Tunisia - Structural Adjustment Loan Project

Document of The World Bank FOR OMCUAL USE ONLY Reprt No. P-4808-TiN REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US$150 MILLION TO THE REPUBLIC OF TUNISIA May 20, 1988 This document has a restricted distribution and may be used by recipients only in the performance of their offical duties Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS SDR 1.00 = dinars (TD) 1.1035 (as of end 1987) Official exchange Rate: Dinar (TD) Per US Dollar Period End of Period Period Average 1980 0.4187 0.4050 1981 0.5157 0.4938 1982 0.6158 0.5907 1983 0.7271 0.6788 1984 0.8666 0.7768 1985 0.7570 0.8345 1986 0.8402 0.7940 1987 0.7779 0.8287 Source: DMP, International Financial Statistics, April 1988  TUNISIA FOR OFFCIACL USE ONLY STRUCTURAL ADJUSTMET LOAN LOAN AND PROGRAM SUMMARY Borrower: Republic of Tunisia Amount: US$150 million equivalent Terms: 17 years, including five years of grace, at the standard variable interest rate. Description: The proposed loan would support the medium-term macroeconomic adjustment program of the Government and the objectives of the VII Plan (1987-1991). The main areas covered under the program are: i) measures to continue the progress achieved to date-on liberalization of trade and producer prices, and to start a gradual liberalization of distribution margins; ii) improvements in the system of direct and indirect taxation through changes in the consumption taxes and introduction of a Value Added Tax and of a new law on direct taxes; iii) reforms in the financial system, including higher interest rates on preferential credits and on treasury bonds, a more effective treatment of the exchange risk on foreign denominated debt and a review of the commercial bank interest rate spread cap. Program Benefits: The objective of the program would be to implement policy changes that would allow Tunisia to achieve sustained growth in the framework of an internally and externally balanced economy, that would provide the basis for employment creation. The adjustment program is essential in assisting in the transition from an economy largely dependent on oil exports to an oil importing one. In addition, the reforms supported by the loan would reaffirm Tunisia's position as a creditworthy borrower and facilitate external flows needed to finance the country' s development. Program Risks: The program is a major part of the far-reaching shift that has been taking place from a highly dirigiste system to a fairly liberalized economy, and some of the measures contemplated might face strong opposition and might be difficult to implement. The expected reduction in consumer subsidies, in particular, is a sensitive political issue after the reductions in real wages in recent years. The risks are considered to be justified based on the progress in implementation to date, the general quality of Tunisia's administrative system, the political cohesion shown recently by the country, and the commitment toward the program's objectives shown by the new governement. 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.  - {i -e Estimated Disbursements: The proceeds of the loan would be disbursed in two tranches: US$100 million upon loan effectiveness, and US$50 million upon implementation of a number of actions related to the adjustment program. Effectiveness is expected in September 1988, while second tranche release is planned for June 1989. Appraisal Report: None. Nap: IBRD No. 18707 (attached) 942Z3  Table Of Contents Part I - THE ECONOMY ........... .............................. . 1 Part II - THE ADJUSTMENT PROGRAM *.* ........... .... .. The Macroeconomic Program... ...... .... 5 Trade and Price Liberalization. .. ......... 13 The Financial Sector........ ....................... I8 Fiscal Reform ........... ..... ......... . 22 Part III - BANK GROUP OPERATIONS IN TUNISIA ............... ...... 24 Part IV - LOAN ADMINISTRATION ..... - ....... ... ...... ...... * 27 Management, Coordination and Monitoring ............. 29 Cooperation with Other Agencies ..................... 30 Part V - RECOMMEMDATION ........ .. ..... ..... .. 31 ANNEXS Annex I Key Economic Indicators .. .............. ......... 32 Annex II Indicators for the Monitoring of the Medium-term Macroeconomic Program ..... ... .. 0...... .- ... . 38 Annex III Draft of the Letter of Development Pol icyc...6..-. 46 Annex IV Progress under Existing Adjuvtment Operationso.... 53 Annex V Summary of the Program to be Supported by the SAL.. 59 Annex VI Supplementary Proj ect Data Sheeta..... e ... 