Senegal - The challenge of international integration

19094 December 1997 Senegal The Challenge of International Integration World Bank December 1997  SENEGAL: THE CHALLENGE OF INTERNATIONAL INTEGRATION TABLE OF CONTENTS EXECUTIVE SUMMARY. I CHAPTER 1: PAST AND PRESENT. 5 BACKGROUND. 5 ADJUSTMENT AND STRUCTURAL REFORMS IN 1994-96. 7 MACROECONOMIC EFFECTS. 9 THE PRIVATE SECTOR RESPONSE TO THE PROGRAM OF REFORMS .......................................................... 11 SECTORAL PERFORMANCE ............................................................ 12 INVESTMENT ............................................................ 12 CHAPTER 2: INTEGRATION WITH THE WORLD ECONOMY ............................................................ 15 TRADE INTEGRATION ............................................................ 16 HIGH TRADE PROTECTION .16 COMPLEX AND LENGTHY TRADE REGULATIONS ............................................................ 16 INEFFICIENT EXPORT INCENTIVES . 18 REGIONAL INTEGRATION: A GRADUAL PROGRESSION ............................................................ 18 Low TRADE OPENNESS ............................................................ 19 EXPORT STRUCTURE AND PERFORMANCE ............................................................ 20 STRUCTURE OF EXPORTS .21 MINOR CHANGES IN SPECIALIZATION ............................................................ 22 INCREASING MARKET DIVERSIFICATION ............................................................ 23 FINANCIAL INTEGRAT ION: MISSING THE OPPORTUNITIES ............................................................ 25 TRENDS IN SENEGAL ............................................................ 27 WHY IS SENEGAL NOT ATTRACTING HIGHER PRIVATE CAPITAL FLOWS? ............................................. 28 THE BUSINESS ENVIRONMENT: HAS IT REALLY CHANGED? ............................................................ 28 CHAPTER 3: INTERNATIONAL COMPETITIVENESS ............................................................ 31 INTERNATIONAL COMPETITIVENESS ............................................................ 32 PRICE AND COST COMPETITIVENESS ............................................................ 33 ENDOWMENTS, ACCUMULATION AND PRODUCTIVITY GROWTH ............................................................ 34 COMPETITIVENESS AND EXCHANGE RATE MANAGEMENT ............................................................ 36 CHAPTER 4: THE EXTERNAL ENVIRONMENT ............................................................ 39 IMPLICATIONS OF THE WORLD ECONOMIC OUTLOOK FOR SENEGAL ..................................................... 39 OUTLOOK FOR KEY CURRENT ACCOUNT REVENUES ............................................................ 41 SERVICES ............................................................ 44 REMITTANCES ............................................................ 44 VULNERABILITY TO EXTERNAL SHOCKS ............................................................ 44  CHAPTER 5: RAPID EXPORT GROWTH: MAKING IT HAPPEN ........................................................................ 47 WHY EXPORTS? ......................................................................... 47 HOW RAPID WOULD EXPORT GROWTH HAVE TO BE? ......................................................................... 47 WHICH EXPORTS? ......................................................................... 49 EXPORTS OF SERVICES: MYTH OR OPPORTUNITY? ......................................................................... so SENEGAL IS WELL PLACED TO BENEFIT FROM THE SERVICES REVOLUTION .............. ......................... 51 A STRATEGY FOR RAPID EXPORT EXPANSION ......................................................................... 52 CONCLUSIONS ....... .................................................................. 53 BIBLIOGRAPHY ......................................................................... 55 ANNEXES ANNEX A: STATISTICAL TABLES ......................................................................... 63 ANNEX B: THE SUPPLY RESPONSE TO THE DEVALUATION AND THE REFORMS: RESULTS FROM THREE SURVEY INVESTIGATIONS ......................................................................... 87 ANNEX C: FACTOR COSTS AND PRODUCTIVITY: A COMPARATIVE ANALYSIS ...................................... 93 ANNEX D: SERVICES EXPORTS: THREE SUCCESS STORIES ........................................................................ 