Tunisia - Public Enterprise Reform Loan

Document of The World Bank FOR OFFICtAL USE ONLY RqportNo. P-5055-TUN REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPNENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PUBLIC ENTERPRISE REFORM LOAN IN AN AMOUNT EQUIVALENT T0 US$130 MILLION TO THE REPUBLIC OF TUNISIA JUNE 12, 1989 This document has a restried distion and may be used by recipients only In the performance of their offidal duties. Its contents may not otherwise be dbilosed withoot World Bank authorization.  CURRENCY EQUIVALENTS (as of May 31, 1989) Current Unit = Tunisian Dinar (TD) US$1.00 = TD 0.9849 GLOSSARY OF ABBREVIATIONS CAR_-? Interministerial Commission for Restructuring and Divestiture CIF Cost, Insurance and Freight CPG Compagnie des Phosphates de Gafsa DEP Directorate for Public Enterprises GC Groupe Chimique IFC International Finance Corporation EMF International Monetary Fund MLT Medium and long-term PDG President Director General (Company President and Chief Executive) PE Public Enterprise PEAL Public Enterprise Reform Loan PM Prime Minister PPG Public and Publicly Guaranteed P205 Phosphoric Acid SNCFT Societ6 Nationale des Chemins de -Fer Tunisiens SNT Societe Nationale de Transport S02 Sulfur dioxide TA Technical Assistance TD Tunisian Dinar UNDP United Nations Development Programme USAID United States Agency for International Development Fiscal Year January 1 to December 31  FOR OMCILAL USE ONLY REPUBLIC OF TUNISIA PUBLC ENTERPRISE REFORM LOA- Table of Contents Page No. LOAN AND PROGRAM SUMMARY PART I - THE ECONOMY . . . . . . . . . . . . . . . . . . . . PART II - BANK GROUP OPERATIONS AND ASSISTANCE STRATEGY . . . . . 8 PART III - THE PUBLIC ENTERPRISE REFORM PROGRAM AND THE PROPOSED PUBLIC ENTERPRISE REFORM LOAN (PERL). . . . . . . . . . 11 Introduction. . . . . . . . . . . . . . . . . . . . . . 11 The Public Enterprise Sector: Issues and Actions. . . . 12 A. Systemwide Reforms .steniwideReforms..... .......... 14 (i) Legal and Institutional Reforms . . . . . . . . . 14 (ii) Introduction of performance contracts and management improvements . . . . . . . . . . . . . 17 (iii) Budgetary and Financial Reforms . . . . . . . . 19 B. Divestiture and Restructuring Program. . . . . . . 21 C. Subsectoral Action Programs 'or Priority PEs . . . 25 The Phosphate Sector . . . . . . . . . .. ... 26 Compagnie des Phosphates de Gafsa. . . . . . . . . 27 Groupe Chimiqe . . . . . . . . . . . .. . . . . . 29 Transport Sector Policy. . . . . . . . . . . . . . . 32 Soci6t6 Nationale des Chemins de Fer Tunisiens . . 33 D. Social Implications of the Proposed PERL . . . . . . 36 PART IV -LOAN ADMINISTRATION. ............. .... 37 Eligible Expenditures Procurement and Disbursement. . . 37 Release of Funds, Tranching and Key Conditions. . . . . 38 Management, Coordination and Monitoring . . . . . . . . 40 Cooperation with other Agencies . . . . . . 41 Justification and Risks .... . . . . . . ..... . 42 PART V -RECOMMENDATION. . . . . . . . . . . . . . . . . . . . . 43 This report is based on the findings of an appraisal mission comprising: P. Donovan (Mission Leader) and S. Kebet-Koulibaly (EM2IE), R. Taylor (EMTTF), S. Contreras and P. Geraldes (EM2IN), S. Mitric and K. Viswanathan (EMTIN), A. Covindassamy (AS4TE) and J. Malkin (Condultant) which visited Tunisia in February/March 1989. 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.  REPUBLIC OF TUNISIA PUBLIC ENTERPRISE REFORM LOAN Table of Contents (continued) I. Key Economic Indicators .... . . . . . . . . . . . . 44 II. Status of Bank Operations in Tunisia . . . . . . . . . . . . 46 III. Progress Under Existing Adjustment Operations (ASAL-1, ITPAL and SAL). . . . . . . . 48 IV. Letter of Sectoral Development Policy . . . . . . . . . . . 57 V. Policy Matrix for the Public Enterprise Reform Program. . . 65 VI. Key Provisions of New Public Enterprise Law . . . . . . . . . 68 VII. PE Sector: Macroeconomic Indicators 1983-85 . . . . . . . . . 69 VIII. Aggregate PE Data - 40 major PEs, 1981-86 . . . . . . . . . 70 IX. Key 1987 Indicators for Selected Public Enterprises . . . . . 71 X. Government - PE Financial Relations 1982-88 . . . . . . . . . 72 XI. World Supply/Demand Phosphate . . . . . . . . . . . . . . . . 73 XII. Government Financial Contributions to CPG 1980-88 . . . . . . 74 XIII. CPG Production Raw Phosphate 1980-93 . . . . . . . . . . . . 75 XIV. CPG Cost Structure - Variable and fixed cash costs - 1988 . . 77 XV. CPG Investment Program 1986-93 . . . . . . . . . . . .. . 78 XVI. CPG Personnel Evolution 1980-88 . . . . . . . . . . . . . 79 XVII. CPG Staff Reduction Program . . . . . . . . . . . . . . 80 XVIII. CPG Financial Performance Indicators 1988-93 . . . . . . .... 81 XIX. Groupe Chimique: Production Data by Company 1986-88 . . . 82 XX. Groupe Chimique Ownership Structure . . . . . . . . . . . . . 85 XXI. Groupe Chimique Past and future Financial Performance Indicators . . . . . . . . . . . . . . . . . . . . . 86 XXII. Railway subsector (SNCFT) ............. 