66  REPORT AND RECOMMENATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT LOAN [N AN AMOUNT EQUIVALENT TO US$150 MILLION TO THE REPUBLIC OF TUNISIA INTRODUCTION 1. I submit the following report and recommendation on a proposed loan for the equivalent of $150 million to the Republic of Tunisia. The loan would support the program of structural adjustment presented in the Government's VIIth Development Plan (1987-91). The new Tunisian Government, established in November 1987, is committed to continuing the program of macroeconomic and sectoral reforms initiated in 1987 and supported by two Bank sector adjustment operations. The proposed loan would assist the authorities in implementing economic policies aiming at sustained growth and external and internal economic equilibrium. The loan would have a term of 17 years, including five years of grace, at the standard variable interest rate. PART I - THE ECONOMY 2. Ekbround. Tunisia is a medium-sized, middle-income country, with a population of 7.5 million and a per capita income of US$1,130. Much of the country is arid or semi-arid. Only 3 percent of arable land is irrigated and rain-fed agriculture is subject to severe year-to-year fluctuations in rainfall. Nevertheless, agriculture still occupies nearly a third of the labor force. Tunisia's most important raw materials are petroleum, natural gas, and phosphates. Output of known exploitable teserves of oil and gas is diminishing because of depletion, and the limited new reserves require costly off-shore drilling. Unless large new oil and gas reserves are discovered, the rise in domestic energy demand is expected to turn Tunisia into a net oil importer in 1990. The low quality of phosphate deposits constrains the expansion of the Tunisian phosphate processing industry. The country also has a considerable tourist industry with much further potential. 3. Tunisia has undertaken a massive effort to develop its human resources, paying special attention to family welfare, and education. As a result, between the early 1960s and 1985, infant mortality declined from almost 160 to 60 per thousand, life expectancy at birth rose from 48 to 62 years, adult literacy increased from 15 percent to 62 percent, and calorie intake per capita increased from 95 percent to 121 percent of minimum standard requirements. An active family planning policy led to a decrease in birth rates by 27 percent between 1965 and 1985. But mortality declined by 45 percent, so that population growth continues at 2.5 percent p.a.. The population has a young age structure, which, together with the increasing entry of women into the labor force, has caused the labor force to grow faster  le$ss -2- than population. The effect on unemployment, which reached 14 percent in 1987 and particularly affects young entrants into the labor force.-is a major concern of the Government. 4. During the 1970s the Tunisian economy performed strongly, aided by oil exports. GDP growth averaged 7.4 percent a year over the decade and non-oil exports grew at over 10 percent p.a. on the average. All sectors did well, especially manufacturing, whose share in GDP and exports increased substantially. Although the non-oil ICOR for the second half of the decrde was 4.9, it was not high compared to the levels of similarly placed countries. To a great extent the rapid growth of GDP was due to high levels of investment, about 30 percent of GDP, which was compatible with a respectable growth of per capita consumption and a modest level of external financing, thanks to earnings from oil. The current account deficit averaged '-6 percent of GDP, though there was a brief increase in 1976-78 to a peak of 11 percent of GDP, which the resurgence of oil prices reduced again without necessitating cutting back investment or consumption. Since Tunisia attracted considerable foreign investment, it had no difficulty in completing the financing of the current account by foreign borrowing. The country emerged from the decade with a modest increase in its external debt to 42 percent of GDP in 1979, as compared to 38 percent in 1970, and a debt service ratio of only 10 percent. Domestic inflation remained below world levels, averaging 6.1 percent a year. This overall performance of the economy, including the rapid growth of exports, was helped by an almost uninterrupted depreciation of the Tunisian Dinar in real effective terms. From 1970 to 1979 the depreciation amounted to 17 percent. 5. This performance had three flaws. Firstly, unemployment remained high, a situation that has persisted and is a major concern of the authorities. Secondly, certain industries, both public and private, have experienced difficulties. Some, such as the motor vehicle assembly plant, which has recently been closed, were too ambitious and dependent on excessive protection to be viable. Others, such as the phosphate mines and related chemicals complex, have been the victims of depressed world prices for their products. Thirdly, the authorities did not begin early enough to adjust the economy to the decline in oil extraction they foresaw would begin around 1980 and were taken by surprise whet oil prices fell rapidly in 1986. 6. 