103  SENEGAL: THE CHALLENGE OF INTERNATIONAL INTEGRATION EXECUTIVE SUMMARY Senegal's structural adjustment program has had positive macroeconomic effects. However, the country remains poorly integrated into the world economy. Its international competitiveness has improved but remains weak. The devaluation and the program of structural reforms initiated in 1994 have represented a true departure from past policies of adjustment, and have reversed the trend decline in incomes and the cycle of low savings and investment. Real GDP growth has averaged about 5 percent during the last three years, in contrast with the stagnation of the early 1990s. Inflation has been brought down and both the fiscal and the balance of payments current account deficits have been reduced. Between the early 1990s and 1996 the ratio of gross domestic savings to GDP increased by about 3 percentage points, the result of strong fiscal efforts and a recovery in private saving. The ratio of private investment to GDP has increased in line with that of savings. But the share of imports of capital goods, an important signal of the strength of the investment recovery, has decreased since 1990. This share is now comparable to that of other African countries but much lower than in fast growing economies. Despite recent reforms, Senegal does not participate deeply in the world economy. WNhile nominal protection has been cut by a third in 1994, average import charges are high, 22 percent, about twice the level in comparable countries; and trade openness, as measured by the real trade to GDP ratio, is lower than the average for Sub-Saharan Africa. Senegal's export share in world markets is now five times less than it was in the 1960s. Real exports per capita have stagnated since the early 1980s, while they have increased by five times in East Asia and doubled in South Asia and Latin America. Put differently, if Senegal had managed to maintain its 1960s share of world exports, the country's exports today would have been over $4 billion, compared to the actual $870 million in 1996. The 1994 devaluation helped Senegal to restore its export to GDP ratio to mid-1980s levels; but it has not led to significant recovery of Senegal's share in world exports. Finally, Senegal is completely missing the opportunities arising from global trends in private capital flows. It has not attracted significant foreign direct investment or portfolio flows and continues to rely almost completely on grants and concessional flows for its external financing needs. Evidence suggests that foreign investors have shown little interest in Senegal because, to date, the reforms have remained partial, hamstrung by administrative weaknesses. For example, passage of goods through customs and ports is slow and costly because of complex and lengthy procedures and clearing systems; fiscal incentives have failed to stimulate significant amounts of exports because of cumbersome administrative procedures; and the business environment continues to be hampered by government inertia and lack of transparency in the administrationofjustice. Competitiveness has improved since 1994. Senegal's factor costs are now comparable with those of many East Asian and African countries, though they remain high within the West Africa Economic and Monetary Union (WAEMU) region. Despite Executive Summary I  SENEGAL: THE CHALLENGE OF INTERNATIONAL INTEGRATION the decline in recent years, real wages in the formal sector of the economy are relatively high, compared to other developing countries, and labor productivity is low. After the devaluation, the cost of intermediate inputs in dollar terms has come closer to that of competitors. However, sectors sheltered from international competition (electricity, transport, energy etc.) but which are important suppliers to the traded sector, continue to constrain the economy's efficiency. And the costs of energy, particularly electricity, and of water, compare unfavorably within the WAEMU market. Looking toward the next decade, Senegal is not likely on current policies to see an acceleration in exports. During the next decade the global economic environment is expected to remain favorable, with high world output growth, low inflation and interest rates and declining oil prices. Senegal's terms of trade are anticipated to decline, but slightly. Market import demand will be stronger than in the last decade. However, the analysis in this report suggests that Senegal is unlikely, on current policies, to increase its export market share. This is largely because much of the growth in demand for Senegal's exports comes from developing regions of the world, that now account for only a third of Senegal's merchandise exports. By contrast, the European market will be characterized by fairly sluggish growth and increased competition for the key products exported by Senegal, particularly groundnut- and phosphate products. For fish, the outlook would be more optimistic, but the need to preserve a sustainable fish stock implies that export volumes will need be restrained. Thus, without a change in