Tunisia - Economic Competitiveness Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-6890-TUN REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SINGLE CURRENCY LOAN WITH A US DOLLAR TRANCHE IN AN AMOUNT EQUAL TO US$37.5 MILLION AND A FRENCH FRANC TRANCHE IN AN AMOUNT EQUAL TO FRF 193.9 MILLION TO THE REPUBLIC OF TUNISIA FOR A ECONOMIC COMPETITIVENESS ADJUSTMENT LOAN July 2, 1996 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 AND EOUIVALENT UNITS Currency Unit = Tunisian dinar (TD) US$1.00 = TD 1.0417 TD 1.00 = US$ 0.960 FISCAL YEAR January 1 - December 31 GLOSSARY OF ABBREVIATIONS BCT Central Bank of Tunisia CAREPP Commission for the Restructuring of Public Enterprises CCL Commission du contr6le des licenciements CTN Compagnie Tunisienne de navigation ECAL Economic Competitiveness Adjustment Loan EFRSL Economic and Financial Reform Support Loan EPIC Etablissement public a caractere industriel et commercial EU European Union FTA Free Trade Agreement GATT General Agreement on Tariff and Trade GDP Gross Domestic Product OC Office des Cereales ONH Office nationale de l'huile OPNT Office des ports nationaux tunisiens PE Public Enterprise STAM Societe d'acconage et manutention  REPUBLIC OF TUNISIA FOR OFFICIAL USE ONLY ECONOMIC COMPETITIVENESS ADJUSTMENT LOAN Contents INTRODUCTION .................................................. I PART 1: 1986-1996 - A DECADE OF ADJUSTMENT AND REFORMS .............. I A. BACKGROUND ............................................ I Strong economic results ..................................... 2 Fiscal and monetary restraints and exchange rate devaluation .............. 3 Export oriented growth ..................................... 4 B. IMPLEMENTATION OF REFORMS AND REMAINING ISSUES ... ......... 4 Recent developments ....................................... 6 The Free Trade Agreement .................................... 6 The Challenge .................................... 7 PART Il: THE ECONOMIC COMPETITIVENESS ADJUSTMENT PROGRAM ... ....... 8 A. THE MACROECONOMIC FRAMEWORK .......................... 8 Macroeconomic monitoring .................................. 13 B. TRADE POLICY ........................................... 14 C. REDUCING THE ROLE OF THE STATE .......................... 14 D. REFORMING REGULATIONS IN TRADE RELATED AREAS ... ......... 16 Shipping and ports ....................................... 16 Trade facilitation ........................................ 18 Telecommunications ...................................... 18 Improving the legislative environment ........................... 19 E. INCREASING FLEXIBILITY IN THE LABOR MARKET ..................... 20 Labor Regulations ....................................... 20 Social protection and labor costs .............................. 21 PART III: PROPOSED LOAN ......................................... 22 A. LOAN AMOUNT, TRANCHING AND CONDITIONALITY .... .......... 22 B. COFINANCING ........................................... 24 C. BENEFITS AND RISKS ...................................... 24 D. COLLABORATION WITH THE IMF ............................. 24 E. DISBURSEMENT, FINANCIAL MANAGEMENT AND AUDITING ... ...... 25 F. BANK ASSISTANCE ........................................ 25 G. ENVIRONMENTAL ASSESSMENT .............................. 26 PART IV: RECOMMENDATION ....................................... 26 ANNEXES 1. Social Indicators of Development II. Key Economic Indicators Ill. Tunisia at a Glance Tables IV. External Financing Requirements and Sources of Financing V. Status of Bank Group Operations VI. Matrix of Actions VII. Economic Indicators Table VIII. Government Letter of Development Policy MAP: IBRD 24726R [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 wiLhout World Bank authorization.   REPUBLIC OF TUNISIA ECONOMIC COMPETITIVENESS ADJUSTMENT LOAN (ECAL) Loan and ProgLram Summary Borrower: The Republic of Tunisia. Amount: US$75 million equivalent comprising (a) a tranche equal to US$37.5 million and (b) a tranche equal to FRF 193.9 million. Terms: Fixed rate single currency loan for up to 15 years, three years of grace and interest rate for fixed rate single currency loans with an expected disbursement period of two years. Interest Payment Dates March 15 and September 15. and Rate Fixing Dates: Description: The Economic Competitiveness Adjustment Loan (ECAL) would support a reform program aimed at achieving a sustainable increase in the rate of economic growth while improving the international competitiveness of the economy. The ECAL is the first among a series of operations to upgrade the private sector and to prepare it for the establishment of free trade under the implementation of the Free Trade Agreement (FTA) with the European Union, signed in 1995. The specific policy measures concern the following areas: (a) a sound macroeconomic and fiscal framework, including measures to replace revenues lost from the expected reduction in tariffs and tariff surcharges; (b) the acceleration in the implementation of the FTA; (c) the acceleration of the privatization program in competitive sectors; (d) the improvement of the regulatory and administrative environment in which enterprises work, including actions to reduce transport costs, to facilitate the passage of goods through ports and customs and to improve the legislative framework; (e) a greater flexibility in the labor market while protecting dismissed workers and containing labor costs. Benefits and risks: The principal benefits that would derive from the implementation of the reform program supported by the Loan would be: (a) to increase the efficiency of resource allocation in the economy and the productivity of the private sector; (b) to facilitate the integration of Tunisia with world markets; (c) to strengthen Tunisia's balance of payments and to consolidate its access to private capital markets. Two main risks are associated with the  - ii - years show that the Government's commitment to the reforms has remained firm even during prolonged droughts and political crisis in the region. The second risk relates to the transitional social costs (labor dismissals) caused by the necessary restructuring of enterprises. Increased output growth and labor market flexibility should ensure that in the long run the overall effort of trade integration is positive, and these costs are minimum. In the short term, this risk is also limited because of (a) the Government's ability to build consensus among the parties interested in the reforms, and (b) the existing social safety net and the additional measures that will be put in place to protect the welfare of dismissed workers. Estimated Disbursement: The proceeds of the proposed loan would be disbursed in two tranches: US$37.5 million upon loan effectiveness, and FRF 193.9 million after the completion of a number of specific actions. Release of the second tranche is planned for June 1997. Appraisal Report: None. Parallel Financing: Parallel coordinated cofinancing of about US$150 million will be provided by the European Union. Map: IBRD 24726R Project ID: 42287 Vice President: Kemal Dervis Director: Daniel Ritchie Division Chief: Christian Delvoie Task Manager: Miria Pigato This document has a restricted distribution and may be used by recipients only in the performance of their ofricial duties. Its contents may not otherwise be disclosed without World Bank authorization.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED ECONOMIC COMPETMVENESS ADJUSTMENT LOAN IN AN AMOUNT EQUAL TO US$37.5 MILLION AND AN AMOUNT EQUAL TO FRF 193.9 MILLION TO THE REPUBLIC OF TUNISIA INTRODUCTION 1. I submit the following report and recommendation on a proposed Economic Competitiveness Adjustment Loan to the Republic of Tunisia in an amount equal to US$37.5 million and an amount equal to FRF 193.9 million. The loan would provide financial support for the Government's program aimed at improving the international competitiveness of the economy and at accelerating its integration in world markets. It would be a fixed rate single currency loan for up to 15 years, including three years of grace, and cofinanced by the European Union. The Bank's Country Assistance Strategy has been discussed by the Board on June 13, 1996. PART I: 1986-1996 - A DECADE OF ADJUSTMENT AND REFORMS A. BACKGROUND 2. Tunisia is a medium sized country with 8.8 million inhabitants and few natural resources. Agriculture production represents one sixth of GDP. The share of manufacturing, 19 % of GDP, is lower than in comparator middle income countries but it has risen fast in recent years. To a great extent the economy's performance has been export dependent, and manufacturing increased from 20% of total export receipts in 1980 to 50% in 1995. Prudent macroeconomic policies coupled with successful diversification efforts have led to consistent positive growth over the last ten years. Emphasis on social sectors has also led to a literacy rate and general standards of education above those of most countries in the region. Its health and mortality rates indicate that the benefits of income growth have been spread widely and are confirmed by a low incidence of poverty (7 % of the population). 