Tunisia - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 15799-TUN MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF TEE WdORLD BANK GROUP FOR THE REPUBLIC OF TUNISIA JUNE 25, 1996 Country Operations I Maghreb and Iran Department Middle East and North Africa Region This document has a restricted distribution and may be used by recipients only in the performance of their officisl 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 1.034 TD 1.00 = US$0.967 FISCAL YEAR January 1 - December 31 GLOSSARY OF ABBREVIATIONS ADB/BAD African Development Bank (Banque Africaine de DNveloppement) CBT/BCT Central Bank of Tunisia (Banque Centrale de Tunisie) CAS Country Assistance Strategy (Strategie d'Assistance au Pays) DPT Diphteria. Pertussis, Tetanus (Diphterie, Tetanos, Coqueluche) ECAL Economic Competitiveness Adjustment Loan (Pret d'Ajustement pour la Competitivite Economique) EIB/BEI European Investment Bank (Banque Europeenne d'Investissement) EU European Union (Union Europeenne) FDI Foreign Direct Investment (Investissement Etranger Direct) FIAS Foreign Investment Advisory Service (Service-Conseil pour l'Investissement Etranger) FTA Free Trade Agreement (Accord de Libre-Echange) GATT General Agreement on Tariffs and Trade (Accord General sur les Tarifs Douaniers et le Commerce) GNFS Goods and Non-Factor Services (Biens et Services Non-Facteurs) GOT Government of Tunisia (Gouvernement Tunisien) GTZ Gesellschaft fur Technische Zusammenarbeit (German Bureau for Technical Cooperation) ICOR Incremental Capital Output Ratio (Coefficient Marginal de Capital) INS Institut National de la Statistique (National Institute of Statistics) LIBOR London Interbank Offered Rate (Taux Interbancaire Moyen des Eurodollars A Londres) LSMS Living Standards Measurement Survey (Enqtute sur le Niveau de Vie) METAP Mediterranean Environmental Technical Assistance Program (Programme d'Assistance Technique Environnemental pour la Mediterranee) MFA Multi-Fiber Agreement (Accord Multi-Fibres) ONAS Office National d'Assainissement (National Sewerage Company) PE Public Enterprise (Entreprise Publique) RCD Rassemblement Constitutionnel Democratique (Democratic Constitutional Party) REER Real Effective Exchange Rate (Taux de Change Effectif Reel) STAM Societe Tunisienne d'Acconage et de Manutention (National Stevedoring and Handling Company) MMR/TMM Money Market Rate (Taux Monetaire du Marche) UGTT Union Generale des Travailleurs Tunisiens (National Union of Tunisian Workers) UTICA Union Tunisienne de l'Industrie, du Commerce et de l'Artisanat (National Union of Industry, Commerce and Craftmanship)  FOR OFFICIAL USE ONLY REPUBLIC OF TUNISIA COUNTRY ASSISTANCE STRATEGY Table of Contents Page No. O verview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i The Challenge: Stability and Higher Growth through Trade Integration . The Response: Deepening Structural Reforms and Increased Financial Support . . World Bank's Assistance Strategy . Emphasis on Non-Lending Services .ii Shift in Lending Instruments .i Conclusions .ii PART I - COUNTRY CONTEXT. 1 ECONOMIC, POLITICAL AND SOCIAL DEVELOPMENTS .1 A. Economic Performance. I Higher Growth, Improved Social Indicators, and Environmental Management 1 Strong Fiscal Performance. 2 Improving the Efficiency of Investment. 2 B. The Politics of Reformn: Maintaining Stability while Adapting to Change .... 3 C. Social Developments: Strengthening the Gains. 4 Unemployment. 4 Drop-Outs and the Poverty of Opportunity. 4 Health Care Access and Affordability - Social Security Benefits and Contributions .5 D. The External Environment 6 The EU FTA and Foreign Savings Inflows. 6 Increased Competition and Greater Diversity. 6 External Indicators: Manageable Debt, Increased Access to Private Capital Markets 7 II. GOVERNMENT DEVELOPMENT OBJECTIVES: MODERNIZATION AND STABILITY. 7 A. Modernization and Global Integration. 7 Increasing Competition through Trade Integration. 7 Promoting Private Investment and Preparing Enterprises for Competition . 7 Modernizing Telecommunications, Trade, Financial and Transport Services 8 B. Macroeconomic Stability and a Declining B3udget Deficit. 8 Policies to Reduce the Fiscal Deficit. 8 mn:ii aXcwtc Monetary Policies to Achieve Price Stability and Strengthen External Trade Relations. 8 This doc-.xrnt has a restricted distribution and may be uscd by recipicnts only in the perfoniance of their oficial duties. Its contents may not otherwise be disclosed wiLhout World Bank authorization.  Table of Contents (Cont'd) Tunisia - Country Assistance Strategy C. Reinforcing Social Programs, Human Capital Development, and the Environment ................................. 9 Labor Policies and Human Resource Development ............... 9 Health Care and Social Security ........................... 9 The Environment .................................... 9 D. Comparisons with Other Countries ............................ 9 E. Remaining Agenda ..................................... 10 III. MACROECONOMIC PROJECTIONS: GROWTH AND THE PACE OF REFORM 11 A. Moderate and High Growth Scenarios .......................... 11 B. Expected Financing Requirements and Macroeconomic Indicators .... ..... 12 Macroeconomic Indicators ............................... 12 PART II - BANK GROUP ASSISTANCE STRATEGY ....... .. ......... 14 IV. COUNTRY ASSISTANCE PROGRAM .14 A. Overview of Past Performance .............................. 14 Lessons and Experience from the Last Country Assistance Strategy 14 Traditional Projects .14 Policy-Based Lending .................................. 15 B. Country Assistance Objectives ............................... 15 Deepening Structural Reforms .16 Human Resource Development .17 Modernization of Services .17 Managing Scarce Natural Resources .18 C. Instruments of Assistance .18 Emphasis on Non-Lending Services .18 Shift in Lending Instruments .18 D. Resources .19 E. Coordination with Other Donors .19 The European Union .19 Other Donors .20 V. COUNTRY RISK MANAGEMENT .20 A. Risk Management and Creditworthiness .20 Lending Flows and Exposure Levels .20 Risks and Uncertainties .21 B. Lending Scenarios .21 Triggers for Higher Lending .21 m:Ainda\cas\Loc  Table of Contents (Cont'd) Tunisia - Country Assistance Strategy C. Performance Indicators ................................. 22 D. Conclusions .22 E. Agenda for Board Discussions .23 ANNEXES Annex Al: Selected Indicators of Bank Portfolio Performance and Management Annex A2: IBRD/IDA, IFC, and MIGA Lending Programs, FY93-99 Annex A3: Summary of Economic and Sector Work Annex A4: Social Indicators, and Resources and Expenditures Annex A5: Key Economic Indicators Annex A6: Key Exposure Indicators Annex A7: Status of Bank Group Operations in Tunisia Annex A8: Tunisia at a Glance Annex A9: Performance Indicators Map IBRD 24726R List of Tables Table 1.1: Main Economic Indicators ............................. I Table 1.2: Sources of Foreign Exchange ........................... 6 Table 1.3: External Debt Indicators ............................... 7 Table 2.1: Comparison of Selected Performance Indicators ................ 10 Table 3.1: Financing Plan ..................................... 12 Table 3.2: Selected Macroeconomic Indicators ........................ 13 Table 4.1: Portfolio Performance ................................ 14 Table 4.2: Historical and Projected Resources ........................ 19 Table 4.3: Commitments ..................................... 20 Table 5.1: Net Lending by the World Bank .......................... 20 Table 5.2: World Bank Exposure ................................ 20 Table 5.3: FY97-99 Country Program: Resources Allocation .... .......... 24 List of Figures Figure 1.1: Central Government - Selected Expenditures as % of GDP ... ...... 2 Figure 1.2: Fixed Investments (Public & Private % of GDP) ............... 2 List of Boxes Box 1.1: The State, Privatization, and Expansion of the Private Sector ... ..... 3 Box 1.2: Elimninating the Gender Gap ............................ 5 Box 4.1: Bank-IFC Strategy to Promote Private Sector Development ... ...... 16 mAiinda\cas\toc   MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK FOR REPUBLIC OF TUNISIA Overview The Challenge: Stability and Higher Growth through Trade Integration I . Tunisia's highly commendable socialprogress and solid macroeconomic performance place it well ahead of many other countries in the region, and now, after nearly a decade of reform, Tunisia is embarking on a closer commercial relationship with Europe. As the first country in the region to sign a free trade agreement with the European Union (EU FTA), the Government of Tunisia (GOT) has committed itself to undertake deeper trade reforms than in any other prior agreement. The EU FTA is critical to Tunisia's strategy to modernize its economy, achieve higher growth rates and improve the country's living standards while maintaining stability. The agreement poses challenges for Tunisia which go well beyond trade measures. Heightened international competition will require Tunisia to strengthen its human capital base, increase labor flexibility and develop a stronger, more dynamic private sector. The Response: Deepening Structural Reforms and Increased Financial Support 2. Officialfinancialflows from the EUIEIB to Tunisia are expected to more than double in 1996/9i7 compared to pre-1996 levels (from US$150 to US$300 million annually, half as grants) and should enable the country to ease what might otherwise be a difficult transformation. Conversely, the sharp increase in assistance could postpone the timely introduction of structural changes, depending on the policies pursued by the GOT. The next two-three years may well provide a unique opportunity for Tunisia to use the momentum (and financial assistance) from the FTA to absorb the transition costs and promote a real international integration of the Tunisian economy by putting in place measures that reinforce trade reform and provide clear signals to the business community that the "rules of the game" have changed. Three key messages emerged from the analysis presented in the Country Economic Memorandum (1995) which present strategic choices for Tunisian authorities. * The pace of structural reform needs to move forward decisively, particularly in the areas of trade facilitation/liberalization and opening more investment activities to the private sector. * The State needs to redefine further its role in the economy, strengthen its actions in the provision of public goods and the management of scarce resources, while encouraging a higher level of private investment--domestic and foreign. * Tunisia will need to upgrade further its human resource base and environmental management. Despite good progress in both of these areas, heightened international competition and the fragilities of Tunisia's ecosystem merit the GOT's and the Bank's strong efforts. World Bank's Assistance Strategy 3. The timely implementation of policies to promote economic integration while maintaining social stability and sustainable environmental management will guide the strategies of the GOT, the EU, and the World Bank Group (IBRD, IFC, MIGA) and the IMF. Continued and close partnership between the Bank, the GOT, and the EU is critical. In the past, Bank activities have contributed to building a consensus among the authorities and different groups in Tunisia which helped to keep the reform process moving forward. Now, the Bank and the GOT have a strong partner in the EU, which should enhance the national debate on policy issues and provide a joint framework for all future operations.  - ii - 4. The Bank and the GOT have consistently agreed on the direction of policy reforms. The issues have been more on the speed of implementation and the costs the authorities are prepared to incur to compensate vulnerable groups that would suffer short-term costs from reforms. The Bank's strategy has had to adapt to the GOT's strong emphasis on gradualism, and in view of Tunisia's good record at avoiding crisis management situations, the approach has been reasonable. The main issue for the near future is whether this approach can be sustained in the face of a fast changing world environment. Significant structural adjustments are needed to complement the tariff measures included in the EU FTA, and their implementation should proceed in a timely manner. The Bank will work with the GOT and the EU by providing objective advice and financial support to promote an acceleration of the reform effort consistent with both social stability objectives and faster integration in world markets. This, however, will be a difficult balancing act for the authorities and is likely to result in varying speeds of reform in different sectors. Emphasis on Non-Lending Services 5. At this stage of Tunisia's development, non-lending services will play a particularly important role and dissemination efforts will increasingly become the instruments of choice to support the implementation of structural reforms and illustrate options. Non-lending services will emphasize: (i) dissemination of information through the Bank's information center (to be established in Tunis, June 1996), open seminars, and round-table workshops that present to the Tunisians the different ways other countries have dealt with similar problems; (ii) expanded co-operation with Tunisian experts, whereby suitable local Tunisian consultants work with Bank teams to prepare sector analysis and recommendations; and (iii) continued preparation of sector work that identifies the cross-sectoral implications of different policy measures. Sector analysis plays an important role in helping Tunisian policy-makers to weigh the options and develop a strong sense of ownership which has contributed significantly to the success of Bank operations in Tunisia. The lending program is the most visible measure of the Bank's commitment to help Tunisia achieve its growth and development objectives. Lending services reinforce "know-how transfer" and dissemination efforts and promote the implementation of policies which have already been developed and agreed upon with the GOT. Shift in Lending Instruments 6. To support this strategy, we are proposing a significant change in the mix of instruments, with fewer traditional projects and more sector investment loans, while maintaining the same level offinancial assistance as in the past (averaging US$240 million per year). Between FY90 to FY95, 54% of Bank lending was for traditional projects, 33% for policy based loans, and only 13% for sector investment loans. The FY96-99 program calls for nearly half the portfolio to be for sector investment loans with the other half divided between policy-based loans and traditional projects. The reason for the increased emphasis on sector investment loans is two-fold: (i) to incorporate limited, well-focused, sectoral policy objectives with modemization investments in key sectors (transportation; education; water; and telecommunications); and (ii) to expand the use of private concessions in selected areas. Conclusions 7. Tunisia easily ranks among the Bank's best borrowers, and despite the Bank's relatively high exposure (as measured by IBRD debt to Tunisia's total debt), the risks to the World Bank of lending to Tunisia are relativelysmall. The Government has managed economic and regional political uncertainties quite well (the Gulf War, droughts), by gradually diversifying its export base, forging closer relations with the EU, and maintaining social and macroeconomic stability. The sharpened interest and support of the EU in the region provides an opportunity and a challenge for Tunisia and for the World Bank. The  - iii - proposed assistance program responds to this challenge and maximizes the opportunities for co-operation. The key objectives of Bank services will be to provide a catalytic role that complements EU grant financing and helps to keep the reform agenda moving forward. The Bank Group has much to offer and to learn from continuing its policy-dominated assistance strategy with the GOT. * The Bank has the opportunity to work closely with the EU, which should strengthen the policy dialogue and all operations that are prepared and appraised with the EU. * Flexibility in lending instruments, an increased emphasis on non-lending services, and an agreed list of performance indicators are an important complement to the EU's assistance program and the GOT's development objectives. * Successful implementation of reforms in Tunisia could have important repercussions in the region in particular and throughout the Arab world and Africa in general.  I  PART I - COUNTRY CONTEXT I. ECONOMIC, POLITICAL AND SOCIAL DEVELOPMENTS A. Economic Performance Higher Growth, Improved Social Indicators, and Environmental Management 1.01 Tunisia 's macroeconomic performance, social achievements, and attention to environmental issues distinguish it from many other countries in the region and provide Tunisia with a solid basefor pursuing a closer integration of its economy with global markets. The stabilization and adjustment measures introduced after 1986 brought a significant degree of macroeconomic stability and an improved level of efficiency in the use of resources. Mostly as a result of these reforms, the per capita GDP growth rate increased from an average of 1.2% for the period 1981-86 to 2.4% for 1987-1994 (Table 1.1)--resulting in the highest level of sustained per capita growth in the North Africa region. Table 1.1: Main Economic Indicators 1990-95 av. % Share GDP 1981-86 1987-1994 1994 1995 1996 (poL) GDP Growth Rates 3.8 4.5 3.3 2.6 7.1 Agriculture 16.8 1.4 0.1 -9.9 -9.0 16.1 Non-manufacturing 13.0 -0.5 1.5 1.7 3.4 8.3 Manufacturing 19.6 5.4 5.8 7.5 4.5 5.9 Services 50.6 3.6 5.2 5.8 5.2 5.2 Per Capita GDP Growth 1.2 2.4 1.4 0.7 5.1 Inflation (CPI) 9.5 6.2 4.5 6.3 5.0 Money Market Rate* 10.2 8.8 8.8 8.8 Fiscal Balance/GDP -5.9 -3.9 -2.7 4.2 -3.8 National Savings/GDP 23.5 22.5 21.6 20.4 21.5 Gross Investment/GDP** 31.7 25.4 22.1 24.4 25.3 Current Acct Balance/Gi)P** -8.3 -3.3 -2.0 4.0 -3.8 ' Year-end money market rates. Excluding 2 large gas and oil investments (Gazoduc and Miskar) which are self-financing. Source: Ministry of Economic Development, INS. 1.02 The Poverty Assessment (1995), showed a good example of successful adjustment with a favorable impact on the incidence of poverty: the number of poor was reducedfrom 11% of the population in 1985 to 7% in 1990; mean incomes increased; and income inequality was reduced The GOT's long-standing commitment to social development, the expansion of labor-intensive export activities (textiles/tourism), higher growth, and relatively low inflation all contributed to these commendable results. Expenditure levels on health and education were maintained, even during the strongest period of stabilization-induced expenditure cuts. For the future, global integration will pose new challenges for Tunisian authorities who will need to maintain past achievements and increase efforts to improve the living standards of the society overall and the human capital base of the labor force in particular. 1.03 The GOT has become increasingly aware that growth objectives in agriculture, industry, and tourism must take into account natural resource constraints and climatic vulnerabilities and as a result, they have created one of the strongest environmentalframeworks in the region. About one third of the labor force is still employed in agriculture, where production is highly variable. The past ten years have brought some of the sharpest swings in rainfall and production the country has ever experienced. Nearly 80% of Tunisia's available water resources are reserved for irrigation, and by the year 2000, all sources will be fully developed, causing competing demands for scarce water supply and imposing constraints to long-term growth. By 2010, Tunisia's population is estimated to grow by another 3-4 million (from its present 8.8 million), with more than 75% living along or near the coast.  -2 - Strong Fiscal Performance 1.04 Tunisia has made signif cant progress in reducing the fiscal deficit through successful tax reforms andfiscal expenditure reduction policies. From 1989 to 1994, total fiscal expenditures fell from 37% of GDP to 30%, with most of the decline due to a reduction in transfers and subsidies and a slight reduction in fixed capital expenditures (Figure 1.1). After maintaining a budget deficit below 3% of GDP from 1992 to 1994, the deficit increased to 4.2% in 1995 due to lower t add. _ " G growth brought on by the drought, a shortfall in revenues, and exceptionally large imports of cereals at higher *ot _ - - international prices than in previous years. The draft .o o budget for 1996 and 1997 calls for lowering the deficit to eo 3.8% and 3% of GDP through further reductions in food ,. subsidies and transfers, wage restraint, and revenue 70 Trtnett;_ increases. Additional tax revenues are expected through go VAT rate consolidation and its wider application and s - k= through a broadening of the income tax base and collection _ ____,_,__ enforcement, which should compensate for a decline in lul X 0 OWl OWl trade-related taxes and lower non-tax revenues. 1.05 The GOT has also improved the transparency of,fiscal accounts by assuming the accumulated debts (TD 700 million) of two large public enterprises (PEs)--which are actually agencies of the GOT carrying out price support and subsidy policies (les Offices de Cereales et de I 'Huile). These debts placed a burden on the banking system that reduced available funds for potentially profitable private investments and slowed down the application of policies that would promote bank competition. The GOT has undertaken to pay off its obligations through the PEs to the public banks, and it has put in place mechanisms in the budget that ensure these past practices are not repeated. Improving the Efficiency of Investment Fh n t 2: Fad iwvshm 8 t .cjd1ngGa zoic and0Atsnrca Cof MOP) 1.06 National savings and gross investment 2ti0 rates have been stable and reasonably high (on 24 0 average about 21% and 24% of GDP respectively), 200 but below the rates observed in high growth 18o countries. In Tunisia, the public sector still , PubtcSoeor accounts for more than half of total investment '40 (P.Eand A*mWlibon) (54%), and private investment/GDP has declineddli 0 since 1992 (Figure 1.2), even though real interest 0 rates remained the same and/or fell. P*vime Enteaquses Manufacturing investment, which should enable 4loss i u ,gqo 7X0 t842 1X05 Tunisia to modernize, has seen its share in total S- d.rl INS, 1995 ,,n,.N. ..i..........8 ,,n.tttU,Wt,n investment fall from 17% in 1991 to 13% in 1995. 1.07 There are several reasons for declining private investment: the changes in incentives introduced with the 1994 Investment Code; the anticipation of additional benefits from the mise CJ niveau (competitiveness upgrading) program (1995/96); uncertainties surrounding the tariff removal schedules agreed with the EU; concerns about the strong competition from lower cost producers in international markets; the slow pace of privatization; and continued restrictions on investments in many activities, particularly in services (Box 1.1). A significant increase in private investment is feasible, provided public savings increase (deficit reduction) and provided the private sector takes on the leading role that the authorities intended for it since the mid-1980s.  -3- Box 1.1: The State, Privatization, and Expansion of the Private Sector The slow expansion of the private sector is partly explained by the government's policy to maintain a role for state enterprises in many sectors. The INS estimate of the PEs' share in total value added in 1994 is 23%*, while the PEs' share of value added for developing countries as a whole was around 11% in 1990.* l Tunisia's divestiture program has been modest, in part because of the limited size of the domestic financial market and the concern that privatization may reinforce the concentration of ownership that already exists among a limited number of private groups. So far, about 50 companies have been sold over the past ten years (mostly in tourism), with accumulated proceeds of about TD 200 million in 1995 (1.5% of GDP). The State dominates several sectors: transportation; banking; the import of certain agricultural products; telecommunications; construction materials; chemicals and fertilizers; and energy. The past experiencewith privatization has been favorable: job loss was minimal and enterprise profitability improved. Several developments in 1995 should enable a more rapid acceleration of state divestiture and deregulation in 1996: the stock market has become reactivatedand several marketable instruments have been introduced; foreign investors are now permitted to purchase up to 30% of a company's shares; numerous divestiture plans have been completed; and increased deregulation of state monopolies is more feasible now, as trade liberalization reduces concems about replacing public with private monopolies. ' The Institut National de la Starusrique includes as PEs those enterprises where the State holds directly more than 34% of the share capital. The GOT, according to Law ND 89-9, has narrowed the definition of a PE to enterprises whose capital is owned by more than 50% individually or jointly by the State. local government, public entities, and enterprises whose capital is entirely owned by the State. Enterprises owned by public banks would not be considered PEs under this definition. ' Bureaucrats in Business: the Economics and Politics of Government Ownership, World Bank 1995. The intemational definition is broader than the one used in Tunisia and includes all enterprises where the State (or state-owned enterpfises and/or banks) name the board members and top management of an enterprise (even with less than 50% of the share capital) B. The Politics of Reform: Maintaining Stability while Adapting to Change 1.08 Social and macroeconomic stability are inextricably linked in Tunisia and are of paramount importance to the authorities. The unstable situation in neighboring countries and recent political developments in the region have brought the potential risks of instability close to home and convinced Tunisian authorities they can not afford to make mistakes. The State's promotion of a strong social agenda and stable macroeconomic policies have had the intended effect of promoting internal stability. 