policies that would lead to a sustained recovery in exports, Senegal may not be able to achieve economic growth of 5 to 6 percent, as it has in the last three years, and certainly not the 9 percent growth rate foreseen in the government's Ninth Economic and Social Development Plan (1998- 2001). An acceleration in the pace of reforms is necessary to increase international integration and economic growth. Evidence from around the world shows that countries that are open to international markets and attract substantial private capital flows grow faster. Senegal is now at a crossroads. The recent reforms have restored internal and external balances and improved competitiveness. This window of opportunity should not be lost. A strategy to increase international integration and growth would be based on the acceleration and deepening of structural reforms, with a special emphasis on measures to encourage rapid export growth. Deepening of structural reforms. Maintaining political stability and sound macroeconomic policies are most important prerequisites for integration and growth. This report stresses the significance of further reducing trade barriers and trade opening as a way to increase competition, attract foreign investors and improve the quality of output. But other measures, which are fully discussed in recent World Bank reports and in the country assistance strategy, are important: 2 Senegal: The Challenge of International Integration  SENEGAL: THE CHALLENGE OF INTERNATIONAL INTEGRATION i) eliminating barriers to competition would improve the efficiency of the economy and help increasing wage flexibility in the formal sector; further relaxation of labor market regulations would also facilitate the reallocation of labor among industries; ii) reducing the role of the State in the economy through privatization and deregulation; and improving the functioning of the judicial system would strengthen the private sector and attract foreign investors; iii) promoting financial sector deepening would mobilize savings and help meeting the finance needs of small and medium enterprises. Increasing regional cooperation Deepening regional integration within the WAEMU-while conforming to WTO rules regarding customs unions-may represent a real opportunity for success for Senegal: regional coordination of tariffs and fiscal measures should enhance the credibility of national governments; time spent for customs clearance procedures will be reduced, as will the opportunities for corruption; a transparent and uniform tariff regime will decrease the complexity of trading activity; and a larger market should help attract foreign investors. Investing in human and physical capital The report recognizes that the reasons for Senegal's low level of competitiveness are primarily stagnant productivity and low levels of physical and human capital, In a longer term perspective, the ability of Senegal to compete and grow will depend on the accumulation of human and physical resources and gains in the efficiency with which these are used. Since independence, Senegal has had poor performance in terms of accumulation of both human and physical capital, and efficiency improvements have been almost zero. Two areas need increased investment, both public and private: first, investment in human capital, especially in primary and vocational education. Literacy and increasingly higher levels of education are necessary to improve productivity and benefit from technological progress. Second, investment in infrastructure to augment the existing stock as well as to improve the quality. Rapid export growth: making it happen! Sustained export development can only be based, in the long run, on an economy that is open to trade and foreign investment, and in which prices are market determined. Within this context, however, there is also room for an active role of the Government to encourage export growth. Existing distortions in Senegal are the result of either market failures or discriminating policy interventions, which act as taxes on producers. Firms that sell in the domestic market remain relatively unaffected, as they are still shielded from outside competition; by contrast, the impact of policy distortions is larger on exporters, as their selling prices are determined in international markets. While the best policy for the Government is to deal directly with the distortions, this is a long process. In the meantime, the government can help mitigate some of the market failures in the export market, as well as compensate for some of the costs of doing business imposed on firms by administrative inefficiencies. More importantly, the government, through its Executive Summary 3  SENEGAL: THIE CHALLENGE OF INTERNATIONAL INTEGRATION commitment to exports