3. Since 1986, when a decline in oil export earnings and excessive levels of public sector investments brought the country close to a balance of payments crisis, the Government of Tunisia has consistently pursued a program of macroeconomic stabilization and adjustment. The Bank supported this program through six adjustment loans, the most recent of which, the Economic and Financial Reform Support Loan (EFRSL), helped the country to overcome the aftermath of the Gulf war in 1991. In 1986, the IMF provided support with a Stand-by Arrangement followed, in 1988, by an Extended Arrangement. All the Bank and IMF programs were successfully concluded and are closed. The reforms have aimed at liberalizing the economy, which had been highly controlled, removing major distortions arising from taxes and subsidies, improving the allocation of resources and reducing the role of the public sector. The  -2- objectives of the reforms were substantially achieved, and the adoption of a gradual pace in their implementation minimized social disruptions and conflicts. Fig.1: Export Growth Fig. 2 Tenn of trade and Real effective exchange rate 12- 1 105 10 0 8 95 12 J 190 Term ortrade 85 4 _ _ _ 80 2 - 75 Real effecfe exchange rate 70 Manufacturing ris m Total Goods gWS 65 -2- 60- f raQJ C Ca Ca Ca C a C C D , a , a , a |1980-86 * 1987-94 |M a -, a, a, a, a, a, a, (D m, D, _ a, Fig. 3: Current Account and Budget deficit Fig. 4: Debt and Debt Service C') v C) (D N- a a, O - a) C' v U) m co Ca o a m m cc m a m a, 0 a 4. ~ ~ a a,spteo a,vrs a, elpens a,c as a,vra a,ar a, a,uh,th ufwa n h 01 80 2.0 70 00 ~~~~~~~~~~~~~~~~~~60 -4t0 40 30 -6 0 20 10 -10 0 0 Ca C Ca Ca a , C 0) a, a 12.0 a, a a, a, a, a f e a, a, i a raude 1cit m Current ACccoun ect Total DebtIGDP -.De lt Ser.ceWE-port] Strong Economic Results 4. In spite of adverse developments, such as several years of drought, the Gulf war and the recession in Europe in the early 1990s, real GDP increased from a 3 % annual rate during 1980- 86 to more than 4% during 1987-94. The result was a doubling of per capita income growth, 2.4 % per annum. This perfonmance was achieved within a framework of improved internal balances, a strengthening of the balance of payments and a declining inflation rate. The comprehensive program of structural reforms that accompanied the stabilization measures succeeded in increasing the efficiency of the economy and the role of the private sector. Thus, in spite of a marked reduction in public investment, the rapid output growth and improvements  -3- in productivity brought the ICOR down from 12.4 in 1980-1986 to 6.6 in 1987-1994. During the same period, private non financial enterprises increased their share in total value added from 45% to 60%. The share of private investments in total investment grew from 44% in 1986 to almost 50% in 1992. Fiscal and Monetary Restraints and Exchange Rate Devaluation 5. Monetary and fiscal restraints contributed to the restoration of macroeconomic balances. The growth of monetary aggregates was kept in line with nominal GDP growth. The elimination of prior requirements for all credits in 1987, the liberalization of virtually all interest rates, completed in 1994, and the development of a money market created the conditions for a shift from direct to indirect methods of monetary management. The fiscal deficit (see Fig. 3) declined from an average of 5.5% during 1980-86 to 3.9% during 1987-94. The brunt of the adjustment was on public investment, while the Government protected social expenditures. Moreover, by 1994, the deficit was completely financed with non bank-instruments. This financing pattern resulted in a fast expansion in the share of commercial bank credit to the private sector. Real interest rates remained positive in spite of a reduction of two percentage points in 1994. Together with the reduction in the fiscal deficit, this contributed to an increase in gross domestic savings from 19.5% of GDP in 1986 to 21.9% in 1994. 6. Fiscal and monetary policies were supported by adjustments of the exchange rate. The real effective exchange rate (see Fig. 2) depreciated by a total of 30% in 1986-1991, and, since then, has remained roughly stable. Some of the elements that result from the Government's policy to maintain a stable real effective exchange rate are the absence of a black market and a strong growth in exports'. 7. The cuirent account deficit moved from an average of 7.8% of GDP during 1980-86 to 4.3% during 1987-91 slipping back to 5.8% and 6.5%2 of GDP in 1992 and 1993 respectively. This transitory deterioration reflected a recovery in investment, a worsening in the terms of trade and sluggish export growth due to the stagnation of European demand. The improvement in the late 1980s of the current account allowed an amelioration in external debt indicators. Total debt over GDP decreased from 67% in 1986 to 58.7% in 1994 and the debt service (see Fig. 4) declined from 28% to 18.5% of exports. Notice that between 1990 and 1995 the real effective exchange rate appreciated by 9%, 78%, 29% and 11% in Morocco, Poland, Hungary and Portugal respectively, countries that compete in the European market with Tunisia. v The figures exclude the contribution of the construction of a new gas pipeline to Italy (Gazoduc) and the development of a new offshore gas field in Miskar as these projects were totally financed with foreign direct investment. The current account deficits including the Gazoduc and Miskar projects were: 6.9% of GDP in 1992 and 8% in 1993.  -4 - Export-Oriented Growth 8. Between 1987 and 1994 the volume of manufactured exports increased on average by more than 10% per year, and total exports by 7.2% (see Fig. 1). This performance financed the acceleration in imports of capital and intermediate goods, essential for investments and income growth, and an improvement in the current account balance. Exports of goods and services increased from 30% of GDP in 1986 to 43% in 1994. The structure of exports showed remarkable changes: the share in GDP of exports of primary products (agriculture, fuel and phosphates), dropped from 17% in 1980 to 4% in 1994, while the share of manufactured exports moved from 10% to 25% of GDP. During the same period, the share of textile and clothing in manufacturing exports increased from 47 % to 55 %. Europe has continued to be the main market, absorbing 75% of exports. The concentration of markets and products make tunisian exports vulnerable to political shocks and price fluctuations. For example, during 1990- 92 developments in the European market contributed to more than 90% of the 50% fall in the growth rate of exports. B. IMPLEMENTATION OF REFORMS AND REMAINIG ISSUES 9. Accompanying the macroeconomic stabilization program has been a program of reforms aimed at introducing market determined incentives and at improving the outward orientation of the economy. Domestic controls on prices have been drastically reduced. Producer prices have been substantially freed and distribution margins apply only to about 20 % of domestic absorption. Consumer subsidies have been reduced and targeted to the poor. The economy has been exposed to external competition: quantitative restrictions, which in the mid 1980s protected the entire local production, cover now only about 15% of domestic production. But tariff protection is still relatively high: the applied unweighted average tariff rate is 30%, while surcharges, the temporary duties that were imposed, starting in 1991, on the goods previously protected by QRs, range from 10% to 30%. Tunisia joined the GATT in 1990 and was a founding member of the World Trade Organization. It adopted current account convertibility in January 1993 and established an interbank foreign exchange market in March 1994. 10. A tax reform was introduced in the late 1980s, including a value added tax with a main rate of 17% and additional rates of 6%, 10% and 29% (on luxury goods). Direct taxation has been made simple and brought to moderate levels. The standard rate for the corporate tax and the highest marginal rate for income tax are 35 %. There is no double taxation on dividends. Investments in new share issues enjoy major tax incentives, as they are deductible from the taxable income of investors, with a ceiling of 35 % of the taxable income. The Investment Code, approved in December 1993 limits fiscal advantages to a few clearly defined objectives and cases of market failure. However, it contains incentives that are very generous (e.g., a ten-year tax holiday for wholly exporting enterprises) compared to international standards.  11. The privatization program, launched in 1987, proceeded slowly. Because of lack of public support, the authorities needed to build consensus and demonstrate that privatization could entail important benefits without excessive social costs. Most importantly, an adequate institutional and regulatory framework did not exist and was gradually put in place during the years 1989-1995. Privatization began with small-medium sized enterprises for which buyers could be found at acceptable prices. Up to 1994, 50 transactions were undertaken, with proceeds amounting to approximately TD 200 million, or about 1 % of the average GDP. The private sector was also allowed to operate in areas that had traditionally been the domain of the State. Recent progress includes the deregulation of domestic merchandise transport, of urban transport (partially) and the elimination of restrictions on maritime shipping. 12. In addition to the privatization program, the Government introduced a program to restructure public enterprises (PEs), particularly those that were unprofitable. Budgetary transfers to PEs were reduced from 7% of GDP in 1990 to 4.2% in 1994. Most small and medium PEs are now profitable, exposed to the benefits of competition and enjoy management autonomy. However, because of the Government's pricing policies aimed at subsidizing cereals, oil and few other commodities, some of the largest PEs, in particular l 'Office des Cereales (OC) and l'Office National de l'Huile (ONH), have been facing, over the last three years, a structural operating deficit. This deficit has been financed through borrowing from the banking system. The accumulated arrears with the banking system now amount to TD 700 million. The Government recognizes that this situation is not sustainable and is hampering the development of a sound money market, as the loans extended by the banking system to the Offices are refinanced regularly by the Central Bank. The authorities have decided that the Central Bank will grant an advance of TD 700 million to the budget, to allow the Offices to repay any outstanding arrear with the banks. This advance will be repaid by the budget over 12 years. The Government will also ensure that any possible arrears that might arise in the future will be covered by appropriate budgetary allocations. The fiscal consequences of this plan are described in Paragraph 25. 13. Regulatory reforms in the financial sector, which started in 1987 and evolved over several years, have been deep. Liberalization measures included, among other reforms, the elimination of (i) prior authorization by the Central Bank of Tunisia (BCT) for making banking loans; (ii) most controls on interest rates; and (iii) commercial banks' obligation to finance the budget. More recently, between 1991 and 1993, prudential regulations were also revised to introduce stringent rules for loan classification and interest suspension and limits on risk concentration to group borrowers and on exposure. The Central Bank's own capacities for supervising and inspecting banks were reorganized and strengthened. In 1994, with the amendment of the Banking Law the conditions and qualifications for the creation, ownership, and management of banks were also redefined. These measures are enabling the financial market to develop, though it remains dominated by public sector institutions that are less efficient than the private banks. In fact, all financial institutions have strengthened their portfolios,  - 6 - provisioned a higher percentage of income and are now complying with existing prudential regulations, with the exception of a couple of public banks. Recent Developments 14. Real GDP increased only by 2.6% in 1995, because of a 10% contraction in the agricultural sector due to the continuation of the drought, and a reduction in fixed investments. Inflation remained under control in spite of increases in the price of agricultural products. A shortfall in revenues, due to a prolonged stagnation in economic activity, resulted in a budget deficit higher than expected, 4.2% of GDP (see Table 1). Private sector investments continued a two-year decline. Investment decisions may have been delayed by the uncertainty surrounding the beginning of the FTA. The introduction in the 1996 Finance law of measures to accelerate the implementation of the FTA through the elimination of import duties on equipment goods, is expected to have positive effects on investment in the near future. 