introduced sweeping changes in 1967 and embarked on an era of socialism. The new priorities of the country, as enunciated in the Arusha Declaration, were directed towards self-reliance, development of a system of basic education and. broad-based rural development. This led, in the late 19608 and early 1970., to a rapid growth in the public sector through: (i) nationalization of large-scale industry and the financial system, the formation of Ujamaa (communal) villages, and the replacement of farmers' cooperatives with state-run crop marketing authorities; (ii) dramatic increases in the provision of social services; and (iii) the expansion of centrally managed activities. 4. By the end of the 19709, the economy was falteringt industrial output had begun to decline steadily, agriculture was stagnating, while the  -2- fiscal situation deteriorated sharply with deficits averaging about 16 percent of GDP. Inflation accelerated to almost 30 percent, resulting in appreciation of the real exchange rate, and exports and imports declined. Gross Domestic Product grew by 5.5 percent per annum between 1913 and 1978 but only 0.4 percent per annum between 1978 and 1982. At that time it became evident that the economic management system in place lacked the capacity to respond adequately to a changed external environment. The productive sectors of the economy had lost their dynamism. In agriculture, parastatal marketing monopolies dampened incentives for farm output ,yrowth, and involuntary resettlement disrupted productive relationships in rural areas. In industry, inappropriate project design and a heavily protected environment resulted in an import-dependent sector with a largely inefficient structure of production. Despite the major institutional changes and economic setbacks, Tanzania attained significant improvements in the social sectors in the late 1960s and 1970s. Dramatic achievements were recorded in school enrollment, literacy, and life expectancy. 5. In the late 1970s a combination of external factors (worsening terms of trade, the war with Amin's Uganda, and the aftermath of the break- up of the East African Community) placed Tanzania's economy in a vulnerable position. This combination thwarted the economic liberalization efforts initiated in 1978. The policy response involved increased administrative controls on economic activity and passive exchange rate management, resulting in rapid real appreciation of the exchange rate and continued growth in the size of the public sector -- without regard for financial and managerial constraints. 6. During the early 1980s a number of attempts at policy reform failed to address the key problems and did not always obta,n the necessary political support. Economic activity, which had been declining since 1979, was further discouraged by the 1983 'economic saboteurs' campaign during which a large number of businessmen were jailed. Import capacity fell dramatically due to major declines in export volumes and decreasing capital flows. A drought exposed the rigidities of the existing food policy, and the availability of consumer goods fell to unprecedented low levels. 7. The 1984185 Budget represented a turning point, and provided the first indication of a new pragmatism in the Government's economic management. The exchange rate was devalued by one-third, parastatal subsidies were cut, an import liberalization program was initiated through the implementation of an own funds imports scheme (para. 33), and restrictions on the movement of grain were eased. Simultaneously, cooperatives (which had been abolished in 1976) were reestablished, and took over many of the functions of the parastatal crop authorities. Positive responses to these measures encouraged the Government to consider a more comprehensive and systematic policy reform program to deal with the economic crisis. The Economic Rwcovery Progrm 8. In mid-1986, after a number of discussions with. Bank and Fund missions, the Government produced a medium term "Economic Recovery Program' (ERP) which was approved by Parliament and presented to the first Consultative Group meeting in nine years. The EP aimed at achieving a  -3- positive growth rate in real p;r capita income, reducing the rate of inflation, and restoring a sustainable balance of payments position. Its main thrust was to reduce distortions and encourage more efficient resource allocation while exercising fiscal and monetary restraint. In the public sector, rehabilitation of the transport infrastructure and support for agricultural production were identified as the most urgent priorities. The measures initiated at the time of the 1986187 budget includeds (i) significant exchange rate adjustments, aimed at achieving an appropriate rate in 19881 (ii) adjustment in interest rates, aimed at achieving real positive rates by mid-1988; (iii) increases in producer prices in real terms for export crops; and (iv) a significant reduction in the number of price-controlled items, with the aim of attaining by mid-1988 a decontrolled price regime for all but 12 categories. 9. These measures, together with targets limiting overall credit growth and Government borrowing from the banking system, formed the basis for an 18-month standby arranRement approved by the IDF board in August 1986. Complementary measures in agricultural policy (eliminating all remaining restrictions on the transport of grain, and allowing cooperatives to export directly without resort to the marketing boards) and measures aimed at improving foreign extchange allocation and trade regime (both domestic and external) were supported by a Multisector Rehabilitation Credit (MRC) which was approved by the World Bank Board in November 1986. All conditions attached to its three tranches were fulfilled. 10. At the time of presentation of the 1987/88 Budget to Parliament, the Minister of Finance reported that the ERP had been successfully launched and had attracted considerable support from the international community, manifested in large increases in concessional capital flows. The budget reaffirmed the Government's conviction that the ERP represented an adequate response to the serious economic crisis still facing Tanzania. The specific measures adopted in the context of the 1987188 Budget included continuation of the exchange and interest rate adjusttaents, trade reform, price decontrol, and fiscal restraint. A first-year Policy Framework Paper (PFP), elaborating on the MEP policies, was approved by the Bank and the Fund in October 1987 and allowed Tanzania access to the IMF's Structural Adjustment Facility (SAF). In January 1988, the Board of the World Bank approved a supplemental financing for the MRC. The 1988189 Budget reiterated the Governments nommitment to continue carrying out the ERP through the adoption of important fiscal, trade, pricing and sectoral measures. Furthermore, reflecting the Governments commitment to continue implementing a medium-term financial and economic policy framework, the Government, in collaboration with Fund and Bank staff, has now concluded preparations of a second-year PFP which was presented to the Committee of the Whole on November 22nd, 1988 and is scheduled to be presented to the IMF Board (in conjunction with a second-year SAF) on November 30th, 1988. 11. After over two and a half years of implementation of the ERP, the Government remains committed to carrying out the full program of policy reform. The gradual approach to reform takes into account Tanzania's socio-political and institutional context. With the exception of the monetary program, and a slow-down in the exchange rate adjustment during much of 1988, the Government has successfully implemented virtually all intended policy measures within the planned time frame, in spite of  significant practical difficulties and of considerable political skepticism especially amng party officials at the outset. The October 1987 Party Conference, which reelected Mwalimu Nyerere as Chairman, endorsed the Government's management of the economy while reaffirming the goals of socialism and self-reliance. Recent Economic Develomments and the Imnact of the URP 12. In 1986, for the first time since 1980, the rate of growth of real GDP, at 3.4 percent, exceeded the population growth rate. The 1987 real GDP growth rate accelerated to an estimated 4 percent, but a 21 percent terms of trade deterioration (mainly due to declines in coffee, tea and tobacco world prices) resulted in a reduction in income per capita and in virtually no increase in consumption per capita during that year, based on statistics from the official economy. Over two years after the introduction of the ERP, it is evident that a major change is occurring in the economic dynamics of the country and in the expectations of both the population at large and the business community. But much of the observed growth in economic activity is taking place outside of the official sector and is not fully captured in the GDP statistics. This informal sector growth applies to all spheres of economic activity, including food supply, external and domestic trade, tourism and small-scale activities. 13. The cornerstone of the ERP has been the adjustment of the Tanzanian currency, which had become so overvalued that, in early 1986, the official rate (TSh 17 per US dollar) was less than one-eighth of that prevailing in a broad parallel market. By June 1988, the official rate (TSh 96 per US dollar) was over one-half that of the parallel market rate (TSh 180 per US dollar). The behavior of the parallel market rate provides a quantifiable indicator of the success of the macroeconomic adjustment to date, by showing a distinct trend of appreciation in real terms (over 30 percent during the last two and a half years). Meanwhile, the official exchange rate depreciation of about 500 percent in domestic currency terms over the sahie period has already done much to improve resource allocation, and reduce excess demand for imports. However, the adjustment of the exchange rate slowed down considerably between February and October 1988, when the nominal rate moved from TSh 90 to TSh 98 to the dollar, implying an appreciation in real terms during the period. But the Government has reaffirmed its commitment to an active exchange rate management policy by devaluing the currency in November 1988, to TSh 120 to the US dollar. 14. Assigning priority in resource allocation to transport and agriculture was another key element of the ERP. Improvements in the availability of farm supplies and fuel throughout the country, combined with the practical liberalization of grain trade, have resulted in large increases in staple foods. Additions to transport capacity, particularly in the private sector, together with the significant expansion of the own-funds import scheme, have resulted in a dramatic increase in the availability of basic consumer goods and have acted as an incentive for agricultural production and for infusing a new dynamism to private sector activities. 1S. The combination of exchange rate depreciations and of the export retention scheme (for exporters to purchase inputs and other imports) has  also encouraged a significant growth in manufactured and other non- traditional exports, which in 1987 increased by nearly 60 percent (in, current US dollar terms). Revenue from traditional exports, however, declined in current terms during 1987, largely due to processing and transport bottlenecks and world price declines. As a result, the current value of exports did not grow during 1987. 16. The prices of the large majority of commodities are no longer controlled, while remaining official prices have been adjusted in line with market forces as a consequence of the ERP's policies. Interest rates are by now positive in real terms, and petrolr'um derivate prices (which are still controlled) have been adjusted to reflect the exchange rate adjustments. Recurrent industrial inputs (largely imported under aid programs) have also increased in price as the exchange rate has depreciated. In spite of all these adjustments, inflation has not risen from its pre-URP level, because of the recovery of agricultural output, the competitive pressure of goods imported under the own-funds scheme, and fiscal prudence. 17. Fiscal performance has improved through revenue-enhancing measures (such as conversion of specific taxes to ad-valorem and reductions of high marginal rates on personal income), as well as through expenditure- reducing measures (reduction of the real wage bill, cutbacks in non-wage recurrent expenditures, containment of unauthorized expenditures, curbs on transfers to local governments, and a slow-down in implementation of development projects). Until the end of 1987, the Government was able to stay within the ambitious targets set in the context of the IMF standby arrangement for overall deficit reduction, and for borrowing from the banking sector. 18. In contrast with the significant progress attained in other important components of the ERP, the Government failed to maintain the necessary restraint in the monetary area. During the second half of 1987, credit grew at nearly twice the rate targetted, with net domestic aseets increasing by 35 percent. This resulted from a combination of factorst (i) excessive credit requirements from the National Milling Corporation (NMC) arising from inefficient public sector intervention in food marketing; (ii) the credit requirements to procure a record cotton crop, in the context of deteriorated processing facilities, transport bottlenecks and institutional rigidities; and (iii) an inadequate financial system. Although such a spur in the money supply has not had a significant impact in increasing the inflation rate in Tanzania (a relatively non-monetized economy), it is now clear that the ambitious ERP targets for reduced inflation are beyond reach, and, equally important, that the credit requirements of agricultural marketing institutions have resulted in some of the more dynamic segments of the economy being deprived of liquidity. 