can clearly signal its determination to integrate Senegal's economy into the world economy. Obviously, the emphasis on exports is not totally new for Senegal. But all too often ineffectiveness, favoritism, discretionary implementation of laws and rules have rendered good policies meaningless. This has to change. What is needed now is a clear break with the way policies have been implemented in the past. What is needed is a strong signal from the top leadership for radical change and for an ambitious export expansion program. To be credible the Government should commit to: transparency of rules and procedures; and discipline by institutions and bureaucrats in applying and enforcing the law and in making exporters obtain the incentives they are entitled to in time and according to what is announced. The program should build on and complement the reforms already implemented, including the law (December 29, 1995) on Free Export Companies. Moreover, the existing incentive system should be restructured in order to attract resources and innovative entrepreneurship into exporting. This should include accelerated handling of import and export procedures by the relevant authorities; elimination of all foreign exchange formalities; and absolute priority given by the judicial system in resolving possible disputes concerning investment and exporting activities. Conclusions The future in Senegal can be brighter. Optimism over this outlook is justified for a number of reasons. First, recent history proves that the benefits from structural reforms in terms of higher growth can be substantial. Second, the external environment presents unprecedented opportunities for growth and poverty reduction. Third, the country has many advantages, including a stable political and civil system, geographical proximity to both Europe and the United States, a significant pool of highly educated people, a relatively modern telecommunication infrastructure and competitive pricing in telecommunications. Thus, Senegal is potentially well placed to benefit from the ongoing revolution in international services and could attract significant foreign investmnent in this area. However, Senegal will be able to take advantage of the new opportunities only by accelerating the pace of reforms, including a new focus on exports, and by putting new discipline in policy management. 4 Senegal: The Challenge of International Integration  Senegal: The Challenge of International Integration CHAPTER 1 PAST AND PRESENT Senegal is a low-income country with a population of 8.7 million people (1.4 percent of Sub-Saharan Africa), and per capita income of US$560 (compared with US$490 in Sub-Saharan Africa). In 1960, however, Senegal's GDP per capita was higher than most countries in Africa and even in East Asia (e.g., South Korea). Economic performance until the early 1 990s was poor, characterized by low levels of savings and investment, a trend decline in income and weak regional and global integration. In 1994 the Government of Senegal, together with the other WAEMU countries, made the decision to devalue the currency; and it adopted a program of structural reforms that represented a true departure from past policies of adjustment. This chapter discusses the macroeconomic effects of this reform program. It suggests that they have been positive, and are indeed comparable to the results obtained by countries that have successfully devalued. Inflation has been placed under control, both internal and external disequilibria have been reduced and output has recovered. Available indicators also suggest that the private sector has led the recovery in investment and exports and that competitive pressures are increasing its efficiency. The perfornance of exports, however, has been less satisfactory. While recovering from the negative growth rates experienced in the early 1990s, during 1994-96 exports increased barely above world demand. Background A former French colony, the country started its independent life with a highly educated elite, a well functioning physical infrastructure and a solid productive base; and a surplus of civil servants and oversized industries that were created for a larger colonial market. During the 1960s and 1970s, Senegal, like many other countries in Africa, adopted inward-looking policies, characterized by strong govermment intervention in factor and product markets, lack of fiscal discipline and trade and industrial protectionism. These policies resulted in low levels of savings and investment which, combined with high growth in population rates, led to stagnation in GDP per capita. Yet, the substantial volume of foreign aid, which Senegal was able to attract because of its strategic position and political stability, removed the external