15. The external balances show a mixed picture. After a remarkable improvement in 19943, the current account deficit rose to 4.0% of GDP in 1995 because of a slowdown in the exports of olive oil and a drought-induced increase in cereals imports. However, the growth of manufactured exports remained strong, 5.5% in volume terms. External reserves reached 2.6 months of imports in 1995. The stock of external debt stood at 54.7% of GDP in 1995, down from an average of 63.7% during the period 1987-93. The debt service ratio also decreased steadily in the past five years, thanks to rapid export growth. The Free Trade Agreement 16. Tunisia was the first country in the North-Africa and Middle East Region to sign a regional free trade agreement with the EU. The objective of the FTA, which complements recent agreements under the GATT, is to fully integrate the economies of Tunisia and the EU through free movements of goods, and legislative, social and financial cooperation. Under the FTA, tariffs on imports (excluding agricultural goods) will be progressively eliminated over a 12-year period, starting with those on capital and intermediate goods and only subsequently (four years after the entry into force of the FTA) on most consumer goods. Although the transition to free trade is stretched out, the FTA is a major policy initiative for Tunisia. It provides a clear signal to the private sector that in the future there will be no protection to shelter behind. Its credibility is enhanced by the binding nature of the commitment, and by the implicit linkage between the financial assistance that the EU will provide in the coming years and the implementation of the reforms. 31 This was due to a slow import growth, a sharp increase in the exports of olive oil and a good tourism season.  - 7 - 17. The benefits of the FTA and GATT agreements are potentially very large: import competition will induce enterprises to increase their efficiency and allocate resources where Tunisia has comparative advantages; an improved regulatory environment, harmonized with the European one, will attract foreign investors; and the security of market access for Tunisian exports will be reinforced. There remains an issue of losses as a result of trade diversion, which is not, however, very important as trade with Europe accounts for about 75% of Tunisia's foreign trade. While envisaging unilateral liberalization against the rest of the world in the longer run, the Government believes that the benefits provided by the FTA are greater than those that would come from total liberalization: the FTA offers a credible anchor to economic reforms; it includes the harmonization of regulatory regimes pertaining to product standards, testing and certification procedures, legal framework etc.; it allows agreements on anti-dumping actions; and it involves significant financial and technical assistance. The Challenge 18. The signature of the GATT and of the FTA represents an unique opportunity for sustained growth. But it also presents adjustment challenges, as existing enterprises will soon have to face European competition. The Government estimates that one third of existing enterprises will not be able to sustain this competition and will have to be liquidated while an additional third may only survive if they are restructured. The fear of unemployment, which, according to Government estimates falls on 16% of the labor force is the main reason why the Tunisian Government negotiated a gradual pace in the implementation of the FTA. The political consensus to a more rapid pace of change might come as the benefits of the FTA translate into higher employment and standards of living. This outcome will depend greatly on the ability of the Government to: address, over the next 5-6 years, the main constraints that inhibit private sector efficiency; create a sound and internationally competitive business environment and improve cost competitiveness; facilitate the reallocation of capital and labor towards sectors of comparative advantages; and strengthen and upgrade the quality of exports. 19. These reforms are crucial, as the competitiveness of the private sector is still limited. First, as trade liberalization has only been partial, a dualistic structure of the economy has resulted: on one hand, enterprises that sell in the domestic market, protected from external competition, often inefficient; on the other, the exporting firms, under subcontracting agreements in low skilled activities such as garment assembly. With the scheduled phasing out of the Multifibre Agreement, these firms will increasingly need to compete with exporters from Eastern Europe and Asia, that produce at lower wages and/or higher skill levels. Second, firms encounter a number of inefficiencies and obstacles in the environment in which they operate that hinder their competitivity: high transport costs, slow and inefficient port and custom procedures, rigid labor market regulations and limited access to credit. Third, the public sector is still large and operates at low levels of efficiency; and Government controls, although reduced, remain important.  -8- PART II: THE ECONOMIC COMPETITIVENESS ADJUSTMENT PROGRAM 20. In the coming years Tunisia will need to: (a) improve the international competitiveness of the economy; (b) modernize services provision; and (c) preserve the environment and improve the management of natural resources. The Government recognizes that these are the key conditions to increase economic growth and achieve full integration in the world economy. The Bank's country assistance strategy, supporting the Government's agenda in all these areas, was discussed at the Board on June 13, 1996. 21. Consistent with the Bank's assistance strategy, the ECAL would address a broad policy agenda to upgrade the competitiveness of the private sector and prepare it for increased competition in the context of the FTA. The program supported by the ECAL would focus on five components: First, it would foster the continuation of a stable macroeconomic framework; Second, it would accelerate the implementation of the FTA and the reduction of tariff surcharges; Third, by accelerating the pace of privatization, it would increase the role of the private sector in the economy. Fourth, it would improve the regulatory and administrative environment in which enterprises operate, through lower transport costs, trade facilitation and an improved legislative framework. Fifth, it would increase flexibility in lay-off procedures while protecting workers and containing the cost of labor. The macroeconomic framework has been discussed with the IMF and the EU. The following sections as well as the Letter of Development Policy and the policy matrix describe the Government's program. The measures listed in Part III (i) have been fulfilled before Board submission, and (ii) constitute specific conditions for second tranche release. A. THE MACROECONOMIC FRAMEWORK 22. Tunisia's macroeconomic objective is to move to a higher path of growth, while at the same time preserving macroeconomic balances. This objective will require the continuation of prudent fiscal and monetary policies and the implementation of a strong reform program. Under these conditions Tunisia would be able to increase annual GDP growth from around 4 % to about 5%-6%. 23. Growth prospects. GDP growth is projected to reach 7.1 % in 1996, as agricultural production recovers, capital formation peaks up and international demand for Tunisian exports remains strong. The implementation of the reform program is crucial to reach the projected annual growth rates of around 5-6 % during the period 1998-2003. To achieve this objective, the efficiency of investments would improve, as manifested in a reduction of the incremental capital output ratio from 6.3 during 1987-93 to 5 during 1998-2003; gross domestic investment would increase from 24.6% of GDP in 1995 to 27.0% by the end of the decade following the implementation of the FTA and an improvement in incentives. Higher gross domestic savings  - 9 - (from 21 % of GDP in 1995 to 26.0% of GDP in 2003) would result from a reduction in the fiscal deficit and an increase in private savings. Table 1. Selected Macroeconomic Indicators __________________ _ 1 -1980-86 1987-93 1994 1995 1996 :1997 1998-2003 Rate of Growth Real GDP m.p. 3.2 4.3 3.3 2.6 7.1 5.5 5.2 Real Export of GNFS 1.4 5.9 14.9 1.3 4.7 6.8 7.1 Manufacturing 7.5 8.4 23.2 5.5 4.4 8.2 8.8 Inflation (GDP Defl.) 9.0 6.0 5.1 4.7 4.5 3.3 3.1 5 year ICOR 12.4 6.3 5.0 5.9 5.1 5.6 5.0 In % of GDP Gross Domestic Investment* 30.1 25.6 22.1 24.4 25.3 25.8 26.8 Budget Balance -5.5 -3.6 -2.7 -4.2 -3.8 -3.0 -1.4 Current Account Balance* -7.8 -3.6 -2.0 -4.0 -3.8 -3.7 -3.6 Gross domestic saving 23.2 21.6 21.9 21.1 22.2 22.6 24.0 Exports GNFS 35.4 40.1 44.0 44.1 43.1 43.8 47.5 Manufacturing 11.3 19.6 24.8 25.4 25.1 25.9 29.1 Outstanding Foreign Debt 50.2 63.7 58.7 54.7 53.1 52.0 47.4 External Debt Service 20.0 23.9 18.5 18.2 16.9 16.0 15.5 (% of exports) Gross Foreign Reserves 1.7 2.1 2.6 2.6 3.0 3.1 3.0 (in months of imports) * Excluding the Gazoduc and Miskar projects. 24. Export growth. The projected increase in manufacturing exports, from an average of 20% of GDP in 1987-93 to 29.1 % of GDP in 1998-2003 is predicated on the effects of the FTA. These effects will not be significant in the next two-three years, as Tunisia has already free access to European markets. The increase in export growth would result, in the medium- term: from gains in efficiency, due to a reallocation of resources from import-substituting activities to tradables; from an improvement in productivity, as a result of structural reforms that reduce transport, credit and labor costs; from higher levels of foreign private investments; and from an increased market penetration, to be expected from the harnonization in norms and standards.  - 10 - As to employment, the overall effect of the FTA and of the policy reforms supported by the ECAL will be positive, as resources are redeployed toward labor intensive sectors where Tunisia has a comparative advantage. However, in the short term the restructuring of industrial enterprises and the privatization program may exacerbate labor mismatches and pressures. 25. The rfscal program. To maintain economic stability the authorities will continue implementing a restrictive fiscal policy, to reduce the deficit from 4.2% of GDP in 1995 to 1.6% of GDP by the end of the decade. The implementation of the FTA will result in cumulative losses in tariff revenues, of about 1.7% of 1995 GDP during 1996-2001. Starting in 1997, and over a 12-year period, the Government will also repay to the Central Bank about TD 700 million in equal installments, on account of the obligations of the OC and ONH with the banking system; and it will also ensure that each Finance law will contain appropriate allocations to settle the unpaid banking commitments of OC and ONH during the preceding years. The government's strategy is to maintain the overall tax burden and raise additional revenues through greater reliance on indirect taxation and a decrease in the ratio of budgetary expenses (net of debt service) to GDP, while preserving social expenditures. The 1996 Finance Law already includes measures to compensate the revenue shortfall resulting from the reductions in tariff and tariff surcharges: extension of the VAT to the retail sector, elimination of the exemption of VAT on imports of equipment goods, an increase in the excise tax on tobacco, and a move of the petroleum products from the 6% tax category to the normal VAT rate of 17%. Over the next few years, the expected reduction in the fiscal deficit will be achieved through: (a) actions to improve fiscal revenues, including the strengthening and modernization of tax administration; (b) the enlargement of the tax base, in particular with a gradual elimination of the fiscal advantages included in the Investment Code. The revision of the Code will take place in 1998, after the preparation of a study and action plan to harmonize the incentives contained in the Investment Code on the basis of the new commitments made under the WTO Agreement and the FTA; (c) a decline in the ratio between expenditure (net of debt service) and GDP, to be achieved through a reduction in the allocations made to the Compensation Fund (Caisse de Compensation) and a streamline in other budgetary expenditures, including the wage bill. The 1997 Finance Law will include adequate fiscal measures to compensate for revenue losses due to trade reforms and to repay any banking arrears contracted by OC and ONH in 1996. These measures will include limiting budgetary allocations to the Compensation Fund to 1.7 % of GDP; and reducing budgetary expenditures, net of debt service, in relation to GDP, without prejudice to social sector expenditures. Finally, capital revenues are projected to increase sharply in 1996- 1998, as a result of an acceleration in the privatization program, and to remain at a considerable level thereafter, as the disengagement of the State continues. These revenues will not finance current or capital expenditures but will be targeted to restructure public enterprises. 26. Balance of payments viability. Maintaining a viable balance of payments while pursuing the integration of the economy into world markets through the liberalization of trade and exchange regulations, is a key objective of the Government program. The current account deficit is expected to move gradually from 4% of GDP in 1995 to below 3 % of GDP by the  - 11 - year 2004. In the next few years, the current account and its financing will be subject to various sources of uncertainty. First, both import and export flows will increase substantially in the long term, but the respective timing of these increases--and hence the short-run net effect on the current account--is difficult to predict as the reforms involve radical structural shifts in behavioral relations. Second, the Government expects an increase in foreign investment, estimated to reach US$300 million a year by the end of the decade (about 1.5 % of GDP). This represents a large increase from the past as two-thirds of foreign inflows in recent years concerned Gazoduc and Miskar, two oil projects now completed, and is predicated on the successful implementation of the FTA and the reform program supported by the ECAL. Third, Tunisia's agricultural sector will continue to depend on changes in weather conditions4. Finally, remittances and tourism receipts (representing together 30% of export earnings), will continue to remain uncertain and volatile because of reduced migration opportunities and political developments in neighboring countries5. To face the increase in uncertainty and vulnerability, and to preserve the competitiveness of the economy, the Government intends to build up the level of foreign exchange reserves (to more than three months of imports); and to monitor closely the real exchange rate, now estimated to be broadly adequate. 27. Financing plan. Table 2 presents the financing plan for the next four years. The total financing need is expected to average US$1.7 billion a year. Multilateral loans (from the African Development Bank, the European Investment Bank and the IBRD) will cover about 40 % of the needed total financing. Tunisia's access to private international capital markets has recently improved (the country received a Baa3 rating from Moodys in 1995) and private credits are expected to play an increasingly significant role in financing the current account deficit. During the next three to four years private creditors are in fact expected to cover one third of total needs. However, market access is still limited. Thus, the Government is carefully balancing its financing sources, between private markets and multilateral sources, to maximize its debt profile. Thus, it is preferable that a considerable part of the financing come from multilateral credit. Within this context, during the next two years the proposed ECAL would contribute to the remaining financing needs with US$75 million equivalent. The EU would also provide about US$150 million as parallel cofinancing of the ECAL. 28. This financing plan is associated to an increase in reserves from the level of 2.5 months of imports during 1987-95 to a level of 3.1 months of imports during 1996-1998. Such a level of reserves is estimated to provide an adequate buffer against increased uncertainty from at least four perspectives: (i) by historical standards, at 3.1 months of imports, the reserve to import ratio would be 50% above its 1980-95 average (about 2 months of imports) and 20% above its 4/ In 1995, the third drought year, exports of agricultural products declined by 32%. During 1993-95 value added in agriculture declined by 24%. 5/ For example, tourism decreased by 65% in real terms during the 1991 Gulf war (about 2% of GDP).  - 12 - previous historical peak (2.8 months in 1988)6; (ii) net of imports related to off-shore textile activities, the targeted reserve level would be equivalent to 4.0 months of imports, an adequate level by international standards, even for relatively open economies; (iii) the targeted reserve level would allow to absorb balance of payments shocks of a magnitude 50% larger than those experienced on average over 1980-95 while maintaining reserves (after the shock) at a level close to the average over 1980-95;7 and (iv) on the basis of scenarios illustrating possible shocks affecting the current account8. Table 2. Financing Plan (US$ billion) Prel. Est. Projected ___E_____:___ :____ :_:1991-93 1994 1995 1996 1997 1998 1999 Financing needs 1.78 1.32 1.76 1.68 1.68 1.71 2.01 Sources MLT Loans & Credits 1.20 1.01 1.50 1.66 1.49 1.37 1.54 Multilateral 0.60 0.48 0.49 0.62 0.61 0.63 0.65 of which IBRD* 0.22 0.19 0.16 0.16 0.19 0.20 0.22 Official Bilateral 0.31 0.37 0.43 0.36 0.25 0.23 0.21 Private Creditors 0.30 0.16 0.57 0.69 0.63 0.51 0.68 Short-Term, Non-Guaranteed Errors and Omissions 0.07 0.03 0.16 -0.07 -0.03 0.01 0.14 FDI 0.42 0.37 0.28 0.25 0.27 0.29 0.32 Grants 0.13 0.10 0.14 0.21 0.21 0.21 0.21 of which EU 0.00 0.00 0.00 0.15 0.15 0.15 0.15 Change in reserves -0.04 -0.20 -0.32 -0.37 -0.25 -0.17 -0.19 = increase) Financing gap 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Gross disbursements. 6/ Admittedly, reserves have been historically low in Tunisia, so that a 50 percent increase in reserves may not appear very large. Should such an increase happen in the near future, it would occur at a time when Tunisia's standing on international financial markets is better than in the past (as reflected by yield spreads of only about 70 basis points over LIBOR), which, ceteris paribus reduces the need for reserves. 7/ Statistical analysis indicates that very strong negative shock would lower reserves from 3.1 months of to 1.6 months, close to the historical average over 1980-95. Two scenarios have been modeled to simulate possible shocks. The first explores the effects of a shock in tourism revenues in 1997-98 equal (in percentage terms) to the one experienced during the gulf war. Such a shock would bring the current account deficit from the baseline reported in Table 1 to 6.3% and 8.2% of GDP in 1997 and 1998 respectively, and it would increase the firiancing need (comparing to the baseline scenario) by $400 million in 1997 and $920 million in 1998. The targeted reserve level would allow absorbing such a shock without additional borrowing, while leaving reserves at 2.0 month of imports after the shock. The second scenario is based on the hypothesis that import elasticity in 1997-98 would rise to about 2.4 (against 1.3 in the baseline scenario), possibly reflecting a boom in imports of consumer goods. Such a shock would bring the current account deficit to 6.3 % in 1997 and 9% in 1998. The additional financing need would be US$400 million in 1997 and US$1.1 billion in 1998. Reserves in this case would go down to 1.6 month of imports, which, as discussed, is close to the 1980-95 average.  - 13 - Macroeconomic Monitoring 29. Macroeconomic developments will be monitored during semi-annual consultations between the Bank, the Government and--informally--the Fund, on the basis of a set of indicators. As the program focuses on improving competitiveness in the context of balanced macro policies, the indicators will include a number of variables relating to the balance of payments and to the macroeconomic saving-investment balance (see Table 3). Table 3. Monitoring Indicators 1993 1994 1995 1996 1997 1998 Total Gross Reserves (in months' imports) 1.7 2.6 2.6 3.0 3.1 3.0 In percentage Budget Deficit/GDP -3.2 -2.7 -4.2 -3.8 -3.0 -2.5 Real Export Growth (G&NFS) 5.3 14.9 1.3 4.7 6.8 7.0 Manufacturing 1.7 23.2 5.5 4.4 8.2 8.4 Current Account Deficit/GDP * -6.5 -2.0 -4.0 -3.8 -3.7 -3.8 Outstanding Debt/GDP 59.4 58.6 54.7 53.1 52.0 50.5 [Excluding the Gazoduc and Miskar projects. External current account: developments in the external current account (in relation to GDP) will be used as the main indicator of developments in the saving-investment balance of the economy. Export growth: the growth of manufactured exports will be used as an indicator of the program's success in achieving one of its primary goals, that is increasing the competitiveness and the outward orientation of the Tunisian industrial sector. External reserves and gross external debt: raising the level of reserves, in relation to imports, is an important objective of the program, on account of the increase in balance of payment uncertainty in the next few years; thus, the external reserves to import ratio will be an indicator of the program. However, the targeted increase in the reserve ratio should not be financed by excessive new borrowing: gross external debt, will also be considered as an indicator for the program. Fiscal policy: a tight fiscal policy is central to preserving macroeconomic stability and increasing the share of the private sector in the economy. The Government deficit to GDP ratio will be used as an indicator of the ability of the public sector to contribute to the increase in  - 14 - savings, and therefore to maintain consistency between the current account targets and the expected behavior of private sector's saving-investment balance. 30. Deviations from the projections of these indicators would trigger discussions with the authorities to ideiitify underlying problems and explore corrective policy measures. B. TRADE POLICY 31. The FTA will come into force only after the approval -of the European parliament, the parliament of all EU member countries, and the Tunisian Assembly. The Government intends to ratify the FTA, of which a draft law is already before the Chamber of Deputies, before July 1997. The remaining QRs, with the exception of a negative list and of those on cars, for which the GATT has allowed a three-year delay, will be eliminated before the entry into effect of the FTA. Given the importance of reducing tariff barriers and accelerating the integration of Tunisia into the world economy, the Government has already started implementing the trade liberalization program. In fact, the 1996 Finance law includes reduction in tariffs (extended not only to the EU but also to the rest of the world) on the import of equipment goods, as required during the first year of application of the FTA; the 1997 Finance law will include the tariff reductions scheduled up to the second year of application of the FTA. The Government has prepared a plan for the complete elimination of the tariff surcharges in the next three years. A decree establishing a reduction of 10 percentage points in all tariff surcharges was signed in March 1996. This corresponds to a decrease of about 60% in the total revenue deriving, in 1995, from the collection of the surcharges. The remaining tariff surcharges are expected to be eliminated in two equal installments in the Finance laws of 1997 and 1998. The Government will also prepare, by July 1997, a plan to harmonize the structure of tariffs imposed on non European imports; and will make publicly available to the private sector the precise content and tariff reduction schedule of the FTA. C. REDUCING THE ROLE OF THE STATE 32. After independence, the development of industrial and commercial public enterprises (PEs) has been the main instrument for the achievement of crucial government objectives, such as employment generation and income distribution. By the mid 80s, PEs accounted for about 30% of total value added and formal employment, as well as 40% of total investment in the economy. However, because of poor management and weak performance some of the largest PEs became highly indebted. Recognizing the need to change, the government launched in 1987 a program of restructuring and privatization. By 1989, the legal framework for privatization was set up. Law no. 1989-9 redefined public enterprises and streamlined the institutional responsibilities for privatization by creating the Commission for the Restructuring of Public Enterprises (CAREPP) chaired by the Prime Minister. The law provided most elements for the  - 15 - divestiture process, especially granting decision making powers to the Prime Minister based on proposals submitted by CAREPP. 33. As described above (see para. 11), the results of the first privatization program were modest in size and slow in pace. Nevertheless, they created public consensus, as they showed that most privatized enterprises became profitable and the net loss of jobs was negligible. The slow pace was due to the fact that divestitures were undertaken only after extensive consultations among buyers, unions and the Government. This process was long and inefficient, carrying the risk of collusion among prospective buyers. Thus, in 1993 primary responsibility for choosing firms to be privatized and for formulating privatization strategies was transferred to the Ministry of Economic Development.9 Conditions were therefore created to allow the launching of a second more active phase of privatization. By 1994, the Stock Exchange was privatized and its operating and regulatory functions were separated'0. A new regulatory agency was enacted in November 1995, with the purposes of updating the system of prudential regulations and enforcing compliance. 34. Although declining, the weight of the PEs in the economy is still large. It is also difficult to measure, as the definition of PE has changed overtime. PEs, defined in Law 89-9 and Law 94-102 as enterprises where the Government, a local entity or an EPIC (public sector commercial entity) individually or together own more than 50 % (or 34 % in the financial sector), number about 232 of which 98 are public entities with no commercial interest and which can be considered an extension of the public administration. The remaining 124 PEs, which include 15 financial institutions, are considered enterprises producing goods and services. Official statistics indicate that in 1994 these enterprises accounted for 11 % of total wage and for 13.7% of value added." To provide a comprehensive picture of the public sector and reassess the role of the State, the Government has prepared a set of indicators (e.g. total and banking debt, budgetary transfers and profits and losses) to gauge the importance of the PE sector distinguishing between PEs in the competitive sector and those that are considered strategic. 9/ The recommendations of the Ministry, through a newly created Comite Technique de Privatisation, then go to CAREPP which makes the final decisions. IO/ Between 1990 and 1995 capitalization in the stock market increased from 5% to 20% of GDP (reaching 3.5 billion Tunisian dinars in 1995) and new shares issued passed from 8 to 52 operations. However, the banking sector still represents more than 50% of the value of new issues. Foreign participation is small. New regulations passed in July 1995 allow foreigners to buy 10% of companies in the stock exchange and 30% of other companies without Central Bank prior approval. The weight of the public sector in the economy is, of course, much more important. Statistical information on enterprises with a State participation of more than 34 % indicate that in 1992 they represented 23 % of GDP (down from 28% in 1988). In addition, in 1992 the public administration accounted for 12% of GDP and 24% of employment (down from 14% and 25% respectively in 1988). The public enterprise sector in developing economies is estimated at 11% of GDP, while its share of GDP in industrial countries is estimated at around 7% (see World Bank "Bureaucrats in Business: the Economics and Politics of Government Ownership", 1995).  - 16 - 35. The Government is committed to privatizing all enterprises operating in competitive sectors. It has presented to the Bank a list of 63 enterprises, representing about 60% of those producing goods and services and totalling TD 1,413 billion in net asset value, that will be privatized in the next two-three years. The realization of this program would disengage the state completely from the cement sector, and partially from the housing, electrical and construction material sectors. Based on the asset value of these enterprises, expected sales proceeds are approximately five times the revenue achieved in the last ten years of the privatization program. By the end of June 1996, the Government has put up for sale a number of enterprises equivalent to 15% of the net assets of the agreed list of 63 enterprises (totalling TD 1.413 billion as net assets); an additional 35 % will be brought to the point of sale -by July 1997. At that time, the privatization program of the remaining enterprises, corresponding to a value of TD 750 million, will also be presented to the Bank. Moreover, by July 1997, the Govermment will offer for sale a minimum of 10 % in the capital of at least 5 large enterprises (mostly in transport and services) where the State has a majority participation, through public offering at the stock exchange. This follows the sale, in 1995, of 20% of the capital of the airline company, Tunisair. D. REFORMING REGULATIONS IN TRADE RELATED AREAS Shipping and Ports 36. Despite recent improvements, the transit of merchandise through Tunisian ports and to its ultimate destination is slow and costly. In Europe a truckload can be delivered anywhere in the EEC within 24 hours'2 while in the ports of Tunisia merchandise stays on average 3-4 weeks to complete all operations of unloading and custom clearance. Multi-modal transport is unexploited and even lack legal recognition. The additional cost borne by Tunisian exports as a result of inefficiencies in the transport and transit chain 13 has been estimated to be about 1.2 % of the total value of Tunisian external trade, and 17 % of the total transport cost. Because of its importance for competitiveness, the Government intends to intensify efforts to reduce transport costs through deregulation of the maritime transport sector, removal of obstacles to competition, and measures to facilitate trade. The objectives of the program supported by the ECAL are: (a) to increase competition in maritime transport services; (b) to improve the efficiency of ports operations, in particular the handling of goods and the pricing of services; (c) to reinforce the regulatory and supervisory functions of the port authority; (d) to eliminate rigid and lengthy port 12/ See Republic of Tunisia "Private Sector Assessment". Report no. 12945-TUN, November 1994, pages 51-55. 