88 XXIII. SNCFT's Traffic 1981-93 . . . . . . . . . . . . . ... . . . . 92 XXIV. Suimmary Financial Indicators of SNCFT 1985-93 . . . . . . 93 XXV. Urban Transport Enterprises (SNT) . ........ . .. . . 94 XXVI. Supplementary Project Data Sheet . . . . . . . . . . . . . . 100 XXVII. Disbursement Schedule . .. .... ...... 101  REPUBLIC OF TUNISIA PUBLIC E:TERPRISE REFORM LOAN Loan and Program Sunary Borrmar: Republic of Tunisia. Amount: US$130.0 million equivalent. ters: 17 years. including S years of grace, at the standard variable interest rate. The proposed loan would support the implementation of a comprehensive program of Public Enterprise Reform which has been initiated by the Tunisian authorities. This program centers around: (i) legal and institutional reforms which substantially reduce the role of the Government in the public sector and clarify and streamline Government interventions in enterprises which will remain in the public sector and (ii) a program of privatization and restructuring of public enterprises (PEs) to further reduce the role of the Government in the competitive areas of the economy while addressing the social costs associated with these measures. The proposed loan is designed to assist this program by identifying specific time-bound short- and medium-term measures to address the objectives and by assisting in their implementation. The loan therefore supports (i) the imalementation of the new law governing PEs (phased strengthening of Boards of Directors, introduction of performance contracts. abolition of ex-ante controls, increased transparency in the budget allocation process. etc.), (ii) the implementation of privatization decisions and the financing of the associated budgetary costs and (iii) initiating the process of subsectoral restructuring of three major PEs in severe difficulty: Compagnie des Phosphates de Gafsa (CPG) -- the phosphate mines, Groupe Chimique -- fertilizer producers, and Societe Nationale des Chemins de Fer Tunisiens (SNCFT) -- the Tunisian Railway. ae1tiiti anld Risks: Major benefits include: increasing the efficiency of the economy by progressively transferring potentially competitive PEs to the private sector wherever the latter has the resources, expertise and flexibility to realize the full potential of these enterprises; in:reasing the efficiency of PEs remaining in the public sector by progressively introducing transparent and quasi-comnercial performance criteria, through performance contracts; progressively addressing the social and financial costs of privatization and restructuring of PEs. some of which are in severe technical and/or financial difficulties. As in other major programs of PE sector reform, the main risk is that bureaucratic and social opposition will hamper the implementation of difficult and politically sensitive policy decisions. These risks are mitigated by the support for the Reform process at the highest levels in the Government. by the actions already taken, by the explicit programs underway to manage the social costs of adjustment and by monitoring under this loan specific quantifiable measures to be implemented over a two-year period. litinatad Disbursements: The proceeds of the loan would be disbursed in two tranches: US$70 million equivalent upon loan effectiveness and US$60 million equivalent after implementation of specific actions, including an overall review of the implementation of the sectoral adjustment program. Agprailal Reoort: None.  REPORT AND RECOMMENDATION OF TiIE PRESIDENT OF THE NTRNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PUBLIC ENTERPRISE REFORM LOAN IN AN AMOUJNT EQUIVALENT TO US$130.0 MILLION TO THE REPUBLIC OF TUNISIA INTRODUCTION 1. I submit the following report and recommendation on a proposed loan for the equivalent of US$130.0 million to the Republic of Tunisia. The loan would support the extensive program of Public Enterprise Reform being undertaken by the Tunisian authorities. This program consists primarily of the privatization of public enterprises operating in areas where the authorities no longer see a need for public ownersh p, and the establishment of a legal and regulatory framework that would progressively lead to quasi-commercial operating and management conditions in those enterprises which will remain in the pe-lic sector. These measures are intended to maximize economic efficiency and to minimize the budgetary outlays to public enterprises. The proposed Public Enterprise Reform Loan (PERL) will help the Government in the implementation of this program through the use of specific time-bound measures for the progressive realization of the reform objectives. Through providing general balance of payments support to the Government, the loan will also release resources which will finance a portion of the social and budgetary costs of the program, over a two year period. The Public Enterprise Reform Program is an integral part of the overall macroeconomic adjustment process aimed at promoting sustainable growth. PERL would be the fifth quick disbursing operation