1.09 Tunisia is a republic, based on the 1959 constitution, with a National Assembly made up of 163 members, with all but 19 members belonging to the same party, the Rassemblement Constitutionnel Democratique (RCD). Since coming to power in 1987, President Ben Ali has assured his firm position as the head of State and leader of the RCD. The leaders of both the l 'Union Generale des Travailleurs Tunisiens (UGTT) and l'Union Tunisienne de lI'ndustrie, du Commerce et de l'Artisanat (UTICA) are prominent RCD party members. As a tripartite group, they work together through the collective bargaining system to agree every three years on the convention collective. 1.10 The President worked toward building a consensus among these groups behind the 1986/87 adjustment program by introducing reforms slowly and by maintaining a strong role for the State, particularly in strategic sectors. The political establishment, labor, and significant parts of the public administration view the State's role as providing an important counterweight to the potentially inequitable  -4 - dominance of a limited number of large private groups of entrepreneurs. This balance has enabled the country to enjoy good labor relations, wage and employment stability, lower inflation and steady progress in the implementation of economic reforms. 1.11 The rapid pace of economic liberalization and political opening in many parts of the world--Latin America, Eastern Europe and Asia--since President Ben Ali came to power have changed the rules for countries like Tunisia Its approach to development, largely based on state control, a highly centralized and professional bureaucracy, and the predominance of state ownership and state-provided services is increasingly coming under financial and managerial strains. Increased economic opening combined with limited state resources are putting pressure on the State to transform its control-oriented civil service into one that establishes a clear regulatory environment that it manages indirectly. Tunisian authorities are uncertain they will be able to enforce effective regulations, promote the decentralization of decision- making, and a more rapid implementation of reforrns with minimal social disruptions. An improved political situation in the region combined with the extensive contacts envisaged with the EU should reinforce decentralization tendencies and open up Tunisia on the economic, political and social fronts. C. Social Developments: Strengthening the Gains 1.12 Social achievements are among Tunisia's greatest assets and set it well apartfrom other countries in the region: universal access to health care; low and declining poverty (about 7% of the population); reasonably equitable income distribution; declining population growth rates; increasing primary school enrollment rates; and higher life expectancy. Yet despite such admirable progress in reducing poverty and improving Tunisian living standards, increased international competition and closer integration with Europe pose new and particularly demanding challenges for human resource development and labor force flexibility. In both of these areas. Tunisia is starting from levels which are below those attained by many of its competitors (Chapter 2, Table 2.1). Unemployment 1.13 An important concern in thefuture will be to maintain growth rates at a sufficiently high level to absorb new entrants into the labor force. So far, GOT policies in this regard have been relatively successful, through the promotion of offshore activities and tourism. IBRD estimates (using Tunisian INS data) indicate that unemployment remained almost unchanged at around 11% in 1989 compared to 12% in 1980, but the results of the 1994 census will give a clearer assessment of the employment situation. The bulk of the unernplo-yed are young, urban, first-time job seekers (9-10%), while primary bread- winners are estimated to represent only about 1-2%. The labor law remains rigid, limiting flexibility in the labor market, particularly for the onshore enterprises. Drop-Outs and the Poverty of Opportunity 1.14 Education completion rates are more revealing of human resource development than enrollment rates, and in Tunisia, nearly half of all children who begin school, drop out before completing 7 years of basic education. The State's vocational education system tries to provide training for these drop-outs, but without the basic cognitive, language and analytical skills obtained in school, young people have very limited employment opportunities and additional training has a modest impact. The Tunisian labor force has lower levels of completed years of schooling than many of its competitors. Low literacy rates and comparatively low education completion rates are the main reasons why the UNDP ranks Tunisia significantly lower in human development terms than would be expected from its per capita income ranking (see Table 2.1). An important recommendation of the Poverty Assessment was that Tunisian authorities need to make a concerted effort to reduce high drop-out rates from basic education, which disproportionately affect students from poorer farnilies and girls in rural areas (Box 1.2).  -5- Box 1.2: Eliminating the Gender Gap Les Acquis - Strengthening the Gains ... Thanks to the foresight of former President Bourguiba and the continued commitment of President Ben Ali, Tunisian women have exemplary legal rights and privileges, enjoying equal rights in virtually every respect under the law except inheritance. The legal advances in 1992 further help to strengthen the socio-economic position of women in Tunisia and promote the country's economic integration with Europe. Several institutions have been established over the years to enhance opportunities for females: * I 'Union Nationale de la Femme Tunisienne was established in the 1950s and promotes rural education, health care and microenterprise development for women and young girls. * La Chambre Nationale des Femmes Chefs d'Entreprises was established in 1990 and has gone from 800 to 1500 members. It provides management training and helps women prepare investment proposals. * In 1992, Tunisia became the first and only country in the region to have a separate unit attached to the Prime Ministry devoted to women's issues, le Ministere Charge des Affaires de la Femme et la Famille. Increasing the Opportunities ... Tunisia has rates of female labor force participation that are higher than for other countries in the region, but at 25%, the rate is low compared to 30-36% for other low-middle income countries. Women account for 28% of civil servants (fonctionnaires publics), but have a modest representation in the cadres of public administration (10%). Some of the laws passed in 1992 still need to be promulgated and information campaigns need to be expanded to inform women of their rights. Access to credit is poor, due in part to collateral requirements which are difficult for women to fulfill under inheritance laws and due to bank lending practices which tend to favor men. Primary school enrollment rates for females have increased to 82% in 1993 compared to 51% in 1974/75, but the gender gap in education is still significant, especially in rural areas. In 199?., nation-wide literacy rates for females, age 20-29, were 66% compared to 90% for males. In rural areas, female literacy rates for this age group drop to 36% compared to 80% for males. In spite of its impressive progress and comparatively favorable performance in the North Africa region, the GOT recognizes that continued strong efforts are needed to eliminate the gender gap and bring Tunisian education achievement rates to the level of other middle income countries. Years of Schooling (ages 25-34) TUNISIA Morocco Malavsia Jordan Chile 1970 1987 1970 1987 1970 1987 1970 1987 1970 1987 Males 3.6 8.3 1.1 4.2 5.0 8.9 3.3 9.5 5.6 7.1 Females 1.1 4.1 0.4 1.5 2.2 6.6 1.2 6.7 5.1 7.0 Source: Dubey and King, 1994; and Tunisia's Ministry of Social Affairs and INS. Health Care Access and Affordability - Social Security Benefits and Contributions I.15 With birth rates dropping and the population getting older, Tunisia is already beginning to face OECD-type problens in health care and social security. The public health system is providing free or highly subsidized care to as much as 40-50% of the population, even though only 7% fall below the poverty line and would require this level of subsidy. The budget provides a major source of funds to cover the total cost of health care which has resulted in underfunding and a quality of service that increasingly falls short of the population's expectations. The challenge for the future will be to maintain access, improve the efficiency of resource use, and diversify the sources of provision and financing. 1.16 The link between social security/insurance benefits and contributions is weak forcing the budget and inefficient cross-subsidization techniques to finance the ballooning shortfall. In addition, the progressive aging of the work force will increase social security payroll taxes in the future. The GOT is  -6- introducing politically difficult reforms to increase the link between contributions and benefits, and it is exploring options to increase the role and scope for private social security and insurance funds in order to maintain coverage while improving the financial sustainability of the system. D. The External Environment The EU FTA and Foreign Savings Inflows 1.17 Tunisia has traditionally been an open economy, with a ratio of imports plus exports to Table 1.2: Sources of Foreign Exchange GDP of 75%. Its sizeable trade deficit and the (US$ billion) large role of tourism receipts and workers' 1995 remittances in financing the trade deficit make Merchandise Exports 5.32 Tunisia's external position vulnerable to adverse (oil & minerals) (0.45) de-velopments in the region's economic and (textiles) (2.65) political stabilitv (Table 1.2). The EU-Tunisia Merchandise Imports 7.28 FTA is part of Tunisia's strategy to reduce these TRADE BALANCE -1.96 vulnerabilities through closer trade integration and (tourism) (0.81) continued diversification of its exports. (other) (0.54) RESOURCE BALANCE -0.62 1.18 One of the main benefits anticipated by Net Factor Services/Transfers -0.15 the agreement is an increase in aid and foreign (workers remittances) (0.72) direct investment (FDI) flows. Following the CURRENT ACCOUNT BALANCE -0.74 Euro-Mediterranean initiative, EU aid flows are Grants and Aid 0.14 expected to double, but an expansion of FDI will FDI and Portfolio Investment 0.25 be more difficult to obtain. Many developing Source: World Bank. countries are undertaking major reforms, thus becoming formidable contenders in attracting capital flows from the developed world. FDI to Tunisia in non-oil related activities has been modest (generally less that US$40 million per year). While the EU FTA will help promote a favorable investment image, Tunisian authorities will need to implement several complementary reforms to attract FDI: opening trade-related activities to foreign investors; adjusting labor laws to promote flexibility; dismantling state monopolies; and promoting closer regional ties. Increased Competition and Greater Diversity 1.19 Tunisia has shifted its export composition away.from primary commodities towards manufactures, but less progress has been made in: (i) diversifying export markets (the EU accounts for nearly 80% of Tunisian imports and exports); (ii) diversifying the composition of manufactures (textiles account for half of manufactured export earnings); and (iii) integrating the offshore sector with the enterprises operating in the protected domestic market or onshore sector. Manufactured goods now account for nearly 50% of export receipts, compared to only 20% in 1980. Textile exports (net of imports) have increased from US$100 million in the early 1980s to US$600 million in 1994. The offshore sector, working under subcontract with EU clothing importers, is largely responsible for this increase, while onshore industries remain highly protected. Tunisia has not significantly expanded its share in the EU market since 1987. Other suppliers, notably China, Indonesia, India, and Poland all increased their market shares in the EU by 7-14% p.a. since 1990, compared to a 1.7% p.a. increase for Tunisia. After completion of the Multi- Fiber Agreement (MFA), Tunisian exporters will face even stronger competition. Textile products and tourism, traditional sources of export earnings, will need to move up-market to products with higher value- added.  -7- External Indicators: Manageable Debt, IncreasedAccess to Private Capital Markets 1.20 Tunisia's current account and external debt ratios relative to GDP are manageable and the overall terms on the outstanding debt are favorable, largely because bilateral and multilateral loans account for 80% of Tunisia's total external debt (Table 1.3). Since 1994, the country has begun borrowing competitively on intemational financial markets, and in 1995, Tunisia received an investment grade (Baa3) from Moody's. It's the only country in the region to have such a rating and is comparable to Poland, India, and South Africa (anything below Baa3 is speculative, Table 2.1). Tunisia's last two debt issues, Table 1.3: External Debt Indicators September 1995 on the Samurai market and January 1996 Ratios 1989-1993 1995 on the Euroloan market, were well received (the Euroloan Current Acct/GDP 5.6 4.0 was three times oversubscribed). The Samurai bond issue Debt Service/Exp 21.9 18.2 was 150 billion yen (US$150 million) at 5% with 10 year Terms Maturity 4t. Rate maturity; the Euroloan was US$200 million for 5 years, DOD 16 years 6.8% with 3 years grace, and 70 b.p. above LIBOR. II. GOVLRNMENT DEVELOPMENT OBJECTIVES: MODERNIZATION & STABILITY 2.01 The government 's two main priorities over the next three years are to (i) put in place a solid framework to guide the modernization of the economy; and (ii) achieve higher growth rates with continued stability. The recently signed trade agreement with the EU is critical to both of these priorities and sets the stage for Tunisia's IXth Development Plan (1997-2001) currently under preparation. The GOT believes it can best ensure the successful implementation of the EU FTA by implementing changes gradually and introducing support measures to help businesses and labor respond to the challenge of competition. The GOT's national mise a niveau strategy can be divided into three broad parts: (i) modemization and the gradual opening up of the economy to competition; (ii) continued macroeconomic stability; and (iii) strengthening the social agenda and environmental management. A. Modernization and Global Integration 2.02 Despite its gradual pace of implementation, the EU FTA is the strongest reform measure and signal the GOT has used to introdnce competition in Tunisia. Tunisia already has fairly open access to the EU market, despite tariff and non-tariff barriers against EU products in Tunisia. This significant level of protection will be reduced/eliminated over the next 12 years under the FTA. To prepare for intemational competition, the GOT launched an enterprise mise a niveau program in 1995 to strengthen the financial position of enterprises, improve product quality and the use of more modern technology. There are several thousand enterprises potentially needing assistance. For industrial enterprises alone, the GOT estimates the upgrading cost at TD 2.2 billion (US$2 billion) over the next five years. increasing competi:ion through trade integration ... * For products sensitive to Tunisian producers, tariffs reduced over 12 years; for the most sensitive products, reductions postponed 4 years, and reduced gradually over 8 years. * During the first four years, effective protection rates for some domestic industries will increase, as tariffs on capital goods and most raw materials were removed in January 1996 (prior to treaty ratification and applied to all trade partners); tariffs on many domestically produced outputs range from 43-73% depending on the application of surcharges which range up to 30%. * Surcharges to be reduced by 10 percentage points per year over 3 years, according to schedule agreed with GATT; all surcharges to be reduced by 10 percentage points starting in 1997. promoting private investment and preparing enterprisesfor competition. . . * Govemment assistance to enterprises for diagnostic evaluations; grants to cover part of the costs to upgrade products, improve management and marketing.  -8- * GOT to establish a risk capital fund through the banking system to recapitalize viable, but undercapitalized companies; all banks to set up specialized mise a niveau units. * With EU and IBRD assistance, improve trade administration and upgrade the quality of services provided by the state-owned technical centers and the Standards and Patents Agency. The EU to provide major technical assistance effort to: (i) harmonize product standards with EU requirements; and (ii) promote partnerships between Tunisian and EU firms. * Partial privatizations and accelerated divestiture. * The 1994 Unified Investment Code reduced some investment restrictions, limited tax and other incentives to more narrowly defined objectives. 2.03 The GOT is also working on the mise a niveau of the economy, through the modernization of its financial system, improved infrastructure services, and cost effective trade administration. modernizing telecommunications, trade, financial and transport services... * Continued progress on bank supervision and prudential regulations; appropriate legal and regulatory structures to enable financial market development, improve the functioning of the stock exchange. * Higher budgetary allocations, EU technical assistance and partnerships between Tunisian and EU members that promote a long-term relationship and possibly direct investment. * A regulatory environment that encourages private provision of infrastructure services, in particular concessions for roads, dams, power generation, and wastewater treatment. B. Macroeconomic Stability and a Declining Budget Deficit 2.04 The GOT wants to undertake the above-mentioned modernization reforms while ensuring sound macroeconomic managenment and reduction of the fiscal deficit. policies to reduce the fiscal deficit... - To compensate for declining trade tax revenues, the VAT will be broadened to include large retail companies, VAT exemptions eliminated, petroleum excise tax increased. - Reduction in the wage bill and improved administrative efficiency through implementation of some civil service reforms proceeding at varying rhythms in different ministries. - Reduction in subsidies and transfers to PEs (Caisse de Compensation) as a share of GDP (frozen in absolute terms) over the next three years, as part of reforms in price support and subsidy policies. * Review consolidated financial position of the PEs; proceeds from privatization earmarked for restructuring and debt reduction. monetary policies to achieve price stability and strengthen external trade relations * Preferential interest rates (for short, medium and long-term credits) and mandatory financing for priority - sectors (ratio des activites prioritaires) for medium and long-term loans reduced to 5% of deposits. Interest rate controls removed for investment credits since 1995. * To control monetary expansion, the Central Bank of Tunisia (CBT) relies on interest rate targeting. The move towards system-wide monetary control through open-market operations on Treasury notes will be pursued once the weaker banks strengthen their portfolios. * The Treasury completely shifted to non-bank domestic financing of the budget deficit; improvements in the design of Treasury paper and the maturity structure need to be introduced. * Since 1993, current account convertibility (exporters permitted to retain 40% of foreign exchange earnings). * Since 1995, some opening of the capital account, foreign investors permitted to buy up to 10% of equity in enterprises quoted on the stock exchange without prior authorization and up to 30% for other enterprises. Purchases of bonds require CBT authorization. A modem stock exchange law adopted in 1994. In 1995, the Tunis Bourse privatized and a GOT supervisory body established. * A managed float has kept a stable real effective exchange rate. Interbank foreign exchange market established in 1994, to lead gradually to a market-determined exchange rate. * Established a good reputation in international capital markets; investment grade ratings from U.S., European, Japanese credit agencies; attractive borrowing terms in Japan and Europe.  -9 - C. Reinforcing Social Programs, Human Capital Development, and the Environment 2.05 A major challenge for the GOT is to ensure that the implementation of liberalization reforms does not put at risk the many social achievements attained so far. The GOT is considering various measures to be introduced under the IXth Plan that promote higher levels of employment, improve education attainment rates, and ensure the financial sustainabilitv of the health and social security systems. labor policies and human resource development ... * Limited insurance for workers that lose their jobs when enterprises go bankrupt, revising labor legislation to limit time allowed to respond to an employer's request for lay-offs. * Development projects in the poorest rural and urban areas and improved income support targeting. * In 1993, nine years of basic education made compulsory for all "capable" students; the national examination given between grades 6 and 7 replaced by local exams. * For government vocational training, GOT introducing tax incentives for on-the-job training, participation of the private sector on the boards of the state industrial training and technical centers. * With EU assistance, improved technical education, applied research, transfer of know-how. for health care and social securit ... * Continue guaranteeing health care access for all citizens, but redirect subsidies and revise co-payment system to increase cost-sharing for those able to pay, while protecting the indigent. e Study cost-containment/cost-recovery measures to ensure closer link of payments to quantity/quality of care. * In the medium-longer term, increase autonomy to hospitals, encourage decentralization towards lower levels of the health care system, stimulate the private sector and the purchase of services between private and public providers while strengthening the regulatory and accreditation systems. * Incremental changes to improve financial sustainability of the social security system, for example linking benefits to contributions more closely, expanding private insurance funds. for the environment ... i Cost recovery for operating/partial investment costs by 2000 for water, energy, wastewater. * Incentives to encourage industry to use clean technology, incentive pricing for clean fuels. * Coastal zone management (with other Mediterranean countries), balancing tourism and industrial development in coastal areas; rangeland and forestry development programs. C Strengthen institutions, particularly monitoring functions, information dissemination. D. Comparisons with Other Countries 2.06 The Government's strategy strongly emphasizes equity considerations, stability, and measures to help those groups likely to be adversely affected by opening the economy to more competition. The objective is to establish a foundation that will enable the authorities to become increasingly confident in their application of market mechanisms and allow labor and enterprises sufficient time to adapt to a more competitive environment. The Government is credible, and the strategy is in the right direction. Tunisia's past progress on the economic and social fronts should enable the counitry to undertake ambitious structural adjustment reforrns. 2.07 Table 2.1 compares Tunisian indicators with a few other countries at the time they undertook a closer trade integration of their economies with OECD partners, and shows that Tunisia is in a relatively favorable position to begin implementation of the FTA. Tunisia's major strengths are: a low inflation rate and a manageable deficit and external debt position. Several countries in Latin America suffered failed trade liberalization attempts in thie 1980s due in large part to macroeconomic imbalances. Its main vulnerabilities include the predominance of the State, labor market rigidities and the need for stronger human capital, and the relatively high tariff level and gradual pace of tariff removal which could cause uncertainties and possible policy reversals (12 years compared to 5-7 years in most Eastern European countries).  - 10 - Table 2.1: Comparison of Selected Performance Indicators TUNISIA Portugal Poland Chile Mexico Morocco MACRO INDICATORS (1995) (1986) (1994) (1993) (1993) (1995) Fiscal Balance/GDP -4.2 -13.6 -2.9 2.0 1.5 -5.5 Inflation Rate (CPI) 6.3 11.7 33.3 12.0 9.7 6.1 Unemployment Rate (1990 for Tunisia) 12.0 8.6 16.5 10.0 n.a. 17.0 Private Invest./TOTAL 46.0 66.0 n.a. 71.0 80.0 63.9 Public Enterprise/GDP* 23.0 14.6 n.a. 8.0 8.4 15.0 EXTERNAL INDICATORS Current Acct/GDP 4.0 2.7 -0.8 -5.3 -6.4 -3.4 Average Tariff Rate (unweighted) 33.0 8.6 12.0 13.7 40.0 External Debt/GDP 54.7 58.5 52.7 49.0 35.5 69.8 Debt Service Ratio 18.2 31.8 10.6 23.4 32.7 29.9 Investor Ratings (Moody's)** Baa3 Al Baa3 Baal spec** none SOCIAL INDICATORS*** HDI/Per Capita Income -9 -2 20 8 -6 -26 Literacy Rates (WDR 1995) 63 86 99 95 87 49 Years of School of Labor Force (1992) 5 7 8 8 7 3 % Labor Force in Agriculture 33 26 22 18 30 40 ' Share of PEs in economic activity; the table gives an approximation (Sources: Tunisia INS 1994; for the other countries, Bureaucrats in Business, World Bank 1995, for Chile, Mexico and Morocco, latest estimate available 1991). '* Ratings are all for 1995, Moody's. Morocco has not been rated; Mexico's rating is speculative grade, i.e. below the investment grade. ***JNDP Human Development Index (HDI) ranking relative to per capita income ranking. A positive number shows the human development ranking is better than the GDP per capita ranking, a negative number shows the opposite. Other data, World Bank Sources: World Bank, IMF Statistical Yearbooks, UNDP Human Development Report, 1995, Social Indicators of Development. 1994. E. Remaining Agenda 2.08 The implementation of policies to promote Tunisia 's trade integration into global markets needs to be supported by a redefinition of the role of the State in the economy and by significant progress in the development of Tunisia's human resource base. A key issue is whether the past emphasis on gradualism can adequately address the challenges posed by integration into the global economy, namely more efficient financial and other trade related services, advanced telecommunications and reliable transport services. The agenda for reform calls for decisive actions that actively promote opportunities for the private sector, especially through deregulation, privatization, and a strengthening of the financial sector. The following points include some of the areas where the Bank is working with the GOT on measures to complement its development strategy. * Financial sector management, the Bank Group, the IMF, bilateral donors, and the EU are working with the GOT to further liberalize interest rates, improve Treasury financing, and encourage competition among the banks. The objective is to promote a secondary market in Treasury securities and obtain a market-driven yield curve. The indebtedness of a few large PEs with the state banks has prompted the GOT to begin paying off its obligations and review prudential regulations and governance practices in the banking sector. * Trade reforms are now set, with the signing of the EU FTA. The Bank and the GOT will closely monitor the sequencing of tariff reductions to harmonize them vis-a-vis third parties and keep increases in effective protection rates to a minimum. To reduce uncertainties among potential investors, changes in tariff policies will be widely published. Over time, GOT should review whether liberalization reforms can be accelerated. * The social agenda is achieving results: declining poverty, universal access to health care, a lower population growth rate, and increasing primary education enrollment rates, especially for girls. Nevertheless, strong efforts are needed to develop human capital resources that will enable Tunisia to compete effectively in European and global markets. The Bank/GOT will be preparing a coherent education strategy covering all levels of education/training within the mise a niveau framework.  - l l - * Deregulation of public sector monopolies and a strong privatization program to promote efficiency. The Bank and the EU are working closely with the GOT to accelerate the privatization program. * Labor market rigidities persist. The Bank/GOT to prepare a strategy as part of ESW in FY97. * The enterprise mise a niveau program of grants, loans and technical assistance is intended to enhance existing enterprise performance, rather than promote new activities in tradeable goods. The Bank is encouraging the GOT to monitor whether the State's actions are paying off (i.e. increased exports of onshore companies). * The mise ai niveau of services is critical to the country's competitive performance in international markets. Tunisia's proximity to Europe is a major advantage, but high transport costs and outdated communications/information technology reduce their competitive edge. The private sector can help contribute to the State's development of trade-related infrastructure, particularly in transport and telecommunications. The Bank and EU member countries will be working closely with Tunisian counterparts to upgrade a wide range of services. * Agriculture has undertaken important reforms, but substantial resources (from the budget and domestic savings) still flow to this sector. More efforts will need to be made to enable the structural adjustment of the sector to take place, with safety nets and programs designed for the rural poor. The Bank/GOT are working together to prepare for future trade reforms and sectoral adjustments. * Environmental policy is an area where Tunisia is at the forefront of the MENA region, with strong institutions and competent providers of basic services. The Bank and the GOT are working in close co- operation to balance traditional supply mobilization efforts with demand management and appropriate pricing of services and resources, particularly for water and land. The climatic variability's affects on a significant share of the labor force in agriculture (33%) has reinforced the need for water and land resources management. Likewise, the importance of tourism in the economy makes Tunisian authorities focus considerable attention on coastal zone management. III. MACROECONOMIC PROJECTIONS: GROWTH AND THE PACE OF REFORM A. Moderate and High Growth Scenarios 3.01 The Tunisian economy is subject to large fluctuations mainly due to sudden changes in agricultural production (which in turn depend heavily on weather conditions) and to a lesser extent due to shifts in external demand for Tunisian goods and services, particularly tourism. Three successive years of drought and bad harvests from 1993-1995 kept the GDP growth rates from reaching the period average of 4%. With good rainfall in 1996, agricultural output is expected to increase significantly. This, combined with steady growth (2-3%) in the EU, Tunisia's main market, and higher oil and gas production from exploration and pipeline investments, should result in 6-7% growth for 1996, promising an auspicious start for implementation of the EU FTA. 3.02 The IXth Development Plan (1997-2001), currently under preparation, aims at very ambitious growth objectives, with average real growth rates above 6% p.a. The Bank estimates GDP growth trends to range between 3.5% and 6.2% p.a. through 2003, depending on the timeliness and extent of structural reforms. * Moderate growth trend, averaging 3.5% p.a. to 2003, corresponds to an economy similar to that of the past 8 years, but with a private sector that does not take the lead in the modernization process. The gradual progress toward liberalization and opening of the economy, and the implementation of the EU FTA is not accompanied by a consistent growth in private investment and enhanced efficiency. Macroeconomic and current account balances remain at about the same level as in 1995. In both the high and moderate scenarios, the main sources of growth are manufacturing and services, while growth in agriculture and tourism are projected to slow down, reflecting environmental constraints and the expectation that closer integration will encourage agriculture imports from the EU to replace part of domestic production. Under the high scenario, growth rates in agriculture fall less quickly as production shifts to higher value products.  - 12 - High growth trend averaging 6.2% p.a. to 2003, resulting from accelerated trade and investment liberalization, stronger deregulation of public sector monopolies, an acceleration of the privatization program, and the gradual strengthening of the financial system. The higher GDP growth rate is due to higher investment (one third) and enhanced total factor productivity (two thirds), generated by stronger market incentives for private activity and more efficient services. Public savings would be higher, resulting from the further rationalization of current expenditures and transfers to public enterprises, and appropriate VAT and income tax adjustments to maintain government revenue at around 26% of GDP. Higher competitiveness in international markets would be achieved, among other things, through a market-driven exchange rate, flexible wages and prices, improved total factor productivity and an outward oriented economy. The growth of exports is about 85% higher in the high-growth scenario than in the moderate one and the growth of imports about 80% higher. The corresponding higher share of exports to GDP, together with a greater reliance on both national savings and foreign direct investment to finance the current account deficit, renders Tunisia's external position under the high-growth scenario more secure than under the moderate-growth case. B. Expected Financing Requirements and Macroeconomic Indicators 3.03 The goal of high sustainable growth is achievable in Tunisia, but requires strong determination to maintain macroeconomic stability and push forward the implementation of structural reforms. The following financing plan (Table 3.1) is based on a reasonable expectation of economic performance and corresponds to an average GDP growth rate over the Table 3.1: Financing Plan (USS billions) 1991-93 1994 1995 1996 1997 1998 1999 next 10 years of about 5% p.a. After Financing needs 1.78 1.32 1.76 1.68 1.68 1.71 2.01 1996, FDI is not expected to increase, Sources but the composition may change, as MLT Loans 1.20 1.01 1.50 1.66 1.49 1.37 1.54 energy related FDI declines and flows Multilateral 0.60 0.48 0.49 0.62 0.61 0.63 0.65 to othr secors ofthe eonomy of which IBRD 0.22 0.19 0.16 0.16 0.19 0.20 0.22 to other sectors of the economy Official Bilateral 0.31 0.37 0.43 0.36 0.25 0.23 0.21 increase. Grants are to double, Private Creditors 0.30 0.16 0.57 0.69 0.63 0.51 0.68 private credits should increase and FDI 0.42 0.37 0.28 0.25 0.27 0.29 0.32 credits from multilateral agencies Grants 0.13 0.10 0.14 0.21 0.21 0.21 0.21 remain stable. Change in Reserves -0.04 -0.20 -0.32 -0.37 -0.25 -0.17 -0.19 (- indicates increase in reserves). Macroeconomic Indicators 3.04 Table 3.2 provides a set of macroeconomic indicators based on GDP growth projections of around 5% p.a. through 2003. Three macroeconomic indicators will be monitored as part of the performance indicators described in Chapter V, Section C, and merit discussion here: the internal balance (the primary and overall fiscal balances); the external balance (balance of payments and exchange rate policies); and the adequacy of foreign exchange reserves. * Fiscal Balance. The overall fiscal deficit stands at 4.2% of GDP and is projected to decline to 2% by 2000. Achieving this reduction is an important element to attaining projected growth. An increase in public savings through the continued reduction in the public deficit and the tightening up of excessive PE borrowing practices with the state-owned banks will increase the availability of funds for more productive investments. The consolidated government balance (which would include government obligations through PEs) will be monitored, depending on the availability of this information. The primary fiscal surplus will increase to 1% through both expenditure reductions and an increase in revenues. The wage bill is high (39% of total government expenditures), and health, education and infrastructure account for about 40% of total GOT expenditures, leaving room for reductions/reallocations from less productive areas of expenditure. Revenue increases are expected through VAT consolidation, wider application, and collection enforcement.  - 13 - * External Balances and Exchange Rate Policy. As Tunisia undertakes trade liberalization reforms, it is important that the authorities maintain a competitive exchange rate. The real effective exchange rate should be supportive of the pace of liberalization and the export sector. In the short tern, imports may increase more rapidly while the development of exports may take longer. At present, the GOT targets the real effective exchange rate, keeping it stable through nominal depreciations based on the inflation differential between Tunisia and its trading partners. In 1994, the Central Bank of Tunisia introduced an interbank foreign-exchange market, which is expected to lead, by stages, to a market-determined exchange rate. Full convertibility of the dinar is a medium-term objective which will depend on the successful implementation of structural reforms in the financial sector; a further reduction of macroeconomic imbalances, and the functioning of the interbank foreign exchange market. The exchange rate would be monitored closely as part of the agreed indicators. * Gross Reserves and the Current Account Balance. The appropriateness of the level of foreign exchange reserves is difficult to judge. In the case of Mexico, for example, US$29 billion of reserves (equivalent to 6 months of imports) was depleted in a matter of months, once macroeconomic credibility was lost and the highly overvalued peso came under attack. In the past, Tunisia has managed reasonably well to absorb significant (but not extraordinary) shocks to the balance of payments with average reserves equivalent to around 2 months of imports (notably the Gulf war, and to a lesser extent severe droughts which induced exceptionally high grain imports). In each instance, sharp declines in one area were offset by solid performnance in other areas. Nevertheless, the authorities intend to increase gross reserves to a level of around 3 months of imports which seems adequate for several reasons: (i) Tunisia's relatively stable macroeconomic situation, and its reasonably good access to private capital markets; (ii) for the next 3-4 years, capital account convertibility is not envisaged and the potential for massive capital flight is limited; and (iii) perhaps most important of all, the authorities are committed to maintaining a flexible exchange rate and are unlikely to allow significant appreciation. Table 3.2: Selected Macroeconomic Indicators Rate of Chanae (%p.a.) 1989-1994 1995 1996 1997 1998-2003 GDP mp 4.6 2.6 7.1 5.5 5.2 Agriculture 6.3 -9.0 16.1 5.0 3.8 Manufacturing 5.4 4.5 5.9 6.5 6.6 Services 5.3 5.2 5.2 5.6 5.4 Exports GNFS 5.1 1.3 4.7 6.8 7.1 Manufacturing 8.1 3.7 5.4 8.2 8.6 Gross Domestic Investment 7.0 11.8 8.0 8.5 6.7 ICOR (5 years) 6.5 6.2 5.9 5.4 5.0 REER (1990=100) 103.9 102.6 102.7 102.4 Ratios to GDP (%) Gross Investment 26.6 24.6 25.3 25.8 26.5 National Savings 22.1 20.4 21.5 22.0 23.1 Current Account Balance -5.1 -4.0 -3.8 -3.7 -3.6 Gross Reserves (mos. of impons) 2.0 2.0 3.0 3.1 3.0 Overall Fiscal Balance -3.4 -4.2 -3.8 -3.0 -1.5 Primary Balance -0.8 -0.8 -0.7 0.3 1.0 External Debt Service 21.6 18.2 16.9 16.0 15.9  - 14 - PART II - BANK GROUP ASSISTANCE STRATEGY IV. COUNTRY ASSISTANCE PROGRAM A. Overview of Past Performance 4.01 Tunisia easily ranks among the World Bank's best borrowers. OED reports consistently rate the outcome and sustainability of loans to Tunisia above both the MENA and Bank-wide averages. The number of projects in the portfolio facing problems or with low probability of achieving their development objectives is well below regional and Bank-wide averages (Table 4. 1). Table 4.1: Portfolio Performance DEVELOPMENT OBJECTIVE RATING* FY92 FY93 FY94 FY95 Tunisia 0 0 8.7 4.2 MENA 9.9 15.4 27.0 14.7 IBRD 12.5 13.9 15.2 11.5 * Projects expected not to achieve their development objectives as a percentage of total projects in the portfolio. IMPLEMENTATION PROGRESS RATING** Tunisia 7.1 7.7 8.7 4.2 MENA 17.8 17.3 27.9 27.3 IBRD 17.6 16.9 18.3 17.8 ** Projects facing implementation problems as a percentage of the total projects in the portfolio. Lessons and Experience from the Last Country Assistance Strategy 4.02 The last country assistance strategy (April 1993) recognized that an important unfinished agenda of adjustment issues remained The main areas identified were: high centralization of the public administration; a somewhat fragile banking and financial system; a slow privatization program; and the serious scarcity of water. The Bank completed several revealing studies since 1993 (for example, Post Basic Education, Export Performance, a Poverty Assessment, a Private Sector Assessment and a Country Economic Memorandum) which have contributed to the policy dialogue and enabled the Bank and the GOT to identify where a deepening of structural reforms is needed. Sector work has typically played an important role in Tunisia, helping policy-makers weigh the options, assess the costs and benefits of different policies, and adopt solutions they believe are appropriate for Tunisia. This strong sense of ownership has contributed to the success of the Bank's operations in Tunisia. Traditional Projects 4.03 Traditional projects and the GOT's long-standing commitment to health, education and access to services have contributed significant'y to improving Tunisian living standards. The Bank's first education (1962) and health (1971) projects went to Tunisia. Infrastructure projects have expanded access to basic services (potable water, rural roads, wastewater treatment), and they have reinforced rate increases for utility services with the objective of covering the full cost of operations and part of investment costs by the year 2000. A line of credit for private investment strengthened the Central Bank's application of prudential regulations and introduced greater transparency in the banking system. In agriculture, the focus has been both on poverty alleviation and the implementation of adjustment reforms. Grass roots operations in the most impoverished areas of Tunisia are applying a mix of traditional and innovative approaches to create opportunities, strengthen local participation and community-based initiatives, and reduce the incidence of poverty. A hybrid agriculture sector investment/policy loan introduced reforms to help the sector adjust to competition. The GOT removed numerous subsidies and relaxed some  - 15 - marketing monopolies, but trade protection, irrigated water subsidies, credit preferences, and state controls in several agricultural activities are still significant. Policy-Based Lending 4.04 The Bank has been closelv involved in the evolution of Tunisian policies towards a more outward, market-oriented economy, and the results have been impressive. The Bank and the GOT agree on the direction of policy reforms, the issues have been more the speed of implementation and the costs the authorities are prepared to incur to compensate vulnerable groups who may be adversely affected by reforms. The Bank's strategy on adjustment lending has had to adapt to the GOT's strong emphasis on gradualism. In view of Tunisia's good record at avoiding crisis management situations, the approach has been reasonable and has resulted in a strong partnership. The GOT values the Bank's analysis and objective advice. Bank operations and sector analysis have helped to forge a consensus among the authorities and different groups in Tunisia which have kept the adjustment process moving forward with enviable economic success and social stability. The lessons learned since 1993 combined with the structural reform effort still needed to complement the EU FTA have caused both the GOT and the Bank to recognize that policies still have an important role to play in the Bank's assistance strategy. B. Country Assistance Objectives 4.05 Not since Tunisiafirst launched stabilization and adjustment reforms in 1987 have the authorities felt a more pressing needfor sound advice, financial and analytical support, and an appreciation of the important turning point the country has reached. The main concerns are that the mise a niveau of the enterprises could fail, the implementation of the trade agreement with the EU slows down, and a significant increase in private and foreign investment does not materialize. The GOT's request for Bank assistance at this time comes from the realization that further adjustments cannot be postponed and that their implementation (even gradual) will be difficult for various groups. The Bank can provide the kind of objective advice and support Tunisia needs to make the "new rules of the game" clear and increase the likelihood of Tunisia's peaceful integration into world markets. 4.06 To support Tunisia's efforts to open up its economy to international competition, the Bank proposes a solid lending and non-lending program for FY96-FY99 that maintains past assistance levels and has as its principal objectives helping to improve Tunisia 's standard of living and make the difficult transition from a lower income (US$1,800 per capita p.a.) to a middle-higher income country. Both non- lending and lending services are extremely important to the GOT. The Bank assistance program was developed in close co-operation with the government and benefitted from the views of the private sector and the academic community. The GOT has asked for Bank assistance in four main areas: * deepening structural reforms that strengthen the GOT's commitment to competition. create a policy environment that opens up activities to the private sector in the production/provision of goods and services, and enable enterprises to compete on an equal footing with foreign companies; * human capital development, moving Tunisia towards middle income country standards of education attainment rates, qualified manpower, and financially sound health and social security systems; * modernization of services that improve efficiency in several key areas, especially transportation, telecommunications, and banking as well as the delivery of technical and agricultural support services; * environmental management and the application of appropriate values for scarce natural resources. 4.07 Policy measures will play an even more important role in the Bank's program than they have in the past, and non-lending services will increasingly become the instruments of choice to support the implementation of structural reforms. Lending services will support this "know-how transfer" effort and reinforce the implementation of policies which have already been developed and agreed upon with the GOT. A stronger emphasis will be placed on:  - 16 - * convincing policy analysis and strategic sector work which the Tunisians value and expect from the Bank. The Bank has a comparative advantage in identifying the cross-sectoral implications of different policy measures and in helping the government to design a coherent strategy; * dissemination efforts (seminars, round-table work-shops, the establishment of an information center). Up to now, these types of senrices have not been used extensively, but in view of the Tunisians' interest to learn how to address complex problems and develop a consensus among themselves, well- organized and open forums can be extremely useful tools; and * closer co-operation between the Bank Group and the EU. In the past, the EU has co-financed several Bank operations, but since signing the FTA, co-operation has increased significantly. Deepening Structural Reforms 4.08 In FY96/97, the Bank is encouraging the GOT to use the unprecedented support and momentum of the EU FTA to implement important structural reforms which complement trade liberalization. The proposed ECAL was prepared jointly with the EU and addresses several critical policy objectives: a resumption of the privatization program; deregulating GOT monopolies in shipping, port management, and cargo handling; supporting fiscal measures to enhance revenues and increase transparency between the GOT, the PEs and the public sector banks; and encouraging the timely implementation of tariff reforns under the EU FTA. The proposed loan would support an acceleration of Tunisia's gradual reform pace, and the EU, the Bank, and the GOT worked closely together to prepare the program. Depending on its outcome, a subsequent operation for FY97 focusing on the financial sector would cover: governance; prudential regulations; bank and insurance fund privatization; the money market; and social security reforns. It would build on the ECAL and involve close co-operation with the IFC and the EU. 4.09 