13' See World Bank "Transport and Trade in the Maghreb countries", Report no. 13908-MNA, 1995.  - 17 - procedures and speed up customs clearing systems; and (e) to modify outdated labor regulations 14 suiting them to the needs of modem ports. 37. Deregulation. The adoption by the EU of liberal shipping policies has decreased the importance of the maritime conferences intensifying European competition with Tunisian shipowners. In line with these developments, restrictions on liner shipping have been lifted in Tunisia. Thus, besides the main public enterprise, the Compagnie Tunisienne de Navigation (CTN), comprising a fleet of 10 freighters, eight private shipowners are now operating. However, further deregulation of maritime transport is needed to introduce competition and encourage the development of the private shipping business. To this end, the Government intends to eliminate protective regulations such as those subjecting the right to charter ships to the prior approval of national shipowners (stemming from Articles 6 and 7 of Law 77-13). In addition, the Government intends to introduce full competition in port operations. This means that private companies will be allowed to handle cargos in all ports. Thus, restrictions set forth in Article 10 of Law 95-33, giving the monopoly of these operations in the ports of Tunis, la Goulette and Rades to the Societe d'Acconage et de Manutention (STAM) will be eliminated. And the private sector will be given access to all service operations, such as towage and warehousing, most of which are now under the responsibility of the agency that administers the Tunisian ports, the Office des Ports Nationaux Tunisiens (OPNT). 38. Restructuring of public enterprises. In light of the measures to deregulate maritime transport and increase competition, the Government intends to restructure and eventuaLly privatize the main public enterprises operating in the sector. Two studies are being prepared. Regarding CTN, the study will analyze the need, the timing and sequencing for changes in the organizational and ownership structure. One option would be to unbundle the various activities (transport of passengers, tramping, maritime agency, etc.) of the CTN and then privatize those related to imports and exports of goods. Possibilities for developing joint ventures or partnerships, in particular with foreign investors, and the strategic orientations for each sector of activity will also be explored. Concerning the STAM, the study will redefine its role as one of the main stevedores, in competition with others, and will review its ownership and organizational structure, including options for privatization. The study will also contain a detailed inventory of the company's assets and its personnel needs. 39. Increasing port productivity. To increase the productivity of port operations the Government intends to proceed in several directions. First, port charges (by OPNT) are not based on efficiency criteria and will be revised with the objective of improving port competitiveness. Second, in application of Law 95-73 of July 1995, which grants concessions (applicable to ports, roads and handling operations) for a maximum of 30 years, the Government will publish the implementing regulations, including the pricing of port concessions to the 14i The freight and insurance costs to fob costs over 1988-91 were close to 7% in Tunisia against a world average of 3.2% and an EU average of 1.5% (see World Bank "Maghreb Transport Study, op. cit.).  - 18 - stevedores in each port of the country. Third, the legislation governing dock labor, dating back to 1947, will be revised with the purpose of adapting labor regulations to the needs of modem ports. This is urgent. In fact, there is evidence that the productivity of a Tunisian docker gang is on average half that in Algeria; within Tunisia, the productivity of a gang in Sousse, where there is competition, is more than three times that of a gang in Tunis. Fourth, the statute of the OPNT will be revised. The objective would be to maintain and reinforce the regulatory and supervisory functions of the agency (such as navigational security, control of the environment and research) and incorporate the new regime of maritime domain while completing the withdrawal from service provision and delivery, in particular warehousing and safe keeping. These functions would be handed over to the cargo handlers- so as to complete their role of stevedore-warehouse keepers. 40. Inter-modal transport. A draft law setting the institutional framework for the development of intermodal transport will be submitted to the Chamber of Deputies before June 1997. Trade Facilitation 41. The trade facilitation program supported under the ECAL is a key complement to the trade liberalization reform and the measures of deregulation in maritime transport. Following international experience, and the results of a trade facilitation program initiated in 1993 with World Bank help, the Government has created a "national facilitation committee", composed of all concerned groups and headed by a private sector representative to spear-head the next phase of initiatives. A decree describing the mandate of the Facilitation Committee has been recently published. The work of the committee would be based on continuous consultation with all interested parties and would address, over the next two years, the simplification of documentation and ports procedures and the revision of the Customs Code. Standardized formats for electronic data exchanges pertaining to external trade operations will be adopted. This would decrease the high number and frequency of errors that arise from the use of non standard documents to deliver commodities and would reduce costs. Customs practices will be simplified. The Customs Code will be revised to bring it up to date and in conformity with the EU Code. A commission, headed by the Ministry of Finance but with representatives of various ministries and of the private sector and with the help of international consultants, has already been formed. A revised Customs Code will be submitted to the Council of Ministries before July 1997. Telecommunications 42. Telecommunications. Tunisia's future competitiveness will strongly hinge on the quality, availability and price of telecommunication services, particularly to support communication intensive activities such as tourism, banking and finance. The sector is governed by a 1977 law which provides for the monopoly of the State in all areas of telecommunications,  - 19 - except by specific ministerial authorization. Until recently, telephone services were supplied by a Government department. In April 1995 a new law created a public entity, Tunisie T'lecoms, to assume the operating responsibilities of the Ministry for telecommunications services. In the near future the Government intends to establish Tunisie Tehecoms as a corporate entity with its own accounts and a main carrier license that clearly sets out its rights and obligations as the main operator. It also intends to build on existing initiatives and increase the availability and the quality of services. During 1992-94 network growth has averaged 14% per year, reaching about 475,000 lines by end 1994. The average teledensity today stands at about 5.6 lines per 100 inhabitants, which is below modern standards in comparator countries but above the average in Morocco and Algeria. The private sector has progressively been- allowed to operate certain services using the public telephone network. The most recent example is the operation of private telephone centers, which numbered 1100 at end 1995, totalling 4,600 lines. Measures are also envisaged to review and extend the scope of value added services which can be competitively provided by the private sector. 43. In line with emerging trends in all of Tunisia's major trading partners and competitors, the Government intends to conduct a broad review of its telecommunications policy and to evaluate new options in order to accelerate the growth and provision of telecommunications infrastructure and services. The review will take into account the lessons that can be learned from international experience and practice, and that can be adapted to the Tunisian context. On the basis of this review, a strategy on the development of the telecommunications sector in the medium term will be prepared and presented to the World Bank by July 1997. Improvinz the Legislative Environment 44. The continuous updating of the legal, regulatory and institutional framework is essential to improve competitiveness. Legislation in Tunisia is modem and, by and large, follows European models, with some adaptation to the country's social requirements. Furthermore, recent years have witnessed the enactment of legislation aimed at fostering the development of the private sector, such as that on domestic and international arbitration, rehabilitation of enterprises in economic difficulties, and leasing of real and personal property. 45. Yet, there is still scope for improvement, both on the substantive aspect of the law and on its implementation and enforcement. For example, new Company legislation needs to provide for concepts such as single shareholder companies and holding companies, and for rules governing corporate mergers, amalgamations and take-overs. The Commercial Law is in need of up-dating, especially regarding payment rules, and modern forms of commercial contracts, such as those dealing with factoring and franchising. The subject of conflicts of laws (Private International Law) is now dealt with in numerous unrelated and out-dated statutes and is in need of both consolidation and updating. There is a need to revise the system of law on real and personal property; and to enforce creditor's rights by way of secured interests in respect of such property.  - 20 - 46. In the next two to three years the Govemment intends to (a) accomplish the revision of a substantive body of legislation essential for improving the competitiveness of the economy; and (b) ensure that this process of law reform will be carried out in a transparent way and with the contribution of relevant individuals and groups, including the private sector. 