1980-84: Deteriorating economic performance. Difficulties began in earnest in the 1980s: although oil production began to decline as expected and, in addition, world oil prices fell, the necessary economic adjustments were slow in coming. The VIth Plan (1982-86) did, in fact, envisage the slowing down of greowth and, accordingly, proposed maintaining internal and external stability by reducing the investment rate, increasing emphasis on exports, and slowing the growth of recurrent budget expenditures. To promote job creation it envisaged a shift to more labor-intensive investment. Butt in fact, these objectives were not pursued. Instead, from 1980 to 1984, investment remained high, around 32 percent of GDP. The greater part of investment was in the public sector and included a number of large capital intensive projects yielding few jobs and low economic returns. The five-year non-oil ICOR for this period was 6.0. Wages increased substantially faster than productivity, further reducing the demand for labor. Inflation rose to an average of 10.0 percent p.a., and exports slowed. The current account  -3- deficit grew to 10.9 percent of GDP in 1984. These expansionary policies kept growth high; it averaged 4.5 percent for the period, despite a drought in 1982 that slightly reduced GDP. But they depended on heavy external borrowing, which, though managed with care, raised Tunisia's external debt (public and publicly guaranteed) to 47 percent of GDP and the debt service ratio to 21 percent. The Government attempted to restrain its expenditures; nonetheless, the overall budget deficit stayed close to 6.7 percent of GDP. 7. 1985-87: Stabilization and the stat of adjustment. By 1985 Tunisia had begun to experience difficulties in obtaining external financing for its high current account deficit and it became clear that a balance of payments crisis was threatening. Accordingly, after responding with some initial restrictive measures, the Government began a process of policy revision that has broadened into a wide-ranging process of structural adjustment. Its first step was to restrict imports. This succeeded in bringing the current account deficit down to 7.1 percent of GDP, but, as usual with such controls, it led to shortages of raw materials and spare parts, and to biases against exports. The Government also reduced its investment, which had accounted for most of total investment. By these measures and by mobilizing donor support, it avoided a full crisis. But it recognized that it had a large external debt burden and, as Tunisia's oil reserves ran out, the resources available to the public sector would diminish and the importance of non-oil exports would grow. Hence. the role of the public sector would need to contract in favor of the private sector. The Government also recognized that economic incentives were distorted and that the incentives structure would need to change for an efficient and active private sector to develop. In particular, the Government would need to make the economy more outward oriented, reduce administrative controls, reform the tax system, and improve the efficiency of financial intermediation. In August 1986 it announced a program prepared along these lines in dialogue wish the Bank and IMF to lay the basis for sustained growth and to stabilize the economy. A full description of Tunisia's adjustment objectives is presented in the document of the VIIth Plan (1987-91). 8. The commitment of the Government to economic adjustment and its productive dialogue with the Bank have led to substantial support by the Bank and other donors. The medium-term program of adjustment and stabilization was outlined by the Government in its Letter of Development Policy requesting the Bank's support for an Agricultural Sector Adjustment Loan (ASAL, approved by the Board on September 1986) and an Industry and Trade Policy Adjustment Loan (ITPAL, approved by the Board on February 1987), and the accomparying Letters of Sector Adjustment Policy. A full and updated description of Tunisia's adjustment objectives followed in the VIIth Plan document. The ASAL supported Tunisia's adjustment in tLe agricultural sector with a loan of the equivalent of $150 million. The focus, among a range of actions, was on the prices and incentives framework and on public investment. The ITPAL, also for the equivalent of $150 million, focused mainly on tariff adjustments, price decontrol and fiscal reform. The Bank convened a Donors' Meeting in 1987, at which Tunisia presented its adjustment program to donors and successfully mobilized considerable support. 9. The IMF has supported Tunisia with a Stand-by arrangement for the period November 1986 to May 1988 for the equivalent of SDR 104 million  768S8 -4- (75 percent of quota) and for purchases of the equivalent of SDR 115 million under the compensatory financing facility. 