for Tunisia. The first Agriculture Sector Adjustment Loan (ASAL) for US$150 million was approved in September 1986. An Industrial and Trade Policy Adjustment Loan (ITPAL) for US$150 million was approved in FY87. A Structural Adjustment Loan (SAL) for US$150 million was approved in FY88, and a second ASAL was approved by the Board last June. The latter operation is not yet effective. Performance under each of the other operations has been satisfactory (Annex III). Tunisia also successfully completed the program agreed with the IMF under its first stand-by arrangement covering the period November 1986 to May 1988. An extended financing facility was signed in July 1988, and is being successfully implemented. PART I - THE ECONOMY A' 2. Background. Tunisia is a medium-sized, middle-income country, with a population of 7.5 million and a per capita income of US$1,210. Much of the country is arid or semi-arid. Only 3 percent of arable land -L' This section is essentially the same as that included in the Second Agriculture Sector Adjustment Loan approved by the Board on June 1, 1989, Report No. P-5001-TUN.  - 2 - is irrigated and rainfed agriculture is subJect to severe year-to-year fluctuations in rainfall. Nevertheless, nearly one third of the labor force is employed in agriculture. Tunisia's most important raw materials are petroleum, natural gas, and phosphates. Output of known exploitable reserves of oil and gas is diminishing because of depletion, and the limited new reserves require costly off-shore drilling. With the rise in domestic energy demand, Tunisia is expected to become a net oil importer in the early 1990s. There is a substantial phosphate processing industry, but it is constrained by the low quality of the phosphate deposits. Tourism, however, has been developing rapidly and has much further potential. 3. Tunisia has undertaken a massive effort to *velop 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. Nevertheless, as mortality declined by 45 percent over the same period, population growth has continued at 2.5 percent p.a.. The population ha8 a young age structure, which, together with the increasing entry of women into the labor force, has caused the labor force to grow faster than population. The effect on unemployment, which is currently estitated at about 15 percent 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 per 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. 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 5-6 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 from external sources. The country emerged from the decade with a modest increase in external indebtedness 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 moderate, averaging 6.1 percent a year. 1980-84: Deteriorating economic performance 5. Difficulties began in the earl" 1980s: although oil extraction declined 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, propose maintaining internal and external balance 301 3L  -3- by reducing the investment rate, increasing emphamis on exports, and slowing the growth of recurrent budget expenditurts. To promote job creation, it envisaged a shift to more labor-intensive investment. But, in fact, these objectives were not pursued. Instead, from 1980 to 1984, investment remained high, around 31 percent of GDP. The greater part of this 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 deficit grew to 10.9 percent of GDP in 1984 with the agricultural merchandise trade deficit representing 3.2% of GDP. These expansionary policies kept growth high; it averaged 4.5 percent for the per.od, despite a drought in 1982 that slightly reduced GDP. But they depended on continued external borrowing which raised Tunisia's external debt (public and publicly guaranteed (PPG)) to 46 percent of GDP and the debt service ratio to 21 percent by 1984, reflecting a shortening of average maturities. The Government attempted to restrain its expenditures; nonetheless, the overall budget deficit stayed close to 6.7 percent of GDP. 1985-87: Stabilization and the start of adjustment 6. By 1985 Tunisia had begun to experience problems 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 proces's 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, shortages of raw materials and spare parts developed, as well as biases against production for export. The Government also reduced its investment, which had accounted for most of total investment. 7. As a result of these measures, and by mobilizing donor support, the Government avoided a full scale crisis. But it recognized that it had a large external debt burden and, as Tunisia's oil reserves are running out, the resources available to the public sector would diminish. 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 c3nd that the incentive 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 with the Bank and IMF, to stabilize the economy and lay the basis for sustained growth. A full description of Tunisia's adjustment objectives is presented in the document of the VIIth Plan (1987-91) and summarized in the President's Report for the SAL. (Report No. P-4808-TUN). 