19. With the exception of credit restraint, the stabilization components of the ERP have been successfully implemented and key pricing distortions have been much reduced. The roots of the credit problem are in the serious structural flaws of the agricultural marketing and financial systems. These are complex institutional problems, which are now at the top of the Government's policy reform agenda. A permanent solution for the key problems affecting both sectors is still likely to require some time to  -6- be fully implemented. The Government has taken some important measures to restbre monetary balance, has initiated significant reforms in agricultural marketing and now is preparing an action program for the financial sector (paras. 60-72 below). Nacroeconomic Prosnects 20. Over the next decade the Tanzanian economy is expected to grow at an average real rate of 4.5 percent per annum. Reduced distortions (resulting from the reforms in the exchange rate, trade and pricing regimes), alleviation of serious infrastructural bottlenecks, and institutional improvements (in agricultural marketing, financial institutions and in public sector management) are expected to lead to significant improvements in the efficiency of resource allocation. This would result in a projected income and consumption per capita growth rate of about 1.5 and 0.4 percent per annum, respectively, over the next three years. Income per capita growth is expected to remain at 1.5 percent p.a. after 1991 as well, enabling consumption per capita to grow faster (approaching 1 percent), as export growth in the 19908 (at about 8 percent in real terms) is projected to be somewhat slower than the projected rapid growth over the next three years. The process of resource reallocation (away from highly import-dependent industries towards agriculture) and economic restructuring is also expected to result in a reduction in import dependence over time, and in smaller incremental import requirements to sustain the projected GDP growth rate--particularly over the next three years. Thus, import volumes are expected to grow, on average, at about 2 percent per annum over the next three years. After 1991, the import growth rate is erpected to gradually increase to 4 percent per .nnum. 21. Agriculture is expected to grow at 4.5 percent per annum from 1988 onwards, reflecting improvements in farming incentives and in the marketing system, facilitating the development of each geographical area's relative economic strengths and the increased cultivation of cash crops and non- traditional foodgrains. In industry, capacity utilization (at 25 percent) and productivitV levels are very low at present, the resalt of inefficiencies in resource allocation and supply constraints. Starting from this low base, the expected reorientation in industry is expected to lead to sectoral growth of over 6 percent per annum over the next decade. Such growth rates can be achieved almost entirely through improvements in the use of resources and will not require substantial additional imported inputs. This is because of the existence of negative value added or otherwise very inefficient enterprises in the sector, which are expected to be either phased out or transformed into efficient activities. 22. Government consumption is expected to grow slower than GDP, vhile domestic savings would gradually increase from the currently highly negative level of -14 percent of GDP to a small but positive rate in the late 19909, mainly reflecting improvements in Government finances. Exports are projected to finance a rapidly growing share of imports, increasing from 39 percent in 1986 to over 50 percent in the early 1990s. Export volume increases of about nine percent per annum until the early 19909, and modest improvements in the terms of trade (reversing the significant deterioration in 1987) are expected to result in an annual growth rate of merchandise exports, in US dollars, of about 14 percent p.a., with mUch of  -7- the impetus stemming from manufactured and other non-traditional export categories. In addition, increasing tourism, port and transport serv4ces for bordering countries are expected to contribute to export growth. The improved export performance, coupled with more modest import growth requirements, results in a projected resource balance deficit that will grow at a significantly slower rate than in the past. Hence, as a share of exports, the current account deficit will decline significant over the next few years. But the imported inputs required for a growth-oriented scenario, in the context of the present small export base and large import bill, imply that the current account deficit will continue to increase in absolute terms well into the 1990s--albeit at a slower pace. External Financina Reouirements 23. For many years, therefore, Tanzania will continue to face large external imbalances. Thus, the Government's adjustment program will continue to require an active exchange rate policy coupled with large amounts of external financing and debt alleviation to support sustained growth. Balance of payments and external financing projections are included in Annex I, pages 2-4. The total resource requirement for the 1989-91 three-year period is expected to be about US$5.68 billion, including import requirements of US$4.39 billion and scheduled debt service, supplier credit repayments and reserves build-up totalling US$1.29 billion. The resources expected to be available to finance the resource requirements over the period include US$1.99 billion in official exports, US$0.54 billion in private transfers (largely reflecting unofficial exports of services and goods), US$2.40 billion in donor aid and multilateral financing (including, inter alia, about US$600 million-from the SPA initiative and the US$135 million of the proposed IRTAC), and US$0.73 billion in debt service reduction (excluding arrears rescheduling of almost US$1 billion expected to take place by end-1988). Collaboration with the IW 24. Bank and Fund staff have collaborated in assisting the Tanzanian authorities in formulating the ERP since it was launched in 1986. For the past three years, the Bank and Fund staff have worked closely reviewing macroeconomic, exchange rate and sectoral developments, aiming at consistency between policy instruments and the objectives of stability, economic restructuring and growth. The results of this coordination have been reflected in the Bank's MRC, in the first and second-year MFPs and in the IHF's standby arrangement and SAP programs. The second-year PFP outlines the underlying macroeconomic and general policy directions for this proposed operation. The Bank's Country Assistance Strategy 25. The Bank's first and most immediate objective in Tanzania is to assist the Government in further development and implementation of specific policy and institutional reforms, in the context of the continuing ERP, and as supported by the Bank's policy-based operations and the PFPs. As recognized in the second-year PFP and SAF programs and in this proposed operation, Tanzania needs to continue major policy and institutional changes in order to achieve sustainable economic growth. The proposed  -8- IRTAC supports measures in trade policy and industrial restructuring which are expected to have a major impact on resource allocation. 26. In the coming years, a series of additional policy-based operations are planned to address key areas requiring substantial further progress. These policy-based operations will continue to support appropriate exchange rate, fiscal, and monetary regimes, as summarized in the 1988-91 Policy Framework Paper. The Bank's policy lending agenda over the next three-to-five years addresses the following areas: (i) agricultural policy, to improve the responsiveness and cost-effectiveness of the marketing system; (ii) financial sector reform, to improve the mobilization and allocation of financial resources while restoring the health of the financial intermediaries; and (iii) public and parastatal sector management, to ensure that Government expenditures are concentrated on the core recurrent and capital programs including basic infrastructure and social services, and that the productivity of the public and parastatal sector is raised. In addition, the trade reform and industrial restructuring programs to be initiated and expanded under the IRTAC would have to be pursued further alongside future policy-based operations, in order to attain trade and pricing regimes devoid of administrative controls, and to achieve full subsectoral coverage in industrial restructuring. 27. A second set of objectives of the Bank's assistance to Tanzania, reflected in its lending program, is tos (i) support projects which preserve and extend the achievements of the last 25 years in education, health and provision of basic services to the populationt (ii) support the rehabilitation of the country's infrastructure (particularly in transport, where the need is critical), and (iii) develop agricultural support services. The recently completed transport sector work, and sector reviews currently underway in health and education, together with the recent parastatal sector review (Report No. 7100-TA) and the ongoing public expenditure review, are expected to provide further guidance on the relative priorities for future IDA allocations. 28. A third objective of the Bank's involvement in Tanzania is to assist the Government in its debt alleviation efforts and in mobilizing external resources in the amounts and (highly concessional) terms required to finance the expenditures which are essential complements to the policy reform program. Aid coordination e_.forts are being heightened to promote the concentration of donor programs on rehabilitation needs and the provision of a higher share of untied aid flows. PART II: THE PROGRAM OF TRADE POLICY REFORK Introduction 29. The past three years mark a significznt departure from previous entrenched and unsustainable policies in Tanzania. The macroeconomic and exchange rate reforms already undertaken provide the building blocks for the continuation of a far-reaching program of trade reform and for the first steps in a long-term program of industrial restructuring. Maintaining an appropriate macroeconomic framework, through the  -9- mplementation of prudent fiscal and monetary policies, is a crucial preconditica-for the success of a program of trade reform and economic restructuring (paras. 60-65 below). Similarly, complementary reforms in the agricultural and financial sectors are essential to attain sustainable recovery in future years (paras. 66-72). Tbe Z*chane late and Trade Policy Framework 30. The Early 1980s. Between the late 19709 and the mid-eighties the policy regime affecting the tradeable sectors in general, and the manufacturing sector in particular, consisted of mechanisms introduced by the Government to cope with the excess demand for foreign exchange arising from an increasingly overvalued exchange rate. The main instrument of demand control was a system of foreign exchange rationing through administrative allocation to individual users. This system, together with import licensing, was used to restrict imports of competing goods and to channel foreign exchange to the importation of industrial and other raw materials. This was complemented by restricting most domestic and foreign trade operations to selected parastatal agencies--known as the confinement policy, and by an elaborate system of price controls. 31. This set of interrelated policies (overvalued exchange rate, rationing of foreign exchange, prohibition of competing lmports and price controls), together with the channeling of scarce foreign exchange to medium and large-scale industrial enterprises to keep them afloat, has had major implications for the performance and efficiency of the industrial sector. Manufacturers have been able to charge prices significantly above border prices, leading to high levels of average protection on manufacturing output in the recent past. Moreover, until recently, the undervalued prices of imported inputs and capital resulting from the overvalued currency implied a large subsidy tc industries enjoying access to administratively allocated foreign exchange (and official credit). 32. The analysis in the Bank's Industry Sector Reportl indicates that an extremely high average level of effective protection on domestic manufacturing production, of about 470 percent, resulted from the cascading combination of the 70 percent average nominal protection on the output side and the 45 percent effective subsidy on the iaputn side. Not every manufacturing firm was similarly protected; the variation within industry was also very large. Some activities have enjoyed virtually unlimited protection (like many large firms producing intermediate goods), the result of their monopolistic status and access to subsidized foreign exchange and credit, while others have been effectively unprotected (li'ie some smaller consumer goods enterprises). Heavily protected firms have had a huge financial incentive to produce and expand activities, at the expense of more efficient firms with less protection. The degree of protection enjoyed by an industrial firm was shown to be inversely related to its economic efficiency; unprotected firms have had, on average, an economic rate of return of 11 percent, while highly protected firms have had negative economic returns averaging -33 percent. The high degree of protection enjoyed by the more wasteful firms has been in large measure the 11 Tanzania: An Agenda for Industrial Recovery, op.cit.  _ 10 - direct result of the administrative system of fcreign exchange allocation. By attempting to keep all large and medium scale enterprises afloat, a disproportionately large share of foreign exchange has been channelled to the more inefficient firms at the expense of more efficient activities. 33. Trade Policy During 1986-87. The economic reform program initiated under the ERP has resulted in an improvement in the trade policy environment, mainly thrcough the large exchange rate adjustment, the policy of own-funded imports, and price decontrols. The policy of allowing own funded imports, whereby the importer is authorized to use foreign exchange from unofficial sources to import a wide range of commodities, now accounts for an estimated one-third of total imports. The range of conmodities allowed under the scheme has been broadened significantly and the implementation of the scheme has been such that virtually any self-financed item can be imported. The opening and significant expansion of the own- funded imports scheme over the past three years has represented a de facto sanctioning by the Government of a sizeable trade liberalized window. 34. These improvements in exchange rate and trade policy resulted in a reduction in the average level of effective protection for industrial activities from 470 percent in 1984 to an estimated 170 percent in 1987. However, until recently, the level of protection was still relatively high for many industrial firms and, equally important, the variation across subsectors and enterprises is still substantial. Also, a significant share of the official (undervalued) foreign exchange continued to be allocated to inefficiant manufacturing activities during 1986 and 1987. 35. Until early 1988, the overvalued currency had not allowed a move away from administrative allocation of foreign exchange. However, under the ERP, the Government has significantly depreciated the currency and, while the rate of devaluation slowed down considerably between March and October 1988, the Government is now moving decisively to establish an exchange rate regime (and complementary fit al and monetary policies) consistent with the elimination of excess %semand for liberalized imports. The adjustment process for the currency is a key component in the proposed design and timetable of the trade reform measures being initiated now and to be intensified during the implementation of this proposed operation. The Proaram of Trade Reform: 1988-1989 36. During 1988 and 1989, the Government intends to continue implementing significant trade reforms in a number of areas, which will be supported by this operation, including: (i) movement away from the system of import restrictions and administrative allocation of foreign exchange; (ii) rationalization of the system of tariffs and sales taxes; (iii) liberalization in internal trade and pricing; and (iv) improvement in export incentives. 37. Trade Liberalization and Foreian Exchange Allocation. All official foreign exchange had been administratively allocated until February 1988, effectively implying that variable quantitative restrictions (QRs) applied on all imports funded from official sources. During 1987, the Government took measures aimed at improving foreign exchange management. In particular, aid coordination in the Ministry of Finance was  - 11 - strengthened and new guidelines were prepared for foreign exchange allocation. However, a significant overestimation of the available foreign exchange, coupled with the lack of fungibility of most aid flows, diminished the practical impact of the new guidelines and procedures. Furthermore, it became increasingly evident that improved matnagement of foreign exchange resources per se could not result in a substantial improvement in the efficiency of foreign exchange allocation and use, as long as all official foreign exchange continued to be administratively allocated. 38. Starting in February 1988, the Government ';egan to make a portion of foreign exchange available on a non-administrative and automatic basis for selected high priority import categories through an Open General License (OGL) system. The opening of this OGL facility represents an important trade liberalization step for imports financed by official sources of foreign exchange. This OGL facility, already resulting in improved allocation for the selected import categories, has reduced administrative costs and, equally important, is expected to demonstrate within Tanzania the benefits of embarking on a process of liberalization of imports and official foreign exchange allocation. 39. During the first eight months of the operation of the liberalized facility an average of about US$3 million per month have been disbursed against a predetermined list of priority raw materials, spare parts and some other items (see Annex IV for detailed OGL list). Import licenses have been automatically issued upon application, followed by the immediate establishment of Letters of Credit upon the submission of local currency cash cover. Initially, access to the facility has been limited to US$100,000 for each import license and to an aggregate amount of US$200,000 per importer. Furthermore, demand has been restrained by the exchange rate devaluation path and by the maintenance of fiscal and financial discipline. A preliminary review of the functioning of the limited OGL facility indicates that the facility has provided foreign exchange on a non- administrative basis to private and parastatal productive enterprises in industry, agriculture and transport, pointing already to an improvement over administrative allocative mechanisms where inefficient operations have benefitted disproportionally. The Bank of Tanzania has managed to institute an efficient system of automatically issuing import licenses for the OGL facility. However, during the initial stages of operation of the OGL there have been some procedural delays in the opening of letters of credit at the National Bank of Commerce. These problems are now being corrected in order to expedite the process of importation. 40. The OGL facility recently established will be expanded according to a phased timetable with the ultimate aim (once the exchange rate adjustment has eliminated excess import demand) of providing non- administrative access to foreign exchange for most untied imports. The first phase of the OGL expansion, to take place in early 1989, will incorporate at least three-quarters of all imported recurrent inputs and spare parts, as well as selected consumer and capital goods, amounting to well over US$200 million of imports (yearly equivalent), and equivalent to 15 percent of all imports to Tanzania. This first stage of OGL expansion will be financed by IDA and untied multilateral and lilateral aid resources. The liberalized imports through the OGL, when added to the  _ 12 - substantial inflow of imports financed through own funded imports (about US$350 million of consumer and intermediate items) and through retained export earnings (about US$60 million), will result, before mid-1989, in over 50 percent of all imports entering under a liberalized trade regime. The bulk of the imports that will still remain subject to administrative allocation In 1989 (about US$450 million) is accounted for by aid flows tied to procurement in the donor country andlor to project-specific expenditures, with oil (US$150 million) and other Government import requirements (US$60 million) accounting for the rest. 41. During FY88189, the limited amounts of official export earnings surrendered to the Bank of Tanzania are expected to be exhausted by oil and essential Government imports, as vell as amortization and interest payments of non-rescheduled debt, limiting the potential availability of this source for OGL financing. However, as exports grow and aid funds are Increasingly provided In an untied form, the Government intends to channel a greater flow of Imports through the facility. Supplying the OGL facility with foreign exchange generated from exports and from additional untied resources will enable the implementation of the second phase of OGL expasion, with the aim of providing non-administrative access to foreign exchange for all categories of Imports consistent with the implementation ad objectives of the EUP. By the end of 1989, only a relatively limited list of import categories will be excluded from the OGL facility. By early 1990, it is expected that over US$300 million in imports (yearly equivalent) will be channeled through the OGL facility. 42. The attainment and maintenance of an appropriate exchange rate will be crucial to avoid excess demand in the OGL facility and to ensure its sustainable expansion, and the Government is committed to continue pursuing an active exchange rate policy to supportt (i) the trade liberalization process; (ii) increased export growth; and (iii) reduction in the current account deficit as a percentage of GDP. 43. When the OGL facility opened in February, the exchange rate stood at TSh 92 to the US dollar and as of end-October 1988, the exchange rate was TSh 98 to the US dollar. While this exchange rate level was adequate to support the limited OGL facility, a continued real depreciation of the currency was required to ensure a smooth operation and sustainability of a broader OGL facility. In early November, 1988, the Government resumed the aggressive exchange rate management policy pursued between early 1986 and February 1988, and devalued the currency to TSh 120 to the US dollar. Purthermore, the Government intends to continue the depreciation of the currency In real effective terms in order to attain before mid-1989 an exchange rate fully consistent with an expanded OGL facility and vith the other external objectives outlined above. Such a policy of exchange rate adjustment will also be necessary to allow a significant increase of the existing ceilings on individual OGL applications during the first half of 1989, and the eventual removal of these ceilings by the end of 1989. Furthermore, as outlined in the second year PFP, the Government will continue to implement an active exchange rate policy to support the achievement of the external objectives. Based on periodic assessments of developments in the terms of trade, inflation and the operation of the OGL facility, the Government will adjust the exchange rate to ensure that an appropriate rate is in place.  - 13 - 44. Tariffs and Sales Taxes. Until recently, the role of Tanzania's tqriff structure in determining the pattern and efficiency of resource allocation had been overshadowed by the prominence of quantitative restrictions and of the centralized allocation of foreign exchange. From the late 1970s to the mid-1980s, therefore, output and input prices were hardly influenced by the structure of tariffs. Instead, prices were determined by the monopoly power given to the local producer through restrictions on competing imports, the nature of price controls and confinement, and the overvalued exchange rate. However, the introduction of own-funded imports, which has resulted in the de facto relaxation of quantitative restrictions, has gradually enhanced the role of tariffs in influencing prices and providing protection to local activities over the past three years. With the opening of the OGL facility, the role of the tariff schedule has now become even more pronounced and its importance will be increased further as the facility expands and the exchange rate becomes the market ciearing mechanism. 45. Until June 1988, Tanzania's tariff structure was relatively complex, although the bulk of imports were subject to tariff rates of zero, 20, 25, and 60 percent. However, there were fifteen other rates as well, ranging between 15 and 200 percent. The lower rates applied mostly to lntermediate and capital goods, while the 60 to 150 percent tariff rate applied to most consumption items. Agricultural inputs, petroleum distillates, pharmaceutical products, educational and packing materials, and some other items, comprising about one quarter of the import value, have not been subject to duty while a few items, accounting for about four percent of the import value, were subject to specific duties. Imports are also subject to sales tax according to a schedule equivalent to that of domestic sales taxes. Sales taxes are concentrated in the 20-25 percent category, particularly for inputs, spare parts and capital goods. A number of final consumer goods, and some raw materials are subject to higher tax rates, which results in a sales tax structure comprising over 20 different rates ranging between zero and 300 percent. 46. There has also been a pervasive system of official duty exemptions, partly related to agreements with donor agencies and partly discretionary, which subverts the impact of the import tariff and sales tax schedule. In 1986, duty collections were only TSh 2.1 billion compared with 4uty exemptions of TSh 2.9 billion. The actual (collected) duty rate on officially recorded consumer good imports was only 11 percent (as a share of consumer imports value), and for intermediate and capital goods the duty collected was six percent, indicating that in practice virtually no effective protection is offered by the present tariff regime to many domestic activities (that have not enjoyed access to official foreign exchange). In addition there is much evasion of customs duties payments (largely through undervaluation of imports), resulting in overall low duty collection and further lowering effective protection to domestic firms. The widespread use of exemptions on import tariff has also applied to the sales tax on imports. 