financing constraint. The combination of inadequate policy management, low growth and adverse conditions in the external environment finally led to a major economic crisis in the late 1970s. Adjustment efforts, initiated in the early 1980s, were partially successful in restoring macroeconomic balances but not in reducing the structural rigidities of the economy, in particular the weight of the public sector. Chapter 1: Past and Present  Box 1.1 The economy Economic structure Sectoral contributions to GDP. With 59 percent of GDP, services is the most important sector of the economy. The primary sector contributes to two-thirds of employment and 21 percent of GDP. A large share of this value added is produced by agriculture, of which the performance has been erratic, depending on rainfall and world prices. The main crops are groundnuts and cotton, with more than half of production exported, rice, maize, and sorghum, mostly for domestic consumption and horticulture, a tiny but promising export sector. Fishing represents only about 12 percent of the primary sector's value added but a fourth of exports. The secondary sector accounts for 20 percent of GDP, which is produced mostly in industry (65 percent), mining (8 percent) and construction (20 percent). The industrial sector is poorly diversified (it includes fish canning, oilseed processing, chemicals (phosphates), textiles, clothing and light industries). Most sub-sectors are dominated by only one or two large enterprises, with capital owned by either the State or foreigners.' The tertiary sector accounts for 60 percent of GDP (of which about 20 percent can be attributed to public administration). Exports represent 20 percent of GDP, and are concentrated in few products, fish (25 percent), groundnut products (10 percent), rock phosphates (5 percent), processed phosphates (17 percent). Private and public sector. The private sector contributes 100 percent of the value added in the primary sector and 80 percent in the secondary. Among the 22 largest industrial enterprises, 13 are foreign owned and five are owned by private Senegalese. The State retains majority holding in the SONACOS (groundnut oil refining), SENELEC (electricity) and in the Industries Chimiques du Senegal (phosphates and chemical products) and indirect participation in the Societe Africaine de Raffinerie (petroleum refinery). The private sector contributes 77 percent of value added in the tertiary sector (public enterprises dominate in the transport and telecommunication sectors). In the financial sector, six out of eight banks are totally private (four of the commercial banks are subsidiaries of foreign banks). Formal and informal sector. The formal sector, which accounts for about one third of GDP but only 2 percent of employment, covers manufacturing, trade, tourism, insurance and banking. By contrast, the informal sector, which dominates agriculture, trade and transport, absorbs about 90 percent of the labor force though little is known about its contribution to investment, output and exports. Regional integration Senegal is a member of the West African Economic and Monetary Union (WAEMU), which also include Cote d'Jvoire, Benin, Guinea Bissau, Niger, Togo, Burkina Faso and Mali. These countries are part of a common currency area, the CFA zone, and have a common central bank, the BCEAO. In 1994 they signed a treaty to become a full customs and economic union. The integration agenda calls for the introduction of a common external tariff and a unified framework for investment incentives by early 2000, and the harmonization of economic policies among the members. The CFA is pegged to the French franc. The convertibility with the French franc is guaranteed by the French Treasury. It is supported by an overdraft facility through the operations accounts with the French Treasury. In return, the BCEAO holds at least 65 percent of the foreign exchange holdings of each member country with the Treasury in Paris. In 1989 the Council of Ministers of the WAEMU adopted a series of reforms aimed at strengthening banking supervision and liberalizing credit allocation and interest rates. The overall credit limit to governments was tightened: the net advance of the BCEAO to a government cannot exceed 20 percent of tax receipts received by the budget. In 1993 the BCEAO reorganized the regional money market and introduced minimum reserve requirements and an interbank market. Since 1996 Central bank bills have been auctioned off to help the absorption of liquidity. Senegal is a member of the Lome Convention, a trade and aid association with the EU that guarantees duty free access to manufactured goods and agricultural commodities to the European market and substantial flows of aid. See T. Latreille and A. Varoudakis (1996). 