3013L  4 - 8. The commitment of the Government to economic adjustment, despite difficult political transition problems, has led to substantial support by the Bank and other donors. The Bank's support has included the program of adjustment loans listed in para 1. above, based on intensive economic analysis and policy dialogue. As also noted, the IMF has supported Tunisia with a Stand-by arrangement for the equivalent of SDR 104 million (75 percent of quota) and for purchases of: tha equivalent of SDR 115 million under the compensatory financing facility. The IMF Extended Arrangement approved in July 1988 was for SDR 207 million. 9. 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 per ;nt in nominal terms in 1986, yielding a 17 percent depreciation in real terms over the year. Wage increases have been tightly restrained. Total investment fell sharply in 1985 and 1986 to about 23.5 percent of GDP and has remained at 21-22 percent since then. The devaluation and demand restraint caused the volt'me of imports to fall sharply, and by 1987, it was 18.4 percent below its 1984 level. Non-oil exports responded strongly to the devaluation; their 1987 volume exceeded that in 1984 by 33 percent. Remittances from Tunisians abroad also picked up: in 1987 they were 53 percent above their 1984 level in real terms. As a consequence, the current account deficit declined to 1.0 percent of GDP in 1987 and the Government deficit, net of amortization, to 3.4 percent. Inflation over 1985-87 was held to about 7 percent p.a. Nevertheless, external debt (public and publicly guaranteed), continued to increase. 10. 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 dispute has now been amicably settled. Regional security problems also reduced the number of tourists substantially, until an amelioration of these problems, aided by the cheaper Dinar, caused tourism 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 14 percent deterioration in the country's terms of trade. Agriculture ranged 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 1988 has been even 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 percenz in 1986. The average annual growth for the three years was 3.2 percent. The Economy in 1988 11. During 1988, the economy was affected by a severe drought and a locust invasion that together induced a 24% decline in agricultural production, bringing down GDP growth to 1.5% from 5.82 in 1987. The poor performance of agriculture and the surge in the international price of cereals negatively affected the budget deficit that reached 4.4% of GDP. Because of a relatively good performance on the external accounts allowing 3013L  - 5 - comfortable levels of imports, the temporary widening of the budget deficit did not put pressure on prices and inflation remained around 7%. The external re';ults were obtained in spite of the decline in oil prices and are traced back to solid growth in revenues from tourism and exports of manufactures. Both latter developments were supported by a policy of maintaining a competitive real effective exchange rate. As a result, the current account was in balance and the additional resources were used to establish a more comfortable reserve position. The ratio of debt to GDP was maintained around 67%, while the debt service ratio came to 26%. Growth induced by a normal agricultural year and a resurgence of investment should be around 4% in 198). Stabilization and Adjustment: 1989-91 12. Despite those favorable developmaents, the challenge for the macroeconomic program remains considerable and obliges the Government to tread a narrow path between growth and austerity. Population is increasing at 2.5 percent p.a., food demand at 4.4X and the labor force is growing slightly faster than population because of its age structure. Economic growth must be adequate to allow income per capita to grow and prevent unemployment from ineveasing. The external constraint will be tight in the coming years since the debt service ratio will remain around 26 percent, while oil extraction is expected to decline by 5 percent annually, making Tunisia a net oil importer in the early 1990's. The budgetary constraint is tight as well; servicing of debt on government account is projected to reach 9 percent of GDP by 1991, when budgetary revenues from oil will have declined to 3 percent of GDP, from a peak of 8 percent in 1982. kn the other hand, overall balance of payments trends and Tunisia's reserve position are such that prudent macroeconomic policy can maintain external equilibrium and there are good prospects for obtaining substantial private foreign financing and investment in the 1990s. Tunisia's policies can be viewed as a systematic preparation for attracting such capital. 