10. The Government's stabilization measures have reduced the imbalances in the budget and the external current account and have established the conditions for carrying on the liberalization program begun in 1986. The Dinar was devalued 23 percent in nominal terms in 1986, yielding a 17 percent depreciatiou in real terms over the year. Wage increases have been tightly restrained, so that real wages in 1987 were below their level in 1984. Total investment fell sharply in 1985 and 1986 to about 23.5 percent of GDP, since when it has remained at 21-22 percent. The devaluation and demand restraint caused the volume of imports to fall sharply, and by 1987 it was 19.3 percent below its 1984 level. Non-oil exports responded strongly to the devaluation; their 1987 volume exceeded that in 1984 by 32 percent. Remittances from Tunisians abroad also picked up: in 1987 they were 38 percent above their 1984 level in dollar terms. As a consequence the current account deficit declined to 1.5 percent of G.)P in 1987 and the Government deficit, net of amortization, to 3.4 percent. Inflation over 1985-87 was reduced to about 7 percent p.a. External debt (public nA pvMlicly guaranteed), nevertheless, continued to increase. MLT debt rose from $3,757 million at the beginning of 1985 to $5,450 million at the end of 1987, reaching 57 percent of GDP, while the debt Pervice ratio rose to 25 percent. L1. Exogenous factors considerably affected the economy's performance and were, on the whole, unfavorable. In 1985 difficulties with Libya led to the repatriation of 30-35,000 Tunisian workers, thus ending their remittances and most exports to that country. The process of settling the dispute began in 1987 and is continuing. Regional security problems also reduced the number of tourists substantially, until the dissipation of the apprehensions of potential tourists, aided by the cheaper Dinar, caused it to increase sharply in 1987. The drop in oil prices caused a big loss of income for Tunisia and accounted for nearly all of a 15 percent deterioration in the country's terms of trade. Agriculture renged between extremes on account of fluctuations in rainfall. 1985 was a record year, with a cereal harvest 58 percent above the average of the previous five years, and 1987 was almost as good. But 1986 was an exceptionally poor year and the prospects for 1988 are worse. The outcome of these conflicting factors has been that GDP grew 5.7 percent in 1985 and 5.8 percent in 1987, but declined 1.6 percent in 1986. The average annual growth for the three years was 3.2 percent. 12. Prospects for 1988. 1988 will be a difficult year because of severe drought followed by locust infestation and continuing low oil prices. GDP growth is projected at 1.8 percent. Rural incomes will be seriously affected and import requirements for additional food and animal feed will be considerable. Even with a continuation of recent favorable trends in remittances by Tunisians abroad, the current account deficit is expected to rise to 4.6 percent of GDP. However, Tunisia has successfully mobilized concessional external assistance to finance the increase in imports due to the poor harvest, which will help the Government continue its program of import liberalization without significantly increasing austerity.  76861 5- PAR.T E - TMIE ADJUSTMENT PROGRAM: 1987-91 13. The SAL wouid support the comprehensive medium term adjustment program that the Government has presented in its VIIth Plan (1987-91). Successful implementation would constitute the transition to an appropriate economic structure and set of incentivea for more rapid and efficient growth after 1991. The proposed policies would deepen and extend the adjustment that has been taking place, notably under the Industry and Trade Policy Adjustment Loan (ITPAL) and the first Agricultural Sector Adjustment Loan (ASAL I), and are intended to help the economy face the challenge posed by Tunisia's debt burden and the loss of oil revenues. They would do this by adjusting the expenditures of the State to take account of the debt burden and the decline in oil revenues; creating conditions for rapid growth of an economically efficient private sector; and strengFhening the increasing export orientation of the economy. The Plan places these objectives in a consistent macroeconomic framework that balances growth targets against a prudent assessment of economic constraints. 14. The SAL would, in particular, support the establishment of an economically efficient structure of incentives through action in three domains. Firstly, it would support liberalization of external trade, notably the reduction of import restrictions, and the decontrol of prices. Secondly, it would help improve the efficiency of financial intermediation by bringing interest rates closer to market levels, improving the treatment of foreign exchange risk, and increasing competition among financial institutions. Thirdly, it would support ref sm of direct and indirect taxation. The framework of these reforms wouiu be a medium term macroeconomic program reflected in a set of projections based on recent developments and a monitorable set of indicators to determine any additional measures that might be needed in case of shortfall from the program's targets. 