47. Before the budget presentation in June 1988, the covernment prepared an action program to simplify the tariff structure. This program has been ln effect r'ince July and its main elements are the lowering of the maximum tariff, the compression of tariff rates, and the reduction In  - 14 - exemptions and evasion. These reforms are aimed at providing moderate and more uniform protection to domestic activities, while increasing revenues. The simplified tariff structure has resulted in only six positive rates being retained and in the elimination of specific rates. The maximum tariff rate has been lowered to 100 percent, which applies only to five small categories of non-competing luxury goods, while virtually all consumption items have duty to 40 to 60 percent (with the exception of basic need items, which are subject to lower duty). Furthermore, the number of zero duty items has been reduced. In the context of the 1988189 Budget, the Government has also initiated some changes in the sales tax regime aimed at increasing revenues. Reforms in sales taxes include the continuation of the current policy of gradual and selective expansion of the sales tax base; the elimination of some distortive provisions, and the implementation of initial steps towards the simplification of the sales tax rate structure. 48. The Government is currently preparing the second phase of the program to rationalize the tariff and sales tax structure. This program, to be prepared by early 1989. and implemented in the context of the 1989190 budget, will aim at further compressing the tariff and sales tax structure. For tariffs, the maximum rate and the number of rates will be further reduced with the objective of reaching a maximwn tariff not exceeding 60 percent and the number of positive rates not exceeding three. For sales taxes, a task force is carrying out the preparation of an action program consistent with revenue and efficiency considerations, that will include the significant reduction in the number of sales tax rates, with the objective of instituting one basic low rate, excepting a limited list of traditionally excisable revenue earners. Furthermore, the task force will evaluate a proposal to institute a credit system for sales tax (value added tax), and if technically and administratively feasible, such a credit system would be introduced in the context of the 1989190 budget. 49. Equally important, the structure of exemptions of tariffs and sales taxes is undergoing a major restructuring during 1988/89. This is already resulting in a reduction in existing discretionary exemptions, in the strict limitation on the issuance of any new exemptions (including a no-exemption policy on OGL imports and on any other imports utilized in commercial activities), and in the review of all aid agreements in order to limit abuse and discretion in the granting of aid-related exemptions. Furthermore, general exemptions currently given for imports of certain categories have been discontinued. 50. Thl. tariff and tax systems are also impaired by a weak institutional structure, by insufficient staffing, training and equipment, low salaries, and a system of enforcement and penalties that does not discourage evasion. The Government, with the assistance of a UNDP Technical Assistance Team, has already begun to take measures to strengthen the Customs and Tax Department by improving training and by taking measures to reduce evasion on duties and tax payments. The compensation package for tax officers was improved during 1987/88, new training programs have been launched, and monitoring and supervision guidelines at points-of-entry have been tightened.  - 15 _ S1. During the 1988189 fiscal year the Government is continuing to strengthen tax and tariff administration by: (i) expanding the existing training programs, including training for customs and sales tax officers in the newly created Institute for Tax Administration; (ii) recruiting additional personnel; (iii) providing remmuneration bonuses for officers and imposition of penalties for poor performance and abuse; (iv) improving facilities and equipment; (v) increasing penalties for evasion; vi) introduction of a harmonized tariff code classification system; and (vii) introduction of a new tariff code book, incorporating the new simplified tariff structure, and streamlining guidelines for exemptions. This package of institutional measures, by improving tariff and tax enforcement, will result in a reduction in evasion, misclassification and underreporting, and will increase revenues. When combined with the measures to reduce exemptions and zero duty items on the one hand. and to reduce maximum rates on the other, the resulting tariff structure will be substantially compressed, providing for more uniform (and moderate) levels of effective protection to domestic activities. 52. Pricins Refogms. The Government has continued with its far- reaching program of price decontrol. Whereas 400 categories of goods were subject to control in the early 1980s, price control coverage was down to 22 broad categories in 1987188. Further decontrols took place in June 1988, when the Government decontrolled 10 categories of goods, reducing the categories of commodities that remain under price control to the following twelve: petroleum products, fertilizers, farm implements, gunny bags, selected textile products, cement, galvanized corrugated iron sheets, beer, sugar, laundry and toilet soaps and selected types of batteries. The price-controlled items remaining during 1988189 constitute less than 15 percent of the consumer price index basket. Equally important, the distortions arising from the remaining price controls are likely to be small due to two factors. First, since 1987 the methodology for calculating controlled prices utilizes equivalent international prices as a key reference point. Second, the policy of own funded imports has resulted in increased competition, applying pressures on prices to reflect international price equivalencies. At present, controlled prices are in line with international prices, allowing for minor tariff-induced deviations. The most recent example of price adjustment reflecting scarcity values was the 50 percent increase for all petroleum products. 53. Deconfinement Policy. Under Tanzania's policy of confinement, wholesale trade for some domestic and imported commodities is restricted to parastatal organizations. Under this system of state trading monopolies, industries are required to sell certain specific goods through national and regional trading companies and to purchase many of their import requirements and some domestic inputs through designated parastatal trading firms. Over fifty broad categories of goods are subject to internal confinement, comprising mainly consumer goods, building materials and agricultural implements. All imported goods are deemed confined, unless specifically exempted. Since many confined items are not subject to price controls anymore, trade companies negotiate prices with their suppliers for these items, generally on a cost-plus basis, a process which has resulted in similar pricing outcomes to those of setting price controls.  - 16 - 54. Over the past two years. some de facto movement away from monopoly ~ouineuimnt to more diversified confinement has taken place (the result of the granting of numerous exemptions) although confinement has remained the norm for imports and domestic trade. Rural cooperatives are now allowed to compete with trading companies, and the regional authorities are now able to appoint any agents, including private companies, to engage in wholesale trading in their own regions. Thus, while domestic producers are still confined in selling their products to designated buyers, there are now more designated purchasers than before. In addition, any products allowed under own-funded imports and export retention schemes are in practice not subject to confinement, although dezonfinement for own-funded imports is yet to be formalized. Finally, the Ministry of Industries and Trade issues permits to individual firms exempting them from confinement on a case-by-case basis. Such permits are effective only for a limited period (e.g., three months) or for a specified amount of a product. Since such permits are given to individual firms on an exceptional basis, other firms which produce or purchase the same products are in many cases still under confinement. 55. During the remainder of 1988 and early 1989, the Government Intends to intensify the process of trade liberalization through the widespread and automatic granting of exemptions to trade confinement for virtually all items. Furthermore, the Government will prepare legislative measures in order to eni confinement for all fimss and items by February, 1989, excepting, in the case of internal trade, the twelve item remain*ng under price controls, For the distribution of imports, exemptions from complete deconfinement will be based only on health or security reasons. the combined effect of the formal deconfinement steps to be enacted by early 1989 and the intensification of the policy of granting automatic exemptions will result in a system of trade which is de facto deconfined. 56. Export Incentives. The major exchange rate adjustment underway is quickly becoming the most powerful incentive for export promotion. Continuation of an active exchange rate management policy will provide additional impetus to exports. Complementary to the adjustments in the exchange rate, the Government is continuing to remove distortions in the existing export retention schemes, instituting an export duty drawback scheme and simplifying export procedures. The streamlining of export procedures is the result of the reduction in the number of licensing steps (which are quasi-automatic but subject to red tape) and the simplification of the licensing application forms. 57. Export Retention Schemes% For the past two years, a variety of export retention schemes have provided significant incentives to exporters and can be credited with recent increases in non-traditional exports. The effectiveness of retention schemes is due to the gap between official and parallel exchange rates, and to the admin'strative rationing of foreign exchange by the Bank of Tanzania (BOT) and the National Bank of Commerce (NBC). However, distortions arose during 1986 due to large disparities in the various export retention percentages provided to different goods and firms and due to the proliferation of these retention schemes--some of which feature discretionary elements.  _ 17 - 58. During 1987 the Government introduced a number of measures towards consolidation of the schemes, to make them more systematic, and to reduce the dispersion of rates applicable to each exporter, by aligning retention rates for a large number of non-traditional exports to 50 percent (the retention rate for traditional exports is 10 percent). Some distortions remained, however, since some of the schemes were not consolidated and continue to allow for high retention rates for many firms. In addition, the distortive commodity exchange program, for producers who barter their output with imported inputs for their production, results in the de facto 100 percent retention rate for a number of exporters. To reduce the remaining dlistortions, since mid-1988 the Government has reduced the maximum export retention share to fifty percent with virtually no exceptions, and has eliminated the issuance of new permits for the commdity exchange program. Furthermore, in order to continue consolidating export retention schemes, in early 1989 the Government intends to reduce the maximum export retention rate to 35 percent, with limited exceptions. 59. Export Duty Drawbackt Until mid-1988, there was no export duty drawback system in place, which resulted in an anti-export bias for exporters that pay duty on their imported inputs. However, due to the widespread duty exemptions and evasion, the absence of a duty drawback system had only a limited detrimental effect on exports. But as tariff reforms are implemented and exemptions continue to be reduced, the implementation of an export duty drawback scheme is required in order to avoid disincentives to exporters. Consequently, the implementation of a duty drawback scheme has been initiated in the context of the 1988189 budget. The scheme relies on specific drawbacks for exported items, and eligible claimants have already received import tax rebates within a few weeks of submitting their application. Fiscal and Monetary Policies 60. Fiscal Policy. Although the Government has been broadly successful in maintaining fiscal prudence over the past two years and in meeting its short-term fiscal targets, it also recognizes that longer term structural problems need to be addressed in order to maintain a stable fiscal situation in the future. Thus, the Government has used the 1988189 budget to take appropriate corrective measures and strengthen its efforts to address existing weaknesses in the areas of the tax system and its administration, the composition of public expenditure, and the monitoring and control of expenditure. The Government has introduced new tax masures and expenditure restraints in order to limit the deficit to a level that allows no increase in the stock of net domestic bank credit to Government. These measures will permit a substantial increase in credit to the non- government sector, in an environment of restrained monetary growth and declining inflation rates. 