13. Economic growth. Bank staff analysis indicates that Tunisia's growth targets can be met. GDP growth in 1989-91 is projected to average 4.2 percent annually. In agriculture, recovery from the 1988 drought will result in a high rate of growth, 9.7 percent p.a. in 1989-91, but output will not reach the level of the trend set by the years 1980-87. Exports are expected to grow at 3.4 percent p.a., implying a growth rate of non-oil exports of 7.5 percent a year, a reasonable rate in view of recent performance. Import growth would be limited to 3.3 percent a year. The non-interest current account deficit is expected to stabilize close to zero and the current account deficit below 3% of GDP. Investment, as a share of GDP, is projected to stay in the 22-23 percent range. Consumption would grow at 4.1 percent p.a. 14. Covernment expenditures. The lower oil earnings and higher debt servicing also affect the Government budget, though it is the objective of the Government to adjust to them not by increasing tax revenues, but by reducing government expenditures. The increase in the overall deficit has been acceptable to the Government because of its strong external positica and the moderate rates of inflation. But Tunisia has the objective of 3013L  - 6 - reducing the overall deficit to about 22 of GDP in the medium-term. Revenues are expected to decline from 29.7 percent of GDP in 1988 to 26.4 percent in 1991, including a drop in budgetary revenues from oil of 1.9 percentage points of GDP. Amortization of external debt will increase from 3.9 percent of GDP in 1987 to 4.1 percent in 1991, though amortization of internal debt will remain constant at 2.0 percent. Since the objective is to reduce the overall deficit, net of amortization, to about 2.3 percent of GDP in 1991, as compared to 4.4 percent in 1988, total government expenditures, net of amortization, must decline from 34.1 percent to 28.7 percent of GDP. Virtually all of this decline must result from restraining: a) the operating budget, b) consumer subsidies, and c) transfers to cover the investments and operating losses of public enterprises. The latter will be monitored annually as part of a program of public enterprise reform, to be supported under the proposed PERL. 15. Adjustment measures. The program of macroeconomic and sectoral policy adjustment supported by past adjustment lending aims at creating conditions for the rapid growth of an efficient private sector and continuing increase in the outward orientation of the economy. The program has been designed to establish a suitable structure of incentives across the economy, for which the Government has defined both specific objectives tad the phasing to attain them in the medium-term. The process of public enterprise reform described in Section III is an integral part of this program. Decontrol of producer prices is expected to be largely completed by 1991, with the exception of a small number of socially sensitive items that are subsidized. At present, 55 percent of producer prices are free, as compared to 6 percent in 1986. Decontrol of distribution margins has been slower, though some important ones, such as for fertilizers, have been freed. The Government's objective is to free at least 50 percent of distribution margins by 1991. Import tariffs bave been reduced to a maximum of 41 percent, and the objective is to bring the maximum to 35 percent by 1991. The weighted average tariff was reduced from 271 in 1986 to 231 in 1988 and is expected to decline further to 21S by 1991. The Government is also committed to eliminate quantitative import restrictions, except for a few cases of subsidized or infant industry products which will benefit from three years of supplementary protection. 16. The restraint on expenditures is accompanied by changes in the tax system, and by measures to diversify the financial sector and increase competition within it. A value added tax was introduced on July 1, 1988, to replace a complicated and distorted system of indirect taxes and is being extended to wholesale trade this year. Even though some excise taxes will remain for a transition period to avoid loss of revenues, the efficiency and transparency of indirect taxation will be greatly improve<. The multitude of direct taxes are being consolidated into two simple taxes, one on personal incomes, with a reduced maximum marginal rate, and the other a flat rate on corporate incomes. The recent establishment of a money market, on which certificates of deposit and commercial paper can be traded, will help diversify the financial market. A program is also being prepared with IFC and UNDP assistance to develop the capital market over the medium term. Further diversification will occur as the segmentation of banking is reduced and competition is 3013 L  -7- encouraged, backed by continued action to limit concessional credits and special tax exemptions. 