15. Complementing the SAL, loans are-under preparation for public enterprises restructuring, (PERL), a second agricultural adjustment program (ASAL II), and an education sector loan. The PERL would seek to improve management and competitiveness of publtc enterprises, support the privatization effort, and support the financial/technical rehabilitation of certain enterprises where it is warranted. ASAL II would continue the reforms in the agricultural sector begun under ASAL I (see paragraph 81 below) and would, among other things, continue the alignment of producer prices with international prices, reduce consumer subsidies and reduce the subsidies on lending to t2 sector. The education sector loan would address issues of resource all ..ation and financing for human capital formation and could be extended to deal with aspects of social policy beyond education itself. The Macroeconomic Program 16. The challenge before the macroeconomic program is considerable and obliges the Government to tread a narrow path between austerity and growth. Population is growing at 2.5 percent p.a. and the labor force is increasing slightly faster as more women seek employment. Consequently, growth sustained by productivity increases must be as high as external and internal macroeconomic constraints allow. The external constraint is tight, since  76S 5 -6- external medium and long term publicly guaranteed debt is at present about 58 percent of GDP, with a debt service ratio of around 24.7 percent, while oil extraction is expecte_ to decline at close to 5 percent annually, making Tunisia a net oil importer by 1990. The budgetary constraint is tight as well; servicing of debt on government account is projected to reach 9.1 percent of GDP by 1991, when budgetary revenues from oil will have declined to 3 parcent of GDP, from a peak of 8.2 percent in 1982 17. Plan scenarios. The Government has revised its original projections for the Plan period to take into account the unexpectedly strong economic performance of 1987, while retaining its growth strategy (See Table 1). Its overall growth target has been slightly raised, though agricultural growth is marginally lower. External MLT debt, which was originally to be reduced by 7 percentage points of GDP, would under the revised target be reduced by 10 points. This implies a reduction of the current account deficit from 2.8 percent of GDP in the original projections to 2.4 percent. Under the new projections, exports would increase 6.4 percent p.a. in volume terms, entailing a 8.7 percent annual increase in non-oil exports. Imports would increase at an annual average of 2.1 perce-nt. The resource gap would be kept at its sharply reduced level of 1987 by keeping a fairly constant investment rate, since the domestic saving rate is expected to remain close to 20 percent of GDP. 18. Given the very unfavorable weather conditions in 1988, some of the targets will be hard to achieve. It would, in any case, be prudent to lower the assumed agricultural growth rate since, though it is not out of line with the performance of recent years, it presupposes a run of relatively good years. In fact the drought and locust infestation of 1988 will affect the crop in 1989 as well. Another respect in which the Plan projections seem optimistic is the extent to which the current account deficit in the balance of payments can be reduced by slowing growth of imports, especially in view of the economic liberalization that is taking place. In order to take these considerations into account, the Bank staff have prepared a revised set of projections. 19. Revised Scenario. A somewhat lower growth of agriculture and less stringent balance of payments targets are the main differences between the Baak staff and revised Plan projections. Agricultural growth is projected to increase at 4.1 percent p.a. on average, a rate that is realistic and respectable, though well below the revised Plan rate of 5.1 percent. The balance of payments targets are eased by reducing the MLT debt reduction target to 3.8 percentage points, rather than the revised Plan target of 10 points (See Table 1). This permits an average real growth of imports of 2.8 percent p.a. Exports are adjusted down slightly to an average real growth of a little less than 6 percent a year. This still implies a fairly high annual rate for non-oil exports of a little above 8 percent, though the performance of recent years indicates that this growth is reasonable. The resulting resource gap would remain in the range of 3-4 percent of GDP, somewhat above the revised Plan projection. This and a marginally lower share of investment in GDP are reflected in a saving rate that is about one percentage point below that assumed in the revised Plan projections. Consumption would increase at 3.2 percent p.a., or 0.7 percent p.a. per capita. This is the scenario that has been agreed with the Tunisian authorities as the basis for the macroeconomic monitoring and review under the proposed loan.  x O.U MACROECONOHIC PROSPECTS FOR THE VITH PLAN PgRIOO 1986 ...I2L 198g'98 - l9 As X Original Revised Sank Staff Nil binar of GOP Estimate 7th Plan Tunisian Forecast --- (average real growth) - GOP (market prices) 7.025.0 100.0 S.8 4.0 4.1 3.9 - Agriculture 933.0 13.3 17.5 5.3 S.1 4.1 - Energy 534.8 7.6 -S.O -4.1 -4.5 -4.4 - - Other 1nel. tawes) S.SS7.2 79.1 4.7 4.4 4.7 4.S Consumption S.886.0 83.8 1.0 2.8 2.5 3.2 Investment 1,649.0 23.5 -12.9 1.8 2.3 1.S Exports (GNCS) 2,161.0 30.8 13.2 5.0 6.4 5.8 Inports (GNFS) 2.671.0 38.0 -5.2 1.2 2.1 2.8 l991 1991 1991 -------------- (as percent of GOP) ----------