6 Chapter 1: Past and Present  Senegal: The Challenge of International Integration Economic conditions worsened in the early 1990s because of a substantial decrease in the terns of trade (4 percent a year during 1991-93), recession in Europe and 2 repeated droughts. While constrained by a fixed exchange rate within the CFA zone , the authorities attempted to raise competitiveness through higher tariffs and export subsidies, and demand compression policies. But the task was made difficult by the low and falling inflation in France and the depreciation of the currencies of the main trading partners. Thus, the trade weighted nominal effective exchange rate, which had remained stable between 1980 and 1985, appreciated by 47 percent during 1986-93. While restraints on domestic demand succeeded in lowering the inflation rate more than tradinf partners, the CPI-based real effective exchange rate (REER) declined by 13 percent but rose by 7 percent with respect to developing countries. During 1991-93 current account revenues in dollar terms dropped by some 6.5 percent a year, marked by declines in virtually all sources of foreign earnings, particularly in groundnuts, phosphates and private services (see table A19 in annex A). On a per-capita basis, revenues declined by 9 percent (and purchasing power reduced by 7 percent per year), clearly unsustainable from an external financing perspective. The external balance worsened and investment and output stagnated. On average, GDP per capita declined by 2.8 percent a year during 1991-93. Adjustment and structural reforms in 1994-96 During 1991-93 most CFA countries experienced a deep economic recession. Govermnents struggled to adjust their economies to declining terms of trade and weaknesses in major export markets within the context of a fixed exchange regime. Yet, some governments were reluctant to devalue. They were skeptical about the ability of a devaluation to induce a supply response and restore growth; and uncertain on the political reaction of the groups that would lose their purchasing power and struggle for salary increases. As the economic and financial crisis worsened, a devaluation could not be delayed. The decision was taken in January 1994, and Senegal, together with the other CFA countries, undertook a 50 percent devaluation of the CFA franc. The measure was accompanied by a stabilization program, centered on fiscal adjustment, and a program of structural reforms to increase market flexibility and develop the private sector, liberalize the economy and reduce the size of the public sector. Since 1994 the major reforms achieved include: 2 The CFA (Communaute Financiere Africaine) zone comprises eight countries in the West African Zone and six countries in the Central African Zone. The two zones have separate monetary arrangements and separate curriencies which, however, have the same exchange parity with the French Franc. 4See S. Devarajan and J. De Melo (1982). See IMF (1995). Note that the weights used to calculate the CPI index (to compute the REER) are biased in favor of the urban consumption basket and thus toward the prices of tradables; moreover, they do not adequately reflect changes in wages. If the exchange rate is deflated with the average wage index for civil servants (a proxy for domestic costs), it shows an appreciation of 10 percent during 1986-93 (see tables A. 17 and A. 18 in annex A. Chapter 1: Past and Present 7  a) strengthening of domestic competition: liberalization of prices and abolition or re-negotiation of special agreements protecting several private and public enterprises; b) liberalization of trade: elimination of prior authorization to import or export, and of customs reference prices; reduction in customs duties and simplification of duty structure; liquidation of import monopoly for all products but oil; c) promotion of private investment and exports: revision of the overall investment regime and export processing zones and points francs; d) reduction of transport costs: liberalization of maritime transport (elimination of the monopoly of the shipping enterprise); e) increase in labor market flexibility: elimination of prior authorization necessary for layoffs for economic reasons; f) reduction of the role of the State in the economy: privatization of specific funtions of the water company, of rice mills and the stabilization board; opening up in the capital of the telecommunications company and of smaller companies; preparation of a plan to privatize most of the remaining public enterprises; preparation of an audit of the civil service and settlement of cross debts within the public enterprises. With the exception of a reference price on sugar until the year 2000. 