61. On the revenue side, efforts to improve the tax system and its administration are being undertaken by the Government. As elaborated previously, during 1988189 the Government will stress the enhancement of the efficiency and yield of the system of import duties and sales taxes. Furthermore, a comprehensive tax review has been carried out by the IMF staff and will be shortly discussed with the Government. Also the 1988189  - 18 - budget includes increases in user charges for education, medical services and roads. in petroleum taxes and in the rates of excise tax for beer, cigarettes and secda. With the 1989190 and 1990t91 budgets the authorities will reform personal income taxes and company taxes, with the aim of broadening the tax base and enhance tax collection, thereby permitting a needed reduction in nominal rates. Income tax administration will also be improved following the preparation of a program by March 1989. 62. On the expenditure side, during 1988189, the Government will stress the following elementst (i) the concentration of recurrent expenditure on key programs (e.g., the maintenance and rehabilitation of the physical infrastructure, the improvement of staffing, equipment, and incentives for revenue departments, the euhancement of basic health and education); (ii) the reduction of overstaffing in the civil service; (iii) progressive improvements in the structure and level of public service pay (consistent with containment of the overall wage bill); (iv) the enhancement o' local government finances and their management; (v) the self-financing objective for commercial parastatals by improving management, reducing overstaffing, and adjusting prices and tariffs; (vi) the improvement of the systems of planning, budgeting, expenditure control, reporting and aid coordinption. As preparation for implementation of this expenditure reform following a census of the public service conducted in March 1988, about 7,600 ghost workers have so far been eliminated from the payrolls of the Central Government and 20,400 from the payrolls of local governments. Furthermore, during 1988/89 the Government will continue its policy of freezing the staffing level of the civil services, except in education and health, while reallocating positions to priority services such as tax administration. The 1988189 budget also includes a 10 percent. increase in appropriations for maintenance expenditures in real terms, with most of the increase being for road maintenance. 63. On the Public Investment Program (PIP), the Government will continue to concentrate development expenditures on the completion of ongoing projects and rehabilitation, while the number of projects in the PIP will be further reduced. Thus, locally funded projects are being reviewed and consolidated to improve implementatior.. In addition, external funding will be applied to selected rehabilitation with high returns (e.g., projects to improve the infrastructure that supports export activity, as well as selected investments in social services). Also, particular attention will be paid to the sustainability of the recurrent costs. In order to continue umplementing measures to rationalize Public Expenditures and Investments during 1989/90, the Government, in consultation with the World Bank, will formulate an action program following the completion of the ongoing Public Expenditure Review. 64. As a resulr of these measures, the program for 1988/89 targets an increase in the revenue/GDP ratio to 21.5 percent of GDP in 1988/89, compared with 18.0 percent for 1987/88. While expenditure will increase in relation to GDP to 31.9 percent in 1988189 versus 25.9 percent in 1987/88, this primarily reflects exchange rate changes, as well as interest payments on the debts of the marketing boards assumed by the Government. 65. Monetarv Poliev. The central objective of monetary and credit policies during the next three years will be to reduce sharply the rate of  - 19 - monetary growth in order to achieve the targeted reduction in inflation (to about 10 percent p.a. by 1991), while providing an adequate supply of credit to the productive sectors. this objective will be achieved through restraint on bank credit by the Government and through the ongoing reform of agricultural marketing that vill eliminate the financial deficit of the marketing boards (that was previously covered systematically by bank credit, see below). In 1988189 the Government's fiscal policy will make it possible to keep the net stock of bank credit to the Government constant, while the total increase in net bank credit to specified marketing boards will be limited to TSh. 2 billion. Furthermore, credit to agricultural cooperatives will be closely monitored by the BOT and NBC. This program will allow the authorities to limit broad money expansion to 10 percent, versus 35 percent in 1987188. The reduction in the rate of monetary growth is intended, inter alia, to achieve the targeted decline in the inflation rate from 30 percent p.a. at end-1987188 to 18 percent at end-1988/89. Agricultural Policies 66. In order to enhance the incentive structure and resource allocation in agriculture and to improve agricultural marketing, the Government has now embarked on major institutional and pricing changes in the sector. These measures also have the objective of restoring balance to the monetary program, which has been adversely affected in the recent past by the high credit requirements of the National Hilling Corporation (NMC), the Tanzania Cotton Marketing Board and the cooperative sector. On foodgrains, the Government is now reforming the food crop marketing system, building on the improvements already achieved (such as increase in producer prices and substantial involvement of the private sector in grain trade). For maize, this is being attained by redefining the role of licensed traders, the cooperative unions, the Government and NMC. In particular, unlike the past, maize marketing costo associated with food security functions is now on the account of the Government (and not NM1C) through its Strategic Grain Reserve (SGR) arrangement. Thus, the Government is now the buyer and seller of last resort. Furthermore, procurement prices for the SGR stock will be differentiated to reflect quality and locational variations, thereby reducing economic distortions in the present panterritorial pricing system. Under the new foodgrain marketing system, cooperative unions and primary societies will be allowed to sell maize to licensed traders, continuing the marketing liberalization process. Complementary to these measures, the role of NM1C and of the cooperative unions in maize procurement and distribution has been redefined: they are now expected to operate in a commercially-oriented fashion. The into-store price that NHC will pay is now being freely negotiated and, similarly, 31fC will be free to determine its ex-store price. 67. In export crops, complementing the reforms already undertaken in the recent past, (real increases in producer prices, private sector involvement and reestablishment of cooperatives), the Government intends to increase the flexibility of export crop marketing and to put greater pressure on warketing margins by reducing the role of the marketing boards to non-monopolistic agents of the cooperatives, and by allowing the cooperatives to retain the ownership of the crops until they are sold, giving the cooperatives more autonomy also for procurement and crop  - 20 - pricing. Phased action programs have been prepared for three major crops (coffee, cotton, and tobacco, to be implemented in early 1989), and action programs for the othe:s will be prepared during 1988189 and implemented during 1989 and 1990. The major ongoing and intended reforms in foodgrain and export marketing will be supported by the Agricultural Adjustment Credit currently under preparation, which is expected to be appraised in early 1989. 68. In addition to these structural changes in the marketing and pricing system for food and export crops, the Government is moving ahead with programs to alleviate other constraints to efficient agricultural marketing. Major rehabilitation programs for rural and trunk roads and for the Tanzania Railway Corporation are under ;reparation; resources are being made available for rehabilitation of agroprocessing facilities and for construction, of storage facilities; agricultural support services (credit, research, and extension) are being strengthened, and a program to increase cotton ginning capacity is being implemented. The Financial Sector 59. Almost every aspect of Tanzania's financial sector is state controlled with the market playing virtually no role. Monetary and credit policies and targets are determined in the Government's annual Finance and Credit Plan, which indicates the distribution of credit classified by economic activity and borrower, with explicit allocations made for the Central Government, public enterprises, and the rest of the economy. Over 90 percent of the credit allocated is absorbed by the Government and public enterprises. This system, combined with the objective of sustaining many uneconomic activities, has resulted in a significant misallocation of credit resources in the economy. The main factors associated with the misallocation of credit have beent (i) limited competition in the mobilization and allocation of financial resources; (ii) lax rescheduling practices and failure to recognize non-performing loans as losses by the financial institutions; (iii) institutional weaknesses in some of the main financial institutions; (iv) administrative allocation of foreign exchange; and, until recently, (v) low interest rates. 70. The deterioration of economic conditions over the past decade and the controls imposed on the sector have combined to contribute to the practical insolvency of many of Tanzania's financial institutions which consist of the Central Bank, two covmercial banks, four development banks, and four other small financial institutions. The two industrial development banks have serious arrears in more than half their portfolios. Furthermore, their portfolio losses are not properly recognized, their capital bases have been considerably eroded, and their external liabilities have experienced a many-fold increase since the exchange rate adjustment began. The largest bank, NBC. which has a virtual monopoly on the mobilization and allocation of short-term funds, is also facing serious financial problems largely due to the accumulation of large overdrafts held by the troubled agricultural marketing boards. 71. Interest rates have been negative in real terms since the mid- 1970s, and have been a deterrent to domestic resource mobilization and efficient credit allocation. However, Interest rates have more than  - 21 - doubled since October 1985, resulting In substantially less negative interest rates during 1987 and 19B8. As compared with the current inflation estimate of 29 percent, by early November, 1988, the savings rate of interest was 24 percent, the maximum commercial bank lending rate was 29 percent; and the lending rates for medium- and large-scale industries was 28-29 percent. Furthermore, in December 1988, the Government is expected to adjust upwards the rates to make them positive in real terms. In particular, the savings rate will be increased by 5 percentage points to 29 percent while the lending rates for medium and large-scale industry will be 31 percent. 72. The Government intends to implement far-reaching institutional, financial, and policy reforms in the financial sector and has established a Commission and Secretariat for this purpose. The main objectives of Government's reforms would be to diversify financial channels and services, improve resource mobilization, and restore the financial health of the banking institutions. Institutional reforms would be aimed at, inter alia, increasing the overall competitiveness and efficiency of the sector. and financial restructuring of the main banking institutions. The diagnostic review of the sector is expected to be completed in early 1989, and implementation of the action program for the financial sector is expected to be underway during 1989190 and would be supported by a proposed Industrial and Financial Restructuring Credit (FY90). PART I1I. THE INDUSTRIAL SEC50R Overview 73. Until the mid-1960s, Tanzania had a small industrial sector dominated by private firms. Without a significant break from the past, a somewhat more ambitious industrial program was undertaken after 1964. The major departure in terms of strategy and implementation, however, took place in 1974 when the Government adopted the Basic Industrial Strategy (BIS), emphasizing import-substitution and the production of capital and intermediate goods, and investments in the parastatal industrial sector, which played a lead role in the development strategy of Tanzania. 74. The combination of external shocks, inappropriate policies, and very low productivity of the massive investments undertaken since the start of the BIS has resulted in an industrial sector that is inefficient, relatively large scale and capital intensive, import dependent, and operating at low capacity. After using a massive amount of investment resources over a decade (amounting to a total of over US$2 billion from the mid-70s to the mid-1980s), Tanzania's industry was producing in 1985 only about 3 percent of the country'&l GDP (measured at world prices) -- yet it utilized direct and indirect imported inputs equivalent to almost one-third of total imports. Capacity utilization averaged 25 percent and one-third of industrial activities were estimated to be producing with negative value-added at world prices.2 The significant decline in industrial X1 'Tanzaniat An Agenda for Industrial Recovery op. cit.  - 22 - output since the late 19709 was related to the decline in agriculture, which meant fewer raw materials to process and dwindling foreign exchange earnings. Underlying the decline in output in both sectors were distortionary exchange rate, trade and pricing policies, which had been in place since the late 1970s (see Part TT). 