17. Apart from these measures directly affecting incentives, the Government is reducing the role of the public sector, attempting to restructure or privatize public enterprises (PEs), and taking a broad array of actions to address sectoral problems. Public sector investment is expected to drop below private investment in the coming years, and many politically motivated projects of doubtful justification are being dropped. In cases where such proj"cts are too far advanced to be dropped, many are being cut back. The public sector is withdrawing or allowing private competition in several activities, such as manufacturing, the distribution of agricultural inputs, and public transport. Comprehensive PE restktcturing is being undertaken for PEs of major importance, such as the phosph.e industry and railways, and some entire PEs or PE activities are being divested or liquidated e.g. in mining, tourism, construction and mechanical industries. The proposed Public Enterprise Reform Loan (PERL), discussed further below is designed to support these efforts. 18. Other areas of structural reform underway include better adapting education and training to economic needs, and improving labor market legislation; further reforming agricultural support services; and preparing a cadastre and a program for limiting fragmentation to improve land management. 19. Social cos0s of adiustment. In Tunisia, as in many other countries a special effort is needed to protect the poor from the initial adverse effects of adjustment, particularly those stemming from a reduction in consumer subsidies and from attempts to tackle overmanning in the previously protected public enterprises. Tunisian unemployment is officially estimated at about 152 and it is especially severe among the younger age groups. Unemployment is a long-term problem: because the labor force is growing even faster than population, it is not expected that the unemployment rate will diminish significantly during the present Plan period and, according to longer term projections, it will also remain high for the following five years. The problem would be worse in the absence of the adjustment program which reduces the cost of labor relative to investment. The Government is attempting to reinforce the effects of these relat!ibs price changes through a number of schemes to promote labor intensive investment and self-employment. The Government is also experimenting with schemes to encourage firms to provide apprenticeships and to attract private investment in training. The underlying problem, though, is population growth, and the Government is continuing to address this problem directly through an active family planning program, and indirectly by changing incentives. The President has endorsed the concept of the family with three children, and the Social Security Fund has commenced limiting family allowances to three children rather than four. Equity and protection of the poorest are major concerns of the I misian authorities, especially in view of the severe drought in 1988. A number of steps are being taken to mitigate hardsuip arising from the adjustment program, and the Bank is and will continue to be supportive of these measures. The reduction in subsidies will be greatest on items with the least redistributive effect so as to minimize the cost to the poor. There are also targeted programs for helping the poor, such as the "Familles 301LSZ  - 8 - Necessiteuses" and subsidized loans for low-income housing. The social security and health care systems are well developed, though both need strengthening. The Bank is supporting a study of the social security system to determine how to ensure long-term financial viability, while keeping down contributions by workers. employers, and the State. Medical care is widely available at nominal charges, but the health system'a further development requires that a more substantial share of costs be recovered through service charges, with exemptions for the poor. The Bank will support the Government's efforts to develop and implement a suitable policy through sector work and through a Health and Population Project under preparation. PART II - BANK GROUP OPERATIONS AND ASSISTANCE STRATEGY Background 20. Lending. Since 1962, IDA has committed 10 credits to Tunisia amounting to US$75.2 million, and the Bank has committed 81 loans amounting to US$2,112.0 million, both net of cancellations. Project implementation is generally satisfactory, and important policy changes and institutional improvements have been achieved. Disbursement delays have particularly affected education, technical assistance, health, and urban projects due to project-specific problems. These are being addressed throtgh supervision missions and sector discussions. 21. Past Bank lending emphasized support for long-term investments in infrastructure, social development and, more recently, agriculture and industry. As of May 31, 1989 the sector share of the Bank Group commitments was as follows: agriculture 24 percent; industry 21 percent; transport 15 percent; urban 18 percent; energy 7 percent; human resources 8 percent; and non-sector lending 7 percent. 