8 Chapter 1: Past and Present  Senegal: The Challenge of International Integration Macroeconomic effects While it is difficult to disentangle the causes of the turnaround in economic activity during the period 1994-96, empirical evidence suggests that the effects of the devaluation and of the program of structural reforms have been largely positive. Exogenous factors may have played a role. For example, a favorable external environment, with buoyant world trade certainly increased the demand for exports; terms of trade ;were positive in 1994 and negative in 1995-96 (table 1.1). Good rainfalls contributed to the recovery of agriculture in 1994 and 1996. Table A4 in annex A shows that macroeconomic results in Senegal during the year of the devaluation and the two years that followed compare well with those of countries that adopted similar reforms (see also box 1.2). Table 1.1 Macroeconomic indicators (annual averages, %) 1997 1986-90 1991-93 1994 1995 1996 est. GDP growth 3.3 0.0 2.0 4.8 5.6 4.7 GDP per capita growth 0.3 -2.8 -0.6 2.2 3.0 2.1 Gross domestic investment/GD 12.6 13.1 13.7 15.6 16.3 16.7 Private investmentlGDP 8.6 8.9 9.0 10.8 11.5 11.7 Gross domestic savings/GDP 6.5 5.6 7.4 10.4 11.4 11.8 Growth in exports, GNFS 7.9 -3.7 5.3 9.4 4.8 0.7 Inflation rate (CPI) 0.1 -0.8 32.1 8.1 2.8 2.5 REER 0.4 -2.0 -35.1 8.3 0.6 -2.9 Current account deficitlGDP (a) -10.7 -9.5 9.3 -7.9 -7.2 -6.1 Fiscal deficit/GDP (a) -3.1 -1.9 -5.7 -3.2 -2.0 -1.3 Terms oftrade (S) -3.7 -4.4 4.1 -2.4 -1.7 6.4 (a) Excluding grants Source: DECPG, World Bank Inflation has been brought down from 32 percent in 1994 to less than 3 percent in 1996; in contrast with the stagnation during the early 1990s, real GDP growth turned positive in 1994 and increased to 4.8 percent in 1995 and 5.6 percent in 1996; the fiscal7 and the current account deficits (excluding grants) were reduced from 5.7 percent and 9.3 percent of GDP respectively in 1994 to 2 percent and 7.2 percent of GDP in 1996. 6 The success in curbing inflation is due to a combination of factors: a) import substitution in favor of cheaper domestic products; b) liberalization of internal and external trade; and c) prudent wage and monetary policies. For example, public sector wages were increased in 1994 only by 10 percent. See IMF (1995). 7 After the devaluation, the maximum import tax rate was reduced from 75 percent to 45 percent. In the area of domestic taxes, the existing system of five VAT rates for non petroleum products was replaced by two rates (10 percent and 20 percent) and the various VAT rates for petroleum products were replaced by a single rate (20 percent); measures were also taken to broaden the tax base and improve revenue collection. On the spending side the authorities maintained strict restraints on spending, particularly on public sector wages. Chapter 1: Past and Present 9  The current account deficit was largely financed by gross official transfers (including multilateral and bilateral creditors and donors, debt rescheduling and debt cancellation). Gross domestic savings increased from 7.4 percent of GDP in 1994 to 10.9 percent in 1996, the result of the strong fiscal adjustment effort and, starting in 1995, a recovery in pnvate savings. Box 1. 2 Devaluation Conventional analysis' suggests that a devaluation will increase the price of tradables relative to that of non tradables, improve the trade balance and switch resources to the exportable sector. By raising the price level and reducing real balances, it creates an excess demand for money, thus inducing an inflow of reserves. Additional capital inflows may also come from commercial banks or international donors that had previously rationed credit. The improvement in the BOP can altematively be (empirically) explained2 by a reversal or moderation of speculative capital flight. Empirically, a devaluation is often associated with a contraction in output preceding it and an expansion in its wake. The contraction usually starts one-two years before, the result of an overvalued exchange rate and worsening external and internal balances. An alternative explanation of the sequencing effects associates the loss of output, before devaluation, to the 3 shortages of imported inputs, as the authorities maintain import controls to avoid depletion of reserves. Following devaluation, exports increase sharply but import growth recovers with a lag, as output rebounds. Empirical evidence Kamin (1988) analyzed a set of up to 90 devaluation episodes between 1953 and 1983. He found that the trade balance typically deteriorates during the three years prior to devaluation, improves significantly in the year that follows it and then worsens again, but moderately. The improvement after the devaluation was associated with a strong increase in exports rather than a