75. Among industrial subsectors, on average only food processing, beverages, tobacco and rubber processing are operating at satisfactory efficiency levels. Textiles, glass, metal products and machinery are marginally inefficient, while tanneries, iron and steel and transport equipment are very inefficient (Annex VT). Among currently inefficient subsectors, however, there are many potentially viable activities (particularly in textiles, taDneries, metal products and machinery). Parastatal firms in the group of highly inefficient activities are significantly over-represented, although a very large proportion of private sector activities are also inefficient. On average, import and capital intensive activities are significantly less efficient than labor intensive activities which utilize local resources, while smaller firms, employing fewer than 100 employees, are more efficient than larger firms. 76. The Bank's industrial sector analysis indicates that while there would be some limited productivity gains in some subsectors from across-the-board increases in capacity utilization in industry, far greater benefits would flow from reallocating existing resources away from unviable activities to other more productive manufacturing activities. In particular, significant gains could be accrued by reallocatikn of resources away from unviable enterprises (producing at negative or very low value added) to high value added activities, and by the restructuring of currently inefficient firms into viable enterprises. 77. The major ongoing macroeconomic, exchange rate, trade and pricing reforms have already resulted in some reallocation of resources. Since 1986, resource allocation in general, and of imported inputs in particular, has shifted away from industry to agriculture and transport. A decline in production and utilization of inputs is already apparent among many inefficient industrial activities while some efficient firms have managed to increase capacity utilization. Aside from the strategic shift of public expenditures towards transport and agriculture, the ongoing reallocation of resources (within industry and between industry and other sectors) is associated with the decline in average effective protection to industry and the reduction in the dispersion of protection across industries. The compression in the structure of protection since the initiation of trade liberalization has been largely the result of significant reductions in protection to very inefficient enterprises. The industrial sector is currently operating at a similar level of average capacity utilization (about 25 percent) as in 1984, but is producing higher value added while utilizing less resources. 78. The evidence of incipient reorientation in industry is encouraging. However, a major restructuring of inefficient industries and a significant expansion of efficient activities will only take place as the Government continues the implementation of the macroeconomic and trade reform program and initiates industrial restructuring measures in key subsectors and firms. In addition to the policy distortions that have  - 23 - plagued industry, which are being removed through implementation of the EP, there are significant structural, operational and managerial inefficiencies in the sector at present. The financial situation of many firms is precarious; managerial and skilled labor shortages are common; infrastructural bottlenecks in power, water and transport are seriously hampering industrial operations, and shortages in raw materials and other inputs persist (Annex V). Industrial Restructuring and Rehabilitation 79. The Government's industrial reorientation strategy emphasizes rehabilitation over new investments, export orientation, reallocation of resources towards more efficient, labor-intensive activities and a better balance between private and parastatal enterprises. For the past few years the Government has reiterated the positive role to be played by the private manufacturing sector, as part of a strategy currently being complemented by attaining a neutral set of incentives throught i) the trade, pricing and foreign exchange allocation reforms underway; ii) the investment code under preparation; iii) reallocation of public expenditures priorities, and iv) the positive signals now faced by the dynamic informal and small scale sectors. Furthermore, the Government's current strategy emphasizes a better balance between industry and other sectors (particularly agriculture and transport), whereby industry is now expected to play a complementary role. In support of this strategy, the proposed operation would initiate the process of industrial rehabilitation and restructuring. The ongoing and proposed trade and pricing reforms are necessary preconditions for the restructuring and recovery of the unproductive industrial activities. The nature of these reforms (supported by this operation), suggest that an adequate set of pricing signals will be present in the economy during 1989. Further allocative improvements will take place during 1989190, following institutional reforms of the financial sector and in agricultural marketing. Therefore, the Government will develop industrial restructuring action programs in order to initiate implementation in early 1989. The interrelated nature of the problems in each sector requires that in-depth action programs be developed through a vertically integrated review in each subsector. 80. Consistent with the existing institutional constraints and the gradualist approach of the ERP, the Government has chosen to implement a phased restructuring program for the industrial sector. During the first phase of industrial restructuring the Government will develop action programs for three subsectors: textiles, leather, and agro-processing (edible oil and meat packing). These subsectors are based on domestic resources, comprise more than one-third of total industrial production and of formal employment in industry and are deemed to have considerable potential for improving efficiency and capacity utilization through restructuring and rehabilitation. These subsectors are currently operating at about 30 percent capacity and with relatively high (and variable) domestic resource costs. The potential viability of a large number of currently inefficient enterprises in these subsectors (both parastatal and private), can be realized by the combination of firm-specific restructuring measures, and the reformed macroeconomic regime. The viable segments of these subsectors will also benefit from the reallocation of resources away from unviable activities, which will be phased out. Additional subsectors  - 24 - will be incorporated to the restructuring program at a later stage, in order to encompass all important industrial subsectors over the 1989-1992 period. Nonetheless, reorientation of resources away from unviable activities towards productive users will continue to take place during 1989 in all industrial subsectors, the result of the macroeconomic and pricing reforms, and the absence of Government subsidies to industrial enterprises. 81. The restructuring programs for textiles, leather and agro- processing will be supported by IRTAC (see Part IV). The Government, with assistance from specialized consultants, will develop action programs during the next six months, and implementation is expected to commence before June 1989. 82. Leather. In the leather subsector, significant institutional, operational and policy issues need to be addressed at all stages of the processing chain, which includes livestock, hides and skins, tanned leather and footwear, and other leather goods. The quality of hides and skins is very poor due to lack of proper care of animals, inadequate slaughtering and curing procedures, insufficient transport and improper storage. The majority of hides and skins have been smuggled out of the country, largely the result of distorted incentives (the overvalued exchange rate in particular). Production, quality defects, and pricing distortions in the subsector will be studied, and recommendations made for their improvement. 83. Virtually all leather processing capacity is concentrated in three large parastatals, which are operating inefficiently and at low capacity utilization levels. The low productivity of the shoe subsector is largely the result of the distressed situation of the Morogoro Shoe Company. This parastatal factory (supported by Loan No. 1386-TA). which is one of the largest shoe factories in the world, has never operated at more than 7 percent capacity utilization and is generally recognized as having been a misconception both in size and in its aim to produce mainly for export. A detailed study will be carried out for each type of footwear in the shoe subsector to determine the va.ability of domestic production and define an action program to restructure and streamline their operations, or dismantle a plant and sell the assets. In the leather subsector, the three parastatals will be subject to an operational, financial and technical restructuring following a viability assessment. 84. Textiles. The textile subsector is the largest industrial subsector in terms of total employment (24 percent), and the second largest in terms of value added (19 percent) after food products. Out of 92 establishments in the subsector, about twenty are of significant size, of which ten are large private textile firms. However, most of the capacity is in the parastatal sector. Some of the problems of the subsector relate to institutional and policy issues affecting the main raw material, cotton. These include distorted seed cotton pricing, inadequate and high costs of ginning, transport problems, and inefficient marketing resulting from the monopolistic status of the Cotton Marketing Board. 85. Textile production facilities, though conventional in terms of tec'lmology, are fairly new, and until recently have been operating in an overly protected market situation. Efficiency levels are low on average and highly variable across firms. Capacity utilization, at 25 percent, has  - 25 - been low. In addition to policy issues such as pricing and the distorted structure of taxes, the subsector is also faced with infrastructural bottlenecks, managerial and skilled labor inadequacies, lack of spare parts and in some instances flawed plant locations. But the prospects for recovery for most of the sector are good, given the abundant availability of good quality cotton, technologically adequate equipment (and no limiting quota restrictions in the EEC countries). Complementary to the vertically integrated review of the subsectoral issues, which, inter alia, will assess whether overall capacity in the subsector exceeds prospective demand and define a subsectoral action plan, the individual viability studies of the large textile firms will result in specific financial, technical and institutional restructuring proposals. AProDrocesina 86. Edible Oil. There are four relatively large edible oil processing plants, of which only one, a joint private-cooperative venture, is both complete and operational. In addition, there are about 25 smaller establishments. Last year's utilization of the combined edible oil processing capacity was only about 9 percent while substantial amounts of oil were being imported. Much of Tanzania's most important source of edible oil, cottonseed, has remained uncrushed year after year largely due to distorted prices and an inefficient marketing structure. The oil processing plants are also plagued with equipment obsolescence, technical and infrastructural bottlenecks, and financial and managerial constraints. The review of the domestic oil milling industry will include an assessment of the demand and supply situation of the industry, as well as the economic and financial viability of the main mills and of the solvent extraction plant. 87. Heat Packina. Tanzania has only one parastatal meat packing enterpriset Tanganyika Packers Limited (TPL), which has been in operation since the 19509. TPL's one operating plant has two main activities, a slaughtering cattle for meat and for processing into corned beef and other meat products; and canning for vegetables and fruit, including fruit juices. Until the early 1970s, when meat quality deterioration resulted in loss of access to the UK market, TPL had a thriving export business. Capacity utilization at present is 2 percent for corned beef and 17 percent for juices. TPL is faced with a host of problems, related to managerial, financial and operational inefficiencies, and equipment obsolescence. Following a viability assessment, TPL could benefit considerably from a restructuring program that would aim to make it internationally competitive again. PART IVs THE PROPOSED OPERATION Backtround 88. Discussions with Government about the scope and content of the proposed credit began in the context of discussions of the Bank's Industrial Sector Report in 1987. The proposed program of trade policy reforms and industrial restructuring measures is an important component of Tanzania's medium-term strategy, outlined in detail in the Policy Framework  - 26 - Papers. The proposed operation was appraised in February/March 1988. Negotiations were held in Washington from May 27 to June 7, 1988. The Tanzanian delegation was led by Dr. F. Mujuni, Principal Secretary, Ministry of Industries and Trade. Obiect'ves 89. Tanzania has embarked on the difficult road of structural adjustment. It has already implemented tight aggregate demand management policies and a major progressive adjustment in the exchange rate and trade regime, and has taken significant steps in the areas of pricing. The objectives of the proposed operation are to support the continuation of the reform process, and build upon the significant adjustments already made. The proposed operation vould support a program of trade policy reform (the centerpiece of which is the process of liberalization of imports and internal zrade), initiate the process of industrial restructuring and rehabilitation, and provide quick-disbursing foreign exchange resources to ease the country's import constraints. 