ESW, grants (IDF and other), and seminar/workshop activities are proposed, starting with a seminar on "Tunisia in the Global Economy and International Developments in Information Technology" (FY96 or early FY97). The subsequent progran of seminars and institutional strengthening assistance is being developed in close co-ordination with EDI. Technical assistance would also be provided by the IMF, the IFC and bilateral European partners in the areas of fiscal and monetary policy, Treasury operations, and capital market development (Box 4.1). The Bank would prepare a seminar on "Cross- Country lessons from Civil Service Reform", strategy notes on "The Role of the State", and on "Structural Changes in Agriculture" that will incorporate the findings of the Living Standard Measurement Survey (LSMS) and the general equilibrium model analysis of the impact of trade liberalization on the agricultural sector. These studies would pave the way for an FY98 or FY99 adjustment operation focusing on trade liberalization in agriculture, the role of the agricultural PEs (les Offices), the opening up of more agricultural marketing activities to the private sector, and reduction in the water subsidy. Box 4.1: Bank-IFC Strategy to Promote Private Sector Development The IFC has focused its activities in Tunisia on financial sector development and privatization. The Bank has concentrated on the broad framework, through financial and banking sector reforms, while the IFC has been active with direct participations in financial intermediaries. The IFC is an equity parmer in the first merchant bank established in Tunisia, the Maghreb International Merchant Bank. To promote privatizations, the IFC is participating in several funds: the Tunisia Private Eguitv Fund and the Inter-Arab Ratin2 Companv (a new holding company that promotes domestic rating agencies in various Arab countries, beginning first with Tunisia); the Emerainp Middle East Fund; and the Framlington Maehreb Fund for Morocco and Tunisia. In the future, as Tunisia's privatization program accelerates, the IFC will continue to provide institutional support for capital market development. Capital market development, bank privatization, and further opening of govemment monopolies in infrastructure and natural resources will provide opportunities for Bank and IFC co-operation.  . - 17 - Human Resource Development 4.10 Past sector and project-related work on education have highlighted three basic issues which make human resource development a cornerstone of the Bank's assistance strategy. (i) the exceptionally high rate of drop-outs from basic education (which disproportionately affects girls and children from poorer families in rural areas); (ii) the State's dominance of the provision of higher education and the inequities resulting from virtually no cost recovery; and (iii) the low quality and low graduate insertion rates from the public vocational centers. Fiscal constraints and the challenges of global integration oblige the GOT to rethink issues of education quality, access, and financing. The Employment and Training project accompanying this CAS is working to upgrade the quality of public vocational training improving employment services and monitoring, promoting the dual training system, and increasing the role of the private sector in training provision which should improve the marketability of graduates. In FY97, the Bank/GOT will prepare an education strategy paper integrating key objectives at all levels of education (achievement rates, relevance within the mise i niveau framework, provision, financing, and resources). The LSMS results and sector notes on labor/gender issues would contribute to the education strategy. A workshop would follow, comparing different education strategies. Depending on the outcome of these efforts, education lending operations (either sector wide or specific loans) would be prepared in FY98. 4.11 Tunisian authorities have a commitment to equity in health care, yet resources are scarce and the system is sufferingfrom growing demand, insufficient funds, and constraints in maintaining quality. The public health system cannot continue providing free or highly subsidized care to as much as 50% of the population, when only 7% fall below the poverty line and would require this level of subsidy. The Bank and the GOT have been working closely together on these issues to identify priorities and measures to strengthen the financial viability of the health care system which would be supported by a health sector operation. The social and financial benefits of appropriate and timely reforms are high and merit the GOT's/Bank's continued efforts. Modernization of Services 4.12 The next few years promise to bring dramatic changes in Tunisia's perspective as well as its practices in the delivery of many services, especially transportation, telecommunications and information technology. The Bank, in close co-operation with the EU and the IFC, can help the government identify bottlenecks and prepare a coherent strategy to alleviate them--in the context of the rapid pace of change and innovation set by the rest of the world. A combination of strategic sector analysis, seminars conveying international trends and developments, and close coordination with other donors would establish a good foundation for sector specific investment loans and private concessions. * In infrastructure, the Bank will support modernization efforts and policy reforms that promote competition and greater private provision. A Second Municipal project would build on the experience from the first such project (closed FY96) and would promote further decentralization efforts in Tunisia. The recommendations and analysis from the FY96 transportation sector study to dismantle public monopolies in shipping and port handling are helping to change views and policies in Tunisia and will be followed up with a transport sector loan in FY97. An information technology seminar would be presented in FY97, and depending on the outcome, could be followed by a sector operation. * In agriculture, resource constraints present the sector with difficult adjustments. In addition to the sectoral adjustment strategy note, grants would be used to (i) help establish a land market (land consolidation and titles) and; (ii) assess how to improve support services to agriculture (for example, an expanded role for the private provision of veterinary and extension services and the necessary regulatory measures needed to promote these developments). * In industry, the proposed Industry Support Upgrading project and the Employment and Training project have likewise been prepared with the EU and have specific modernization objectives: (i) raise the quality and improve the delivery of services provided by the industrial technical centers and  - 18 - vocational training institutes; (ii) significantly increase the private sector's role in the provision of these services and; (iii) set performance indicators that will enable the authorities to determine if their efforts and the State's resources are paying off. Managing Scarce Natural Resources 4.13 The Bank is continuing to help Tunisian policy-makers analyze the various social and economic trade-offs posed by land and water resource constraints. In FY95, the Bank's water mobilization study complemented GTZ 's Eau 2000 analysis and highlighted the critical importance of implementing demand management and water price reforrns, in view of the fact that all of Tunisia's available water resources will be fully developed by 2000. The CEM (FY95) included environmental considerations in its analysis of growth prospects and the role of government and emphasized the need to assess the sustainability of land and water resources in an integrated, intersectoral fashion. Land is also a fragile and "non-renewable resource" in Tunisia, with an estimated 24,000 ha. of productive land being lost each year. A Natural Resources project focusing on land management is currently under preparation for FY97, and subsequent work in FY98 and FY99 will explore such issues as land titling, property rights, and the establishment of a land market. In FY97, a Japanese grant will assess the potential impact of climate change on Tunisia, and an integrated study on land and water will contribute to the preparation of a water sector loan (FY98) that will include measures to reduce subsidies to irrigated water. A seminar/workshop on "Land and Water Markets" will present the experiences of other countries (Chile, Peru, Zimbabwe), and an IDF grant on land issues will help the GOT to develop a strategy adapted to Tunisia. The Bank will prepare a tourism project in FY97 to preserve some of Tunisia's most famous archaeological sites. C. Instruments of Assistance Emphasis on Non-Lending Services 4.14 The proposed assistance program makes use of all the lending and non-lending instruments the Bank has available, with the emphasis gradually shifiing to non-lending services. As explained in Part I of this document, Tunisian policy-makers are extremely cautious, and they evaluate their options and the possible consequences of their decisions very carefully. In this regard, Bank analytical work and the organized presentation of how other countries have handled different problems is enormously beneficial to them. They are demanding of high quality and expert, experienced policy advice, and the Bank can and should make every effort to meet their high expectations of professionalism. Our non-lending services are expected to differ somewhat from previous programs in four ways: * closer co-operation with Tunisian experts, whereby suitable local Tunisian consultants would work with Bank teams to prepare sector analysis and strategy. These arrangements brought positive results in FY95/FY96 and will be expanded to the extent possible in the future; * more direct links between grant activities and formal sector work, so the task managers can ensure that these activities complement one another and are linked to lending operations; * a broader national debate on the challenges facing Tunisia through an information center and seminar/workshop presentations that provide an open forum for discussing difficult policy issues; and * an expanded program with EDI to support reforns through seminars, study tours and training. Shift in Lending Instruments 4.15 The lending program proposedfor the FY96-FY99 period mainfains about the same level as in previous years, averaging about US$240 million per year, but there is a significant change in the mix of instruments, with fewer traditional projects and more sector investment loans. In the past, for example between FY90 to FY95, 54% of our lending was for traditional projects, 33% for policy based loans and only 13% for sector investment loans. The FY96-FY99 program expects nearly half the portfolio to be  - 19 - for sector investment loans, with the other half divided between policy based loans and traditional projects. Broad policy based adjustment operations will be less prevalent than in the past, but still important, particularly in FY96 and possibly in FY99. Traditional projects would incorporate pilot-type operations to support microenterprise development, particularly for women, and several projects would also promote decentralization trends and commuinity based actions with the capacity to monitor progress. The reason for the increased emphasis on sector investment loans is twofold: * to incorporate limited, well-focused, sectoral policy objectives with modernization investments; and * the expanided use of private concessions, particularly for transportation, waste water treatment, electriciLy, possibly telecommunications, and perhaps in the proposed education project. D. Resources 4.16 Table 4.2 summarizes the resource implications of the proposed strategy, compared with the level of support in the last few years. The total amount has been reduced, and there is a shift in resources towards lending while maintaining the allocation for ESW and non-lending activities. The FY95 resources for ESW were exceptionallv high, reflecting a strong effort by the Bank to assist the GOT with preparation of the IXth Plan. in the future, resources on ESW are expected to be lower because more sector working papers (as opposed to formal reports) will be produced. Some savings are also expected by integrating sector analysis more closely with grant work and with the preparation of lending operations. Table 4.2: Historical and Projected Resources FY90/91 FY92/93 FY94 FY95 FY96 FY97 FY98 FY99 Avg., Act Av2./Act Act Act Budget Plan Plan Plan Staffyears 18.1 18.2 20.9 21.3 21.4 17.5 17.9 18.1 US$ 5.2 5.3 6.1 6.2 6.2 5.1 5.2 5.2 % LEN 42 47 39 27 38 40 40 40 % SPN 36 32 34 32 32 31 32 32 % ESW 18 14 21 33 22 20 20 20 % OTH 4 7 6 8 8 9 8 8 Note: Dollar budget computed at average all-in-cost rate of US$290,000/SY. E. Coordination with Other Donors The European Union 4.17 The EU's sharpened interest in the region provide both opportunities and challenges for the Bank and Tunisia. In FY96, all three of the Bank's lending operations were prepared with the EU. For the ECAL, the Bank took the lead on the design of policy measures, but the EU actively participated in its preparation/appraisal. For the Industry Upgrading Support Project, the EU is the lead agency, with the Bank cofinancing a small portion of these activities. For the Employment and Training Project, both the EU and the Bank are financing separate slices of the total investment, while ensuring that the overall design, objectives and support are consistent. The initial experience has been encouraging and has promoted a stronger dialogue with the GOT. This is the first time in Tunisia that the Bank has worked so closely with another donor. The proposed assistance program expects a high level of co-operation to continue, and the arrangement is being used as a prototype for other countries in the region.  - 20 - Other Donors 4.18 The multilateral and bilateral donors will remain Table 4.3: Commitments* active in Tunisia. Table 4.3 presents tentative plans (and the Bank's best estimates) for 1996 commitments from the main Multilateral 1994 1995 1996 multilateral and bilateral donors showinig the increase in EU (grants) 26 70 150 expected levels of assistance from the EU, EIB and France, Credits while other donors are expected to maintain past assistance IBRD 240 230 250 levels. The biggest shift is the doubling of grants from the ADB 480 154 200 EU and the near doubling of official credits from the EIB. Bilaterals (credits and grants) The EU, through the Euro-Mediterranean initiative has France 80 100 150 pledged to provide some 12 countries along the southern Gernany 35 35 35 Mediterranean with increased levels of assistance, based on Japan - 187 180 the implementation of appropriate policies and the economic performnance of these countries. As the first country in the *World Bank estimates (US$ million). region to sign an FTA with the EU, Tunisia expects to receive considerable EU assistance. V. COUNTRY RISK MANAGEMENT A. Risk Management and Creditworthiness Lending Flows and Exposure Levels 5.01 The following two tables (5.1 and 5.2) summarize the financial impact of the proposedprogram on expectedflows and exposure. With Tunisia's improved access to capital markets and the availability of substantial new grant assistance, resource transfers from the Bank will be less important than in the past. The main objectives of Bank interventions will be to: (i) reinforce grant assistance through an agreed policy framework; and (ii) to support the increased flows of direct foreign investment. Bank exposure is somewhat high based on traditional indicators (Table 5.2), but credit-worthiness is strong due to the country's stable macroeconomic situation and sound debt management record. Table 5.1: Net Lending by the World Bank (US$ millions) 1991-93 1994 1995 1996 1997 1998 1999 Commnitments 235.0 267.5 272.8 175.0 230.0 260.0 230.0 Disbursements 199.2 188.5 159.3 164.4 187.8 196.1 216.7 Repayments 139.7 176.7 193.5 190.8 196.0 204.3 201.0 Net Disbursements 59.5 11.8 -34.2 -26.4 -8.2 -8.2 15.7 Interest 115.6 124.8 125.5 118.2 114.7 112.2 110.4 Net Transfers -56.1 -113.0 -159.7 -144.6 -122.9 -120.4 -94.7 Table 5.2: World Bank Exposure 1993 1994 1995 1996 1997 1998 1999 Total DOD (USS billions) 8.70 9.25 9.93 10.52 10.96 11.36 11.81 of which IBRD 1.59 1.72 1.65 1.63 1.62 1.62 1.63 Exposure Ratios IBRD Debt Service/Exports (5%) 4.1 3.8 3.7 3.3 3.1 2.8 2.6 IBRD DS/Public DS (20%) 21.2 22.4 21.7 21.0 20.5 20.8 17.3 Pref. Cred. DS/Public DS (35%) 38.7 40.4 43.1 46.7 48.5 50.9 44.3 Share of IBRD Portfolio 1.5 1.5 1.5 1.5 1.5 1.5 1.5  - 21 - Risks and Uncertainties 5.02 The main uncertainties affecting Tunisia are: (i) the external position 's reliance on a narrow base of foreign exchange earnings (tourism and textile export earnings); and (ii) the potential for regional political instability. The GOT has so far managed to lessen the first set of concerns by gradually diversifying its export base. This process should be further strengthened as Tunisia forges a closer economic relationship with the EU. In the past, Tunisia has managed to absorb shocks to the balance of payments by its overall solid economic performance. Regional instability has caused the Tunisian authorities to be very cautious in implementing reforms. So far, Tunisia has maintained internal stability through sound economic management, social progress, and strong security aimed at containing extremism. As a result, neighborhood risks have been reduced substantially. 5.03 There is some uncertainty associated with the GOT's timely implementation of reforms. The projected moderate growth scenario (3.5%) was prepared to assess the impact of a slower implementation of reforms on the expected economic performance. The growth rate slows down, macroeconomic balances remain about the same as in FY95, the total debt/GDP ratio deteriorates slightly, and the IBRD debt service/exports ratio remains well below 5%. Although overall performance would still be acceptable under this scenario, it is well below the country's potential and could lead to pressures on social spending and unemployment. The higher growth scenarios (5-6%) correspond to a more timely implementation of reforms and a more solid medium-term outlook, with macroeconomic balances improving significantly and Tunisia's external position becoming more secure (para 3.02). B. Lending Scenarios 5.04 The Bank would be expected to lend in a range of US$150 to US$350 million peryear depending on: the pace of reforms; Tunisia 'sfinancing needs and the availability of other sources offinancing; and the possibility of any unforeseen shocks to the economy. Two main factors could reduce the Bank's ability to carrying out the expected (US$240 million p.a.) lending program: e if the pace of structural reform slows down. The Bank's assistance program in Tunisia places considerable emphasis on the implementation of policy reforms. The GOT may not be ready to move forward in certain areas which could result in a somewhat lower lending program for a given year. * if the Tunisians decide alternative sources of financing would be preferable (i.e. the EU, the ADB, and private creditors). Given the expected level of financing which could be available to Tunisia through the EU or on private markets, the Tunisians may decide to borrow less from the Bank Group. 5.05 Two scenarios could result in a significantly higher lending level (from US$240 million average to US$350 million): (i) a shock to the economy and/or (ii) a strong acceleration of structural reforms. So far, Tunisia has weathered less dramatic shocks (the Gulf War, instability in neighboring countries, severe droughts) reasonably well. Regional political uncertainties, however, combined with Tunisia's rather strong dependence on tourism receipts and workers' remittances to fill the trade deficit, mean that for the foreseeable future the Bank and other donors need to be prepared to increase assistance levels in the event of an extraordinary shock. The increased assistance would need to support measures designed to reduce Tunisia's vulnerability to such shocks. Triggers for Higher Lending 5.06 In view of the country's status as a relatively low risk borrower, a strong acceleration of reforns in key areas might also warrant a higher lending level on a temporary basis, including:  - 22 - * a more rapid implementation of the EU FTA (5-7 years rather than the expected 12 year period); * a substantial increase in privatization measures (proceeds increasing from 1-2% to 6% of GDP); * financial sector reforms which strengthen the enforcement of prudential regulations and reduce total government-owned assets in the banking sector from 70% to less than 50%; and * privatization of selected transportation and telecommunication services, and the opening up of the telecommunications sector to private operators. The Bank and the GOT would evaluate the up-front costs of these adjustments and determine the need for increased Bank support. C. Performance Indicators 5.07 An attempt to monitor progress towards achieving the objectives set out in this CAS should enhance transparency in the economy and strengthen the Bank's relationship with the GOT and the EU Despite significant progress in the implementation of stabilization and adjustment measures since 1987, several policy distortions impose constraints that will hinder the ability of Tunisian enterprises to compete against foreign firms which do not face these constraints. The performance indicators are presented in Annex A9 and cover four areas: (i) deepening structural reforms that maintain macroeconomic stability and enhance competition and efficient resource allocation; (ii) human resource development initiatives that increase basic education completion rates, increase cost recovery in higher education, promote labor force flexibility, and improve the financial sustainability of the health care and social security systems; (iii) upgrading the quality of trade related services through the opening up of many of these activities to the private sector; and (iv) environmental management which promotes the sustainable use of resources through appropriate pricing and community based initiatives. D. Conclusions 5.08 The sharpened interest and support of the EU in the region provides an opportunity and a challenge for Tunisia and for the World Bank. The proposed assistance program responds to this challenge and maximizes the opportunities for co-operation. Partnership between the three parties should enhance the national debate on policy issues and promote a more timely implementation of structural reforms. The risks to the World Bank of lending to Tunisia are relatively small, and the Bank has much to offer and much to learn from continuing its policy-dominated lending relationship with the GOT. * The Bank has the unique opportunity to work closely with a strong partner (the EU), which should strengthen the policy dialogue and all operations that are prepared with the EU. * Flexibility ir lending instruments, an increased emphasis on non-lending services, and a list of performance indicators complement the EU's assistance program and the GOT's development objectives. * Successful implementation of reforms in Tunisia could have important repercussions in the region in particular and throughout the Arab world and Africa in general.  - 23 - E. Agenda for Board Discussions 5.09 Three main issues have been identified for board discussions: * adequacy of the proposed Bank/GOT strategy to address the challenge of global integration; * shift in assistance instruments towards non-lending services linked to sector investment lending operations; and * monitoring of performance indicators. James D. Wolfensohn President Attachments Washington, D.C. June 25, 1996  lTUNISIA Page I of2 FY97-99 COUNTRY PROGRAM - RESOURCES ALLOCATION FY97 FY91 FY9 Country Objectives/ Performance Indicators/ % of % of %of Quantifiable Indicators Monitorable Objedives Bank Services Work Program Tasks S Total S Toal S Total Deepening Stuctural Reform (CDP growth, inflation interest rate ilank adjustment lending/ ECAI l 63.5 1.6% 63.5 1.6% 63.5 1.6% ' Macro stability changes lIoldings of liquid Treasury supervision Financial Sector L^-tn 169.5 4.4% 190.6 4.S% 42.4 1.I " ' Aceierate Frivatization bills held by public Agricultural Reform 42.4 1.1% 360.1 9.0% * Trade liberalization * Budget deficit; the exchange rate; current acceount balance; and reserves Btank investment lending Land Markels Developnent 21.2 0.5% 291.9 7.4% 42.4 1.1% ' Deregulation of public secor mrnopolies Analytical output Structural Changes in Agriculture 42.4 1.1% 42.4 1.1% 3.5 0.2% a Privalization proeeeds/GDP Public Sector/Private Secdor/NGOs 21.2 0.5% 161.0 4.1% B.5 0.2% *Private bank assets Irmplemnentation of the FTA General analysis/monitoring 233.0 6.0% 233.0 5.9% 233.0 5.3% CAS/briefs 105.9 2.7% 114.4 2.9% 169.5 4.2% Technical AssisAnce Financial Markets Seminar 21.2 0.5% Internationsl lIessons ofCivil Serv. Ref R.5 0.2% IDF Public Aditin A Civil Service Reforn 33.9 0,9% 1.5 0.2% CGE Model disagregation 33.9 0.9% R.5 0.2% Legislative Reforms 33.9 0.9%/ 1.5 0.2% Modernization of Services * Opening transport, telecommunications, Bank investnent lending/ Transportation Sector 399.5 10.4% 63.5 1.6% 63.5 1.6%