22. Bank Experience with Adjustment Lending. Adjustment lending to Tunisia started in FY87. A first Agriculture Sector Adjustment Loan (ASAL, Loan 2754-TUN), approved by the Board in September 1986, supported the Government's sector reform program and focused on prices, public investment, and support services. An Industrial and Trade Policy Adjustment Loan (ITPAL, Loan 2781-TUN), approved by the Board in January 1987, focused mainly on import tariffs and price decontrol. Approval of a Structural Adjustment Loan (loan 2962-TUN) followed in June 1988. A Second Agricultural Sector Adjustment Loan (ASAL II) was approved in June 1989. Each of these loans was integrated into the Government's macroeconomic adjustment program. 23. Performance under the ASAL-I has been satisfactory, (Annex III). Of the nine original conditions of effectiveness which included an exchange rate adjustment, first round increases in agricultural producer prices and reductions in input subsidies, seven were fulfilled by Board presentation and the remaining two were met on time. A second round of price adjustments, subsidy reductions and interest rate increases, as well as other important measures, were taken as conditions of second trancht 3013L  - 9 - release. The status of the key actions attached to the sector policy letter was also found to be satisfactory at the time of second tranche release, except for the implementation of an agricultural export promotion strategy which took longer than expected to complete, but which is now finished. The loan is fully committed and some US$108 million of the US$150 million loan have been disbursed, as well as US$21.0 million of German (KfW) and Dutch cofinanciers' funds totalling US$24.5 million. Following a satisfactory review of the overall implementation of ASAL-I, including both its macroeconomic and sectoral components, the second tranche of US$50 million was declared open for disbursement in October 1987 and the Board was so informed. The loan will close on June 30, 1989, following an extension of a year from the original closing date. 24. Implementation of the ITPAL has also been satisfactory (Annex III). The price and trade liberalization measures have been implemented on schedule, and a new investment code satisfactory to the Bank was promulgated. There were some delays in the design of fiscal reform and of an improved system for foreign exchange risk coverage. After agreement was reached on the design of these measures, their implementation, including introduction of a VAT, the nature of which has been discussed in detail with the Bank, was supported under the SAL. Disbursements under ITPAL experienced some delays associated with the political uncertainties prevailing in Tunisia in 1987. The sluggishness of private investment, due to weak domestic demand, also caused disbursements to lag. These difficulties are now solved and disbursements have accelerated in recent months. As of the end of May 1989, about US$106.0 million out of the US$150 million loan had been disbursed. The second tranche of the loan was released in January 1389. 25. As a result of the actions taken under ASAL-I and ITPAL, the process of removing the macroeconomic and intersectoral obstacles to improved agricultural and industrial performance has started. The devaluation of 17% in real terms by the end of 1986 helped reduce the bias against exports and raise the price of imported relative to domestic products. The lowering of tariff barriers for domestic industry coupled with first and second round increases in Government support prices for cereals has begun to reduce the difference in protection between industry and agriculture. The reduction in agricultural input and credit subsidies under ASAL-I have also opened the door to a liberalization of the domestic market for agricultural inputs, finance and services. 26. The SAL supports the Government's medium-term macroeconomic program and its measures to liberalize trade, decontrol prices, increase the efficiency of financial intermediation, and reform taxation (Annex III). The loan became effective in March 1989. The Second ASAL follows up on the measures undertaken under ASAL-1 and focusses primarily on further liberalizing the agriculture sector and strengthening essential Government support services. The proposed Public Enterprise Reform Loan (PERL) discussed below builds on the macroeconomic reform program and addresses key areas of reform necessitated by this macroeconomic program. This loan would support efforts, to institute reforms in public enterprise management, to restructure some major loss-making enterprises, and to divest assets which can be transferred to the private sector. 