decrease in import growth. But capital inflows were found to grow more slowly for the devaluing countries than in countries that had not devalued. And while devaluation appears to be associated with temporary increases in inflation, this was not sufficient to cancel out the real depreciation. Finally, countries tended to experience a decline in output before the devaluation but no long run effects on either inflation or output growth were identified. S. Edwards (1989) analyzed 39 major devaluation episodes between 1962 and 1982. In most countries the devaluation was made necessary by inconsistent macroeconomic policies, which were responsible for a deterioration in the current account balance, a depletion of international reserves (even though the authorities imposed trade and exchange controls), capital flight, real exchange appreciation and a contraction in output. The main finding is that although a nominal devaluation does not have real effects in the long run (if the country is in a situation in which the real exchange rate, which depends on fundamentals, is in equilibrium), it can speed up the adjustment process, reducing unemployment and related costs, if prices and wages are inflexible in the short run (that is if the real exchange rate is misaligned). The devaluation was associated with a deterioration of the current account and foreign assets position in the short run but an improvement in the medium term. Some countries experienced substantial capital inflows, particularly those that adopted a stabilization program supported by the IMF and World Bank. (Conversely, capital outflow continued in countries where the devaluation was deemed "insufficient"). Output recovery appeared to be fast, within three years after the devaluation. The countries that did not experience an improvement in the external position and in output were also unable to restore macroeconomic fiscal discipline. I See R. Dombush (1980). 2 See P. Krugman (1979). 3 Under the first explanation, the propensity to import falls as result of devaluation; under the second, it may remain constant, as the authorities keep controls on import spending until the stock of foreign exchange reserves is restored. a Central Government savings were 1.6 percent of GDP in 1994, 3.9 percent of 1995 and 4.8 percent of GDP in 1996. 10 Chapter 1: Past and Present  Senegal: The Challenge of International Integration The 35 percent devaluation of the real exchange rate in 1994 prompted a broad- based recovery of foreign exchange earnings (figures 1.1 and 1.2) in particular a significant rebound in key merchandise exports as well as tourism and private services. After declining by 3.7 percent a year during 1991-93, total exports increased, in volume, by 6.5 percent during 1994-96. Merchandise export growth was marginally higher, 7 percent. Export growth was helped by a strong recovery in world demand, 6.4 percent a year during 1994-96. Thus, the gain in market shares (e.g., the difference between changes in export volume growth and in world demand) was barely 1.9 percent in 1994, negative in 1995 and just 1.7 percent in 1996 (see table A10 in annex A). Figure 1.1 Figure 1.2 Sgl: Mldhxdise ELxwts, 198% Saek OQdw OCnt AlUt fmpts, 19W% fIhi1a n k bhmiS IOOD I]ODD 800 .0 - o 9~~~~~~~~~~~~~~~~~0 D Tmzb 1982 84 8& 88 1990 92 94 %0 Akk d~~~~L&hWZIfi~~~~~~fr~~ 1%2 84 85 88 1990 92 94 % &z fIbhJ*IQHWarA/5(1up5 s9 A#/HbiIik.*/tJ5JwtRC,s The private sector response to the program of reforms Available indicators suggest that the private sector has been the engine of the recent turnaround in growth.9 For example, agriculture and industry (which are almost totally private) have grown at a much faster rate than services, traditionally dominated by public enterprises. Within the formal sector, the large enterprises (with over 100 permanent employees) have reacted extremely well to the devaluation and the reforms. Most are reported to operate at full capacity and to expand their operations, despite the reduction in import and market protection and in the fiscal advantages they enjoyed in the past. Small and medium enterprises (employing between 5 and 100 employees) have been the major source of growth in some sectors, for example agro- industry, fishing and construction, and in private business services. Survey results (see box 1.3) suggest that the enterprises that gained the most were those in the export sector, or with a lower content of imported inputs and labor intensive. Anecdotal evidence 9 See USAID (1997). Chapter 1: Past and Present 11  suggests that informal activities, mostly in agriculture, have performed positively but less than those in the modem sector. Sectoral performance The supply response of agriculture to the program of reforms implemented since 1994