90. Since a stable macroeconomic framework and an appropriate exchange rate tegime are essential preconditions for the successful implementation of a program of trade reform and sectoral restructuring, this proposed operation will also support the continuation of a program of fiscal restraint, the restoration of monetary stability through the adoption and implementation of an action program reforming foodgrain marketing (thereby alleviating credit requirements), and the continuation of the exchange rate adjustment, with the objective of attaining an exchange rate regime consistent with the process of trade liberalization. The fiscal, monetary and exchange rate adjustments have been supported by the IHP standby program (which lapsed at end-February 1988), the first-year SAP program, and will now continue to be supported by a second-year SAP and PFP for the period 1988/89-1990/91. 91. The specific trade and pricing reforms supported by this credit complement the budgetary, monetary and exchange rate measures being implemented, and would lead tot (i) relaxation of internal and external trade restrictions and administrative allocation of foreign exchange, thereby improving the efficiency of use of the country's scarce resources; (ii) further progress on pricing reforms; (iii) improvements in the tariff and tax structures; and (iv) reforms in export incentives. The industrial component of the proposed op ration would lead to the development of subsectoral and firm-specific action programs for the rehabilitation and restructuring of three major subsectors in industry (leather, textiles and agroprocessing) and pave the way for further action programs in other subsectors over the next few years. This package of trade and pricing policy reforms and industrial restructuring measures, together with the balance-of-payments support, is expected to lead to a significant supply response and to improvements in productive efficiency. Liberalization of internal and external trade, in the context of a stable macroeconomic framework and an appropriate exchange rate and tariff regime, will result in resource reallocation from unviable users to production activities, while the combination of trade and pricing reforms will give strong incentives for currently inefficient (but viable) firms to restructure their operations and become more efficient. In industry, this process will  - 27 - a4so be aided by the implementation of specific action programs. f'rthermore, the exchange rate adjustment, the liberalization of foreign eichange allocation and improved export incentives is expected to result in a significant increase in high value added exports. Pronram Description and Financing 92. The objectives outlined in the previous section would be pursued through a fast disbursing US$198 million operation, including US$135 million from regular IDA funds, and an estimated US$63 million eluivalent in cofinancing from the African Development Fund, The Netherlands, Switzerland and the United Kingdom, and a supporting package of policy reforms and action programs for rehabilitation and restructuring of specific subsectors in industry. Other donors have expressed interest in participating in the financing of this program and supporting the OGL facility at a later stage. The proposed credit would be made to the Government and would be released in two tranches. The proceeds of the credit, to be disbursed through the OGL facility (with the exception of a US$3 million technical assistance component) over an estimated 15-month period, would Increase the foreign exchange available to the Government's import liberalization scheme. The trade reform components associated yith this operation were discussed in Part II and are summarized in matrix form in Annex III. The Government requested and has already received from IDA a Project Preparation Facility (PPF) advance of US$1 million to finance the advance payments to consultants for the preparation of action programs for the rehabilitation and restructuring of the selected industrial subsectors. 93. Industrial Restructuring Comnonent. The subsectoral action programs to be developed under this operation would be carried out in three phasess Phase I - diagnostic study of the selected subsectors and identification of issues at a firm-specific as well as a broad subsectoral level; Phase II - development of rehabilitation and restructuring action programs with specific time-tables for implementation; and Phase III - implementation of the action programs. Currently inefficient operations which are judged to be potentially viable will be subject to restructuring measures includings (i) managerial, technical, operational and financial reorganization; (ii) streamlining of activities; (iii) rehabilitation of plant and machinery; and (iv) merging of activities or enterprises to improve efficiency in resource use. Inefficient enterprises for which no measures can be identified to make them viable will be denied access to administratively allocated resources and, when appropriate, subject to phase-outs -and closures. Environmental concerns relating to the three selected industrial subsectors will also be addressed, as discussed in the terms of reference. The terms of reference for the preparation of the action programs for the three subsectors are available upon request. 94. The development and implementation of th.e restructuring programs will be carried out with the significant input of teams of specialized consultants, comprising both foreign and local experts. The selected consultants are expected to commence their field work before end-1988 and the preparation of the subsectoral and firm-specific action programs is expected to be carried out within a six-month period, so that by mid-1989 implementation of the restructuring action programs would have been initiated. The implementation of most restructuring measures in the three  - 28 - subsectors is expected to be completed during the couTse of FY1989190. The consultants will work with an ad hoc task force comprising of representatives from the Ministries of Finance, Industries and Trade, Agriculture, and Energy and Minerals, the relevant holding parastatals, the Tanzania Investment Bank, and the private sector. This task force will report to the existing Interministerial Technical Committee, which would approve the procedures and timetables for securing implementation of the recommendations addressing subsectoral constraints, and for overseeing the implementation of the firm-specific action programs. At the end of each phase reports would be submitted to IDA for review. In consultatien with IDA, the implementation of certain clearly identified restructuring measures may commence prior to the finalization of the action programs. Disbursements. Procurement and Auditing 95. The proposed credit would be released in two tranches. The first tranche of US$62 million of IDA would become available upon effectiveness for disbursement through the OGL Facility, while US$3 million would become available upon effectiveness for the industrial restructuring component. The second tranche of US$70 million, would become available upon satisfactory progress of the program as well as fulfillment of specific conditions for tranche release (para. 103). The closing date of the proposed credit is December 31, 1990. The proceeds of the credit would be used to finance 100 percent of the foreign exchange cost of eligible imports, and 100 percent of expenditures for consulting services. The PPF advance would be refinanced by the IDA credit. Retroactive financing would be available for imports channelled through the OGL facility after September 1, 1988 up to an amount of US$14.5 million. 96. Procurement and disbursement procedures for this operation have been designed to allow for rapid utilization of the Credit's proceeds. To this end, the Bank of Tanzania (SOT) would open a Special Account for the IDA Credit. At effectiveness, an initial deposit of US$40 million, representing about four months of expected expenditures under the credit, would be made by IDA to the Special Account. The account would be replenished regularly. Statement of Expenditures (SOE) would be used to support requests for disbursements for all purchase orders less than US$400,000. SOEs would be prepared by the BOT, which would retain appropriate documentation for review by IDA. Theee statements would be audited annually by independent auditors acceptable to IDA. Disbursements for prefinanced imports under the retroactive financing arrangements will be made on a reimbursement procedure to the Government. The closing-date of the credit is December 31st, 1990. 'It is expected that disbursements may be completed earlier, however. 97. Procurement would be limited to goods from Bank's member countries, Switzerland and Taiwan. Both private and public sector imports would be eligible for financing. Contracts for the procurement of goods by the private sector of less than US$2 million equivalent would follow normal commercial practice. Government contracts equivalent to less than US$2 million would follow the Tanzanian Government's procurement practice, which is acceptable to IDA. All purchases under contracts of more than US$2 million would be procured through international competitive bidding. Expenditures for goods covered by invoices for less than US$1,000  - 29 - equivalent vould not be eligible for financing. Consultants for the studies (para. 94) have been selected according to normal competitive procedures acceptable to IDA. The qualifications, experience and terms and conditions of employment of any consultants financed under this credit would be satisfactory to IDA and in accordance with IDA guidelines. 98. The Bank of Tanzania would be responsible for monitoring credit accounts and for arranging an annual audit of the Special Account by independent auditors acceptable to the Bank. The audit of the Special Account, and the audits of the supporting documentation for the SOEs would -be submitted to IDA within six months of the end of the fiscal year. Lranche Release and Monitoring 99. The Bank will monitor the implementation of the overall ERP as well as the general progress in the implementation of the macroeconomic program, and the specific action plans outlined An the Letter of Government Policy, through regular supervision missions and exchange of views with Government. The Bank will continue to coordinate closely with the IHF on the monitoring of key macroeconomic indicators and policies, including the exchange rate, fiscal and monetary targets. 100. The Government will continue implementing the reform program associated with the ERP and supported by the PFP framework and SAF agreement. We are satisfied with the general progress in the implementation of the overall program, and as a general condition of second tranche release the Government will continue to ensure satisfactory progress in the macroeconomic adjustment program, including appropriate exchange rate policy, fiscal stability and monetary restraint. In addition, the initial OGL facility, which opened in February 1988, will continue to operate without modifications until early 1989, when the Government will expand the list of eligible items and raise the ceilings for each license application and individual importer. Following the reduction in price-controlled items to twelve in the context of the June 1988 Budget, price controlled items will not exceed 15 percent of the CPI basket and the Government will ensure that controlled prices will continue to reflect international price equivalencies (allowing for tariff differentials). The Government will also continue its policy of trade diversification through the continuing provision of exemptions from: (i) internal trade confinement for Cooperatives and Regional Trade Companies; (ii) internal trade confinement for other private and parastatal agents for items not subject to price controls; (iii) import confinement for items in the own-funds and OGL schemes; and (iv) import confinement for many importers. In the area of public investment, the Government will continue its policy of limiting new investments in general, and in industry in particular, sad channeling the bulk of resources to rehabilitation expenditures and recurrent costs. 101. In addition to implementing the overall ERP policies and the specific measures supported by IRTAC, the Government has now initiated steps towards an action-oriented review of the financial sector. This will lead to a finanv'al sector reform program to be implemented during 1989190 that will include measures to increase competition in commercial banking, restructure the portfolios of key banking institutions, and increase the  - 30 - efficiency of the financial sector. The Government has prepared terms of reference for this action-oriented review. 