3013L  - 10 - 27. Although fast disbursing adjustment loans account for about 40 percent of Bank lending in the 1987-89 transition period, the strategy for the 1990s is to shift towards investment lending and to help the Government improve efficiency in the provision of urban and social services. An Education and Training Sector Loan was approved by the Board in May 1989 which supports structural reforms to ensure a better match between education and training provision and Tunisia's medium-term development needs, as well as more cost effective and aquitable services. The planning and delivery of these training systems is being organized in close collaboration with industrial associations. In addition, an Employment Conversion Fund project which would support employment promoting changes in labor markets is currently under preparation. Projects planned in agriculture include financing of research and extension activities, credit, and part of the public investment needs of the VIIlth Plan. Lending for industry and finance is envisaged to improve the competitiveness of Tunisian industry and support export development. Operations are planned to finance transport sector maintenance, water supply, housing finance, municipal development, and health and population. The Fifth Urban Project approved by the Board in May 1989 is the first Bank operation focusing on housing finance improvements and will also assist in the improvement of land management policies. A technical assistance loan was approved.1by the Board in February 1989 for the promotion of oil exploration, and is expected to be followed by an energy project that will assist energy conservation efforts and the efficient choice of energy sources in the medium-term. 28. Country Economic and Sector Work. The Bank's economic and sector work will continue to provide the macroeconomic and sector knowledge needed to analyze critical medium and longer term sectoral issues, to monitor economic performance and maintain a fruitful dialogue with the Government. The main tasks include a study of the efficiency and incentive structure of the private sector, and a study of the prospects and constraints for export development. A study also covering Algeria and Morocco is planned to assess the prospects for economic integration in the Maghreb. The Bank is assisting the Government to prepare its strategy for the health sector, and is completing a study of environmental issues that will be an input into the Environmental Program for the Mediterranean being carried out jointly with the European Investment Bank. 29. Bank Loans Outstanding. The share of the Bank and IDA in Tunisia's external medium- and long-term (MLT) public and publicly guaranteed (PPG) debt outstanding and disbursed was about 18 percent at the end of 1988, while the share of preferred creditors was 30X. That year, debt service payments on Bank debt amounted to 17 percent of the country's public and publicly guaranteed debt service, and the ratio of debt service on Bank debt to exports was 4.2 percent. Because of the emphasis on adjustment lending in the period of transition, the share of the Bank in Tunisia's PPG MLT debt is expected to peak at about 22 percent and its share in PPG debt service at about 24 percent in the mid-1990s. The shift towards more traditional investment financing by the Bank that will start in 1990 and the expected increase in the country's borrowings from commercial sources will result in a gradual decline of these indicators. 3013 L  - 11 - International Finance Corporation 30. As of March 31, 1989, IFC's net commitments in Tunisia totalled US$24.8 million. This financing has benefited the tourism sector, both through direct intervention in projects and through assistance to development banks, and the manufacturing sector, particularly in the chemical, pharmaceutical, construction materials and tex.iles subsectors. In textiles, IFC is helping to modernize and privatize some state-owned mills. The Corporation has also invested in the first leasing company in the country, and in the establishment of a Belgian-Tunisian venture in the field of engineering services. IFC is also financing, with the UNDP, a study on the potential for the improvement of Tunisia's capital market. PART mI - THE PUBLIC ENTERPRISE REFORM PROGRAM AND THE PROPOSED PUBLIC ENTERPRISE REFORM LOAN (PERL) INTRODUCTION 31. As already noted, the objectives of the proposed PERL are derived directly from the Government's overall objective of increasing economic efficiency by introducing greater reliance on economic incentives and reducing direct controls on the economy. During the 1970's and early 1980's, the PE sector which accounts for roughly 30X of GDP (see Annex VII), mirrored the economy wide developments outlined in Part I. First, during the early 80's, large, slow gestating investments in the fertilizer industry, cement, sugar, car assembly, a foundry and a steelmill were undertaken. On the infrastructure side, some large railway investments were undertaken with little economic justification. Overall, PE investment represented 57X of total investment in the industrial sector during the VIth Plan, with the sector's share in total investment in the economy increasing from 33% in 1983 to nearly 40S by 1985. Second, the overall increase in indebtedness was mirrored in the Public Enterprises. A survey of the 40 largest PEs (see Annex VIII) shows a sharp deterioration in profitability from 1981 (aggregate net profits of TD 39 million) to 1986 (aggregate net loss1- of TD 168 million), with their total debt increasing from TD 1.67 b.