47. As far as the process of law reform is concerned, much of the work which might in other countries be required of an autonomous Law Commission can be assured, in Tunisia, by the Centre d'Etudes Juridiques et Judiciaires (the Centre): this is a semi-autonomous body under the supervision of the Ministry of Justice, devoted--on a permanent basis--to significant, in depth, law reform research and legislative drafting. Most importantly, the Centre can assure that the modernization of laws is not handled exclusively within the Govemment but it is carried out seeking the advice of those individuals who themselves are affected by the legislation. To this aim, a decree providing for appropriate changes to the administrative and financial organization and operations of the Centre with the purpose of ensuring private sector inputs will be signed shortly. The Centre will be required to notify the public by press, radio and television of each of its legislative reform activities and to solicit written comments within a reasonable period from any citizens and residents. Also, the Centre will be empowered to establish working groups to assist it in these reform activities. In addition, a ministerial decision (arrete) of the Minister of Justice will also set out the details of the publicity requirements by press, radio and television. 48. As far as substantive legislative reform matters are concerned, a detailed diagnostic analysis of the existing legislative and regulatory framework is being undertaken by the Centre with the objective of identifying the gaps and problem areas and of setting priorities in terms of relevant new legislation. The analysis will allow the preparation of a "Legal Reform Strategic Action Program". The reform agenda, to be completed before July 1997, includes: submission to the Chamber of Deputies of draft legislation concerning a new Company Code and a Code of Private Intemational Law. The Centre will also collaborate with the relevant Ministries to enable the submission to the Council of Ministries of draft legislation conceming the Customs Code (see para. 41). The Centre is being assisted by an Institutional Development Fund (IDF) to strengthen its institutional capacity to undertake its expanded program. E. INCREASING FLEXIBILITY IN THE LABOR MARKET Labor Regulations 49. Up to now, labor relations have been harmonious and lower income groups have shared in the growth of the economy. Only a few countries have managed to achieve this consistently. Tunisia's success is due not only to the fast growth of tourism and manufactured exports, both of which created many jobs for the unskilled; but also to the govemment's labor and wage policies; and to the structure through which the terms of employment are negotiated by the  - 21 - representatives of the employees, the employers, and the Government"5, and through which disputes are settled. Within this structure the Government has consistently tried to ensure that its macroeconomic objectives regarding inflation and income distribution are respected. However, as trade liberalization creates new pressures on fimns to be more competitive, some of the regulations governing the labor market remain cumbersome and represent an obstacle to the fast restructuring of enterprises and to labor mobility. 50. During the next few years, the Government's objectives are: to improve the flexibility of the labor market, and allow a speedy restructuring of private sector enterprises, as the economy opens up; to protect the workers that are dismissed for economic reasons, while ensuring that the separation packages are not so high to threaten the existence of firms in difficulty and the jobs of the remaining workers; and to carry forward a comprehensive reform of the social security system while containing social security charges and labor costs. 51. The Government intends to modify some of the articles in the Labor Code concerning firing for economic reasons, which result in lengthy and cumbersome procedures to obtain authorizations for retrenchment. Currently firms in need to downsize their labor force have to submit a request to the Inspection du Travail and subsequently to a tripartite body, the Commission du controle des licenciements (CCL) which can sometimes take up to a year to come to a decision. The Government is revising the labor legislation concerning layoffs for economic reasons with the purpose of setting a limit of a maximum 33 days the time allowed to the Inspection du Travail and the CCL to evaluate a retrenchment request"6. Social Protection and Labor Costs 52. Social protection of dismissed workers. Under the existing legislation workers that are dismissed for economic reasons from insolvent or bankrupt enterprises receive no separation packages, as firms are unable to pay. The program supports the creation of a system to guarantee the payment of the severance packages to the workers laid off for economic reasons from firms that are insolvent. This system will be managed by the Social Security Fund for the private sector (CNSS). In all other instances the firms will continue to provide the severance payments to the dismissed workers. On the basis of estimates of expected redundancies and bankruptcies and on the assumption that the packages will be similar to those fixed in the Labor Code or in the Conventions Collectives, this system would cost about 0.4% of the wage bill and All rules governing the functioning of the labor market are negotiated by tripartite committees that include representatives of the government, the employers' association UTICA and the labor union (UGTT). The terms of employment are contained in the Labor Code and in 46 collective agreements, so called "Conventions Colleciives", which are negotiated every three years. The Government has also recently revised the Labor Code to improve the rules governing the settling of disputes. 161 However, some of the proposed revisions to the Labor Code may not increase the flexibility of the labor market.  - 22 - would be financed through a reallocation of existing payroll charges for the non-agricultural private sector. 53. Payroll taxation. The contribution rates to the social security system for the private sector (24.75 % of the wage bill in May 1996, 17.5 % being the employer's share)17 are generally lower than those prevailing in Europe, as well as lower than, or comparable to, those of neighboring competitors. However, the declining population growth rate and the progressive aging of the work force may force the Government to increase payroll taxes in the future to maintain the same benefits. To avoid such an outcome, the Government is undertaking a broad reform program of the social security system, in particular of the pension and the health insurance system. The objectives of this reform are to ensure the long term financial viability of the system while ensuring basic coverage for everybody. And while the contributions and benefits of each component will be reconsidered, the Government intends to keep the social charges at the 1997 level, in order not to increase the cost of labor over the next three years. PART m: PROPOSED LOAN A. LOAN AMOUNT, TRANCHING AND CONDITIONALITY 54. The Loan would take the form of a standard adjustment Loan of two tranches, with second tranche release conditional on meeting the key conditions listed in the Loan Agreement. The Loan would be at fixed rate and single currency for up to 15 years, three years of grace and interest rate for fixed rate single currency loans with an expected disbursement period of two years. The amount would be equal to US$37.5 million and FRF 193.9 million. 55. The following were the key actions for Board presentation: (a) Economic performance: satisfactory macroeconomic and fiscal framework. (b) Trade: (i) submission to the Chamber of Deputies of a draft law ratifying the FTA with the EU; (ii) reduction by 10 percentage points in all tariff surcharges; (iii) agreement on a plan to eliminate the remaining tariff surcharges in 1997 and 1998. (c) Disengagement of the State: (i) bring to the point of sale at least 51 % of the capital of a number of enterprises corresponding to 15 % of an agreed list (totalling TD 1.413 billion as net assets); (ii) prepare a set of indicators on the size and weight of public enterprises. 17' In May 1993, it was decided that the employee's share of the payroll taxes would increase by 0.5 % per year over the period 1994-97. Thus, the payroll tax will reach 25.25% in July 1996 (17.5% being employer's share and 7.75% employee's share) and 25.75% in July 1997 (17.5% being employer's share and 8.25% employee's share).  - 23 - (d) Deregulation and facilitation of exchanges: starting of (i) a study to restructure and evaluate the STAM; (ii) a study to prepare a strategy for restructuring the CTN; (iii) a study to revise port regulations; and (iv) establishment of the commission preparing the revisions of the Customs Code. (e) Telecommunications: presentation of the orientations of the Government for the development of the telecommunications sector in the medium term. (f) Legislative reform: (i) submission for Presidential signature of the decree introducing satisfactory changes to the structure of the "Centre d'Etudes Judiciaires et Juridiques"; (ii) presentation of terms of reference for the consultants to prepare a "Legal Reform Strategic Action Program". (g) Labor: (i) agreement on revisions to the Labor Code's articles concerning the reduction of the time-frame for lay-offs procedures; (ii) presentation of measures to create a limited system to cover the separation packages of workers dismissed from insolvent firms. 56. Conditions for second tranche release are: (a) Economic performance: continued maintenance of a satisfactory macroeconomic and fiscal framework on the basis of agreed macroeconomic indicators. (b) Trade: publication in the official Gazette of the law ratifying the FTA. (c) Fiscal: publication in the official Gazette of the 1997 Finance Law including satisfactory provisions on tariff reductions scheduled up to the second year of application of the FTA and the scheduled reductions in surcharges. (d) Disengagement of the State: bring to the point of sale at least 51 % of the capital of a number of enterprises corresponding to 50 % of the net assets of an agreed list (totalling TD 1.413 billion as net assets). (e) Deregulation of maritime transport and trade facilitation: (i) submission to the Chamber of Deputies of a draft law amending Articles 6 and 7 of Law 1977-13 so as to abrogate existing chartering privileges extended to Tunisian shipowners; (ii) publication in the official Gazette of a decree mandating the use of, and setting forth the standard format for a unified document (the "document unique") for customs declaration on imports and exports. (f) Ports management: (i) submission to the Chamber of Deputies of a draft law introducing new ports regulations and incorporating the redefinition of the functions of the Office des Ports Nationaux Tunisiens and the new regime of maritime domain; (ii) publication in the official Gazette of the law modifying the 1949 decree to adapt the regulations of dock labor to the requirements of modern ports; and (iii) implementation of the plan to restructure the STAM and the CTN.  - 24 - (g) Legislative reform: submission to the Chamber of Deputies of a new Company Code. B. COFINANCING 57. The EU will provide coordinated parallel cofinancing to the ECAL equivalent to US$150 million. C. BENEFITS AND RISKS 58. The next few years will be a period of transition during which macroeconomic balances will have to be strengthened and the competitiveness of the economy increased, without incurring high social costs. The successful implementation of the reform program will: (a) improve the efficiency of resource allocation in the economy and the productivity of the private sector; (b) facilitate the integration of Tunisia with world markets; (c) strengthen Tunisia's balance of payments and consolidate its access to private capital markets. Two main risks are associated with the proposed loan: first, there could be delays in the ratification of the FTA by some European countries which, in turn, could entail a postponement of the trade liberalization program. Although the probability associated with this risk is certainly positive, the Government's earlier implementation of the FTA, starting in January 1996, makes this risk manageable. Moreover, the last ten years show that the Government's commitment to the reforms has remained firm even during prolonged droughts and political crisis in the region. The second risk relates to the transitional social costs (labor dismissals) caused by the necessary restructuring of enterprises. Increased output growth and labor market flexibility should ensure that in the long run the overall effort of trade integration is positive, and these costs are minimum. In the short term, this risk is also limited because of (i) the Government's ability to build consensus among the parties interested in the reforms, and (ii) the existing social safety net and the additional measures that will be put in place to protect the welfare of dismissed workers. D. COLLABORATION WITH THE IMF 59. After successfully completing a Stand-by Arrangement with the IMF that ended in May 1988, Tunisia entered into an Extended Arrangement on July 1988. In July 1991, the EFF was extended to a fourth year to support the program prepared by the Government in response to effects on the economy of the Gulf crisis. 60. Coordination between the Bank and the IMF has been excellent. The macroeconomic and fiscal framework of the ECAL has been prepared jointly with the IMF and the EU. During the preparation of the loan regular exchanges of views with IMF staff took place and the various components of the proposed loan have been discussed at different stages.  - 25 - E. DISBURSEMENT, FINANCIAL MANAGEMENT AND AUDITING 61. The Borrower will be the Republic of Tunisia. The borrower will be required to open and maintain five Deposit Accounts in US dollars, Deutsche Marks, French francs, Pound Sterlings, and Yen each in its Central Bank. As each tranche is released, the Borrower will submit a withdrawal application under the Bank's recently introduced simplified disbursements procedures against which the Bank will disburse the loan proceeds for the borrower's use into the Deposit Accounts. If, after deposit into the Deposit Accounts the proceeds of the loan or any part thereto is used for ineligible expenditures, as defined in the loan agreement, the Bank requires the borrower to either (a) return that amount to the Deposit Accounts for use for eligible purposes, or (b) refund the amount directly to the Bank, in which case the Bank will cancel an equivalent undisbursed amount of the loan. Although the Bank will not routinely require an audit of the Deposit Accounts, it will reserve the right to do so. The loan will be made on a two tranche basis. The first tranche of US$37.5 million will be eligible for disbursement upon effectiveness. The French Franc second tranche equal to FRF 193.9 million will be conditional upon satisfactory macroeconomic performance and a limited number of specific measures, noted above. The projected date for second tranche release would be 12 months after loan effectiveness. F. BANK ASSISTANCE 62. As detailed in the CAS, the Bank is responding to the challenges of trade liberalization with the following instruments. First, the recent preparation, in collaboration with the EU, of a medium term competitiveness strategy. The measures of this strategy have been identified in the Private Sector Assessment, in the most recent Country Economic Memorandum and in a strategy note recently discussed with the government. Second, it would provide financial assistance in two stages: the first, covering the next two-three years would address the broad issue of competitiveness through three operations: a policy based loan, the ECAL, which will be supported by a parallel grant from the EU; a project to cofinance the "mise a niveau" program to restructure private sector enterprises, led by the EU (the "Industry Support Institutions Upgrading Project"); and a vocational training loan, to deal with some of the related social issues, such as retraining of the labor force (the Second Training and Employment Project). The second stage, covering the following two-three years, would address specific aspects to reinforce competitiveness. A deeper privatization program, the reform of the financial sector and of the insurance system to promote long term savings and the development of capital markets, the restructuring of the transport and the agricultural sectors, and the modernization and liberalization of the telecom sector are the elements presently identified. 63. Bank exposure. After achieving major progress during the past years, overall debt indicators are expected to improve further in the future. The ratios between total DOD and GDP and between the debt service and exports of goods and services have decreased from 69 % and 22% respectively in 1989 to 54.7% and 18.2% in 1995; they are expected to reach 47.5% and 17.2 % in the year 2000. Efforts to obtain support from financial markets have been extremely successful; because of the country's good credit rating and good payment records, no  - 26 - debt rescheduling has ever been needed. As a result of the reduction in the size of total debt, the Bank's relative exposure has remained high. At the end of 1995 the percentage of Bank debt service over exports was 3.7%, and the share of the Bank in the public debt service was 21.7%. At the same time the Bank held about 19.7% of Tunisia public and publicly-guaranteed medium- and long-term external debt. The share of preferred creditor debt service was around 40%. However all these indicators are projected to decrease during the second half of the 1990s with the exception of the preferred creditor debt service that will increase slightly before decreasing after 1998. 64. Poverty impact. The overall impact on poverty of the reform program supported by the ECAL is expected to be positive as improvements in macroeconomic balances and in the performance of the private sector would create new jobs and expand employment. Losses of jobs may however occur in the short term. The recently approved Second Training and Employment Project would facilitate the placement of unemployed people and increase the productivity of existing workers. The ECAL would also support the creation of a guarantee system providing severance packages to the workers of insolvent firms. The fiscal adjustments that will occur under the loan will not affect social expenditure. The European Union is also helping the authorities to improve the design and management of the existing social safety net. Some of the financial aid that the EU will provide in parallel to the ECAL will be targeted to programs aimed at assisting the poorest groups. G. ENVIRONMENTAL ASSESSMENT 65. The Loan is consistent with the Bank's environmental policies and will follow accepted Bank procedures concerning the environment. The Loan has been given a C rating. PART IV: RECOMMENDATION 66. I am satisfied that the proposed Loan would comply with the Articles of Agreement of the Bank, and I recommend that the Executive Directors approve it. James D. Wolfensohn President by Caio Koch-Weser Attachments Washington, D.C. July 2, 1996  ANNEX I Tunisia Page 1 of 2 Most Same regownfncone group Net Latest single year recent Mid-East Lower- h41ur Unit of estimate & North middk- income Indicator measure 1970-75 1980C85 1988-93 Africa income group Priority Poverty Indicators POVERTY Upper poverty line local curr. .. 182 252 Headcount index % of pop. .. 20 14 Lower poverty line local curr. 142 196 Headcount index % of pop. .. I1 7 GNPpercapita USS 770 1,140 1,720 1,980 1.590 4,350 SHORT TERM INCOME INDICATORS Unskilled urban wages locai curr.. .. Unskilled niral wages Rural terms of trade .. Consumer price index 1987=100 87 146 Lower income Food' 89 145 Urban Rural SOCIAL INDICATORS Public expenditure on basic social services % of GDP .. .. 4.5 Gross enrollment ratios Primary % school age pop. 97 116 120 97 104 105 Male 116 126 125 103 Female 78 106 115 90 Mortality Infant mortality per thou. live births 120.0 71.0 41.8 52.3 39.0 35.8 Under 5 mortality .. .. 52.0 69.9 61.5 42.6 Immunuization Measles % age group .. 65.0 80.0 81.3 77.6 82.0 DPT " .. 70.0 90.0 84.0 82.2 74.2 Child malnutrition (under-5) 20.2 7.8 Life expectaney Total years 56 63 68 66 67 69 Female advantage 1.0 1.0 1.9 2.3 5.9 5.9 Total fertility rate births per woman 6.2 4.9 3.1 4.7 2.9 2.9 Materna mortality rate per 1 00,000 live births low00 127 Supplementary Poverty Indicators Expenditures on social security % of total gov't exp. .. .. .. Social security coverage % econ. active pop. .. .. 64.0 Access to safe water total % of pop. 49.0 66.4 67.4 83.5 .. 86.7 Urban 92.0 96.0 94.7 98.7 .. 93.9 Rural 17.0 31.0 62.0 69.0 .. 66.7 Access to health care .. 95.0 90.0 87.4 Population growth rate GNP per capita growth rate Development diamondb 6+- (auaegprn (annual average, percent) Life expectany GNP Gros 2- 099 I ( +