102. The Government has recently adopted a number of critical measures, namelys (a) significant real exchange rate depreciation, consistent with the objective of eliminating excess demand in the OGL facility and agreement to further depreciation in real terms to ensure consistency between the exchange rate regime and the expanding OGL facility; (b) an action program, satisfactory to the Bank, to improve maize marketing, restore the financial viability of NKC and alleviate its credit requirements; (c) implementation of the first stage of the tariff and sales tax reform program, with the objective of significantly simplifying the tariff and sales tax structure and reducing exemptions. Tariff simplification has been attained by: (i) reduction of the maximum tariff rate from 150 to 100 percent and of the number of positive tariff ad valorem rates from fifteen to seven; and (ii) conversion of all remaining specific tariffs to ad valorem rates. For all sales taxes, an initial reduction in the number of rates has taken place and the sales tax base has been broadened. Exemptions on import taxes are now ruled out for OGL, own-funded imports and other commercial activities, and discretionary exemptions are provided only under exceptional circumstances; (d) limitation of maximum retention percentage for exports to 50 percent (with few exceptions), including the phase-out of the firm-specific commodity exchange program, save some contractual agreements; (e) completion of selection process for consultant firms that will prepare action programs for industrial rehabilitation and restructuring. 103. In addition to ascertaining that the implementation of the overall macroeconomic program and associated policies (as per Letter of Government Policies, Annex II) proceeds satisfactorily, the release of the second tranche would be contingent upon the following specific conditions: 1. OGL Expansion& Progressive expansion of the OGL facility, so thlat no less than three-quarters of imported recurrent imports and spare parts, plus some consumer and capital Roods, are channelled through it before release of second tranche.3 Agreement will also be reached on a timetable for further expansion of the OGL facility later in the year, resulting in only a limited list of import categories being ineligible from the OGL facility by end- 31 A detailed list of import categories to be included in the expanded OGL Facility has been specified and agreed, and is available upon request.  - 31 - 1989. As the OGL expands, ceilings on license applications and individual importers through the OGL facility will be increased to at least US$500,000 per importer before mid-1989, and agreement on a timetable to eliminate those ceilings during 1989 will be reached. 2. Tariffs and Sales Tax Reform: Preparation and agreement on action program to rationalize the sales tax structure and to compress further the tariff structure, which will be implemented during FY89/90. Review of aid-related exemptions, in order to limit unjustified exemptions. Preparation and evaluation of proposal to institute a credit system (value added tax). In addition, institutional strengthening of the Customs Department. 3. Export Incentives: Reduction of maximum retention percentage to 35 percent, with limited exceptions, and satisfactory operation of a duty drawback scheme (currently under implementation). 4. Distribution Policiest Formal deconfinement of all internal trade and import of goods except the twelve price-controlled items and goods whose importation is confined for health and security reasons. 5. Industrial Rehabilitation and Restructuring% agreement between the Government and the Bank on action programs for the three selected subsectors, and start-up of implementation of the action programs. These action programs will include major restructuring measures for inefficient but viable enterprises and phase-outs for unviable activities. Social and Economic AsDects of Adiustment 104. General. The economic and social impact of the measures being implemented and to be adopted in the context of this proposed operation, and the related increase in concessional capital inflows, should be beneficial even in the short term. Gross Domestic Product over the next five years is expected to grow at about 4.5 percent p.a., mirroring the growth of the largest sector, agriculture, while the fastest growing sector in terms of value added is expected to be industry. Consumption per capita is expected to rise minimally in the short-term, and to approach a growth rate of one percent p.a. by the early 19909. The continued devaluation of the shilling will have an impact on the price level, but this will be mitigated by the fact that the prices of most imported items reflect the parallel exchange rate rather than the official rate, and that the prices of many other goods represent temporary scarcity values. In both cases, there would be deflationary forces which can be expected to arise from increasing supply response and availability of imports, and by the continuous reduction in industrial protection and increase in competitiveness brought about by the trade liberalization process. Equally important, the expected fiscal and monetary restraint, coupled with more realistic interest rates, should provide a check on inflationary pressures. 105. Higher producer prices for the main export crops are expected to result from continued exchange rate adjustment and from improvements in  - 32 - marketing efficiency, substantially raising farm incomes, and improving rural purchasing power. Improved price incentives for all export crops will encourage farmers to continue diversifying their crops and to increase production. In the urban areas, food grain prices have remained stable while the shilling has been devalued -- at least partly because of reductions in marketing costs resulting from grain trade liberalization. Regarding urban wages, a very significant downward real wage adjustment for urban workers took place over many years preceding the devaluations of the currency. During the adjustment process, urban unemployment may increase somewhat, and some reallocation of labor resources will be required in the short to medium term. However, as capacity utilization increases and output and productivity growth materialize, urban employment and real wages will increase in the medium and long term. In addition, there are strong indications that the informal sector is growing rapidly, and already accounts for the bulk of urban incomes, which are less vulnerable to reductions in formal employment. 106. Any assessment of the possible economic and social costs of adjustment in Tanzania ought to consider that the expected social costs in the absence of an adjustment program would be much higher. Nonetheless, safeguarding essential social expenditures during the adjustment process is an important objective for the Government, in light of important changes in relative prices, fiscal restraint, and the emphasis on channeling resources to productive sectors. Tanzania's base of social services is high but has been severely eroded in the aftermath of the economic decline of the late 19709 and early 1980s. Education standards have fallen, health services are under great strain and rural and urban water supply schemes are in disrepair. Rectifying this situation will require some shifting of budgetary resources towards health, education and water, more efficient use of resources within the social sectors, wider use of cost recovery measures and greater community involvement in the operation and maintenance of services, and highly focussed interventions by donor agencies, including IDA.'s future lending program. 107. Consequently, the Government, which has long emphasized the social aspects of its economic policies, will monitor the social aspects of the adjustment process to ensure that vulnerable and low-income groups fully participate in the economic recovery program. The Government has already initiated actions in this respect by establishing a Monitoring Committee and by preparings i) a research agenda to identify priorities; ii) terms of reference for a food and nutrition survey, expected to be underway before end-1988, and iii) a social cost of adjustment workshop, to take place in December 1988. Those already identified as needing particular attention during the recovery process include the poorest income groups, women and children, and those displaced from public employment. The Government intends to increase the effectiveness of basic human services (education and health) through iuproved management in local government, quality enhancement and resource reallocation. IDA's health and education sector operations under preparation are expected to support the Government's efforts to improve the provision of social services. In addition, the Government will encourage informal sector expansion, particularly in urban and peri-urban areas, so as to develop a broader income base for the poor.  - 33 - 108. Industry. A gradual reallocation of recurrent resources from low to high value added activities, and the restructuring of currently inefficient, but potentially viable enterprises, are expected to result in significant industrial value added growth, starting from the current low base. At world prices, value added in manufacturing is expected to grow at about eight percent per annum over the next three years. By the early 19909 manufacturing value added at world prices could be 50 percent higher than at present, resulting in a 5 percent share in GDP, while utilizing a smaller share of overall resources. 109. In the short-to-medium term, t3me costs of adjustment are likely to be present, since the policy reform program and industrial restructuring are expected to result in lay-offs and temporary dislocations for some industrial workers. However, massive closures of firms are not expected to take place. The analysis of the Industry Report suggests that although some firms will be expected to close down, including some very unproductive large enterprises, much of the industrial restructuring will take place as a result of the streamlining of product lines within firms. About two-thirds of multiple-activity manufacturing firms with inefficient activities have at least one efficient product line, while most single- activity firms can become viable at higher capacity utilization levels and/or following restructuring and rehabilitation measures. 110. Nonetheless, the potential increase in short-run unemployment resulting from closure of inefficient product linee may only be partly alleviated by labor reallocations across firms, activities and industrial subsectors, since there is surplus employment in industry as a whole. Furthermore, the mobility of semi-skilled workers may be somewhat limited in the very short run. The economic and social costs of these limited jcF losses are expected to be ameliorated by limiting new hirings in activities undergoing restructuring and attrition, the provision of incentives for early retirement, job search, and the promotion of small-scale and self-employed operations in industry and agriculture. In this context, Government and Bank staff are beginning to assess the labor market implications of the adjustment process, and in the future programs for job redeployment and retrainiug may be considered (such as the promotion of small-scale operations through provision of credit and training) for workers leaving medium- and large-scale industrial firms. 111. In the medium term, as a restructured and healthier industrial sector emerges, industrial employment would be expected to rebound. As importan -he substantial productivity gains envisaged under the industrial restructuring program are expected to result in an increase in real wages from the extremely low levels existing today. 112. The continued devaluation of the shilling is expected to continue having an impact on the financial indebtedness of many companies and financial institutions. Many of these institutions are highly leveraged in foreign debt and would need financial restructuring, including debt rescheduling, debt-to-equity conversions, and new injections of equity, in order to permit the viable activities to operate efficiently and grow. The proposed Industrial and Financial Restructuring Project will be prepared with the aim of providing financial and technical assistance for industrial enterprise restructuring and addressing the critical financial situation of the banking institutions.  - 34 - Project Rlisks 113. The main risk to this operation is that the implementation of the main macroeconomic adjustments (particularly regarding credit policy and the exchange rate and trade regimes) could slacken significantly because of drawn-out decision-making and political constraints. Failure to attain and maintain *n exchange rate regime consistent with an expanding OGL facility; delays in liberalizing internal and external trade; and/or failure to maintain fiscal and monetary stability, would seriously jeopardize the economic recovery program in general and the prospects of IRTAC in particular. In addition, failure to implement important institutional reforms in the financial sector and in agricultural marketing would reduce the supply response and allocative impact of the trade reform and industrial restructuring measures under IRTAC. However, the Government has shown over the last two and a half years a firm commitment to the ERP goals and to its implementation, as agreed under the IMF programs, the Bank's MRC and the two PFPs. The commitment to the ERP objectives as reiterated by the Government decisions in early November, 1988, embrace the measures to be supported by the IRTAC and also include decisive measures in the areas of exchange rate, financial and foodgrain marketing policies. The political constraints the Government of Tanzania faces in implementing the EU are well known, but unlikely to overwhelm the widely recognized need for adjustment measures, the Government's own determination to carry them out, and the strong support they receive from the international donor community. 114. The second important risk relates to the Govern