Report No. 8044-TUN

Republic of TunisiaCountry Economric Memorandum: The Road toan Outward-Oriented Economy(In Five Volumes) Volume IlI: Annex 2

The Tunisian Financial System in Support of Investment

March 1990Country Operations DivisionCountry Department 11Europe, Middle East and North Africa Region

FOR OFFICIAL USE ONLY

Document of the World Bank

This document has a restricted distribution and may be used by fecipier.ts

only in the performance of their official duties Its contents may not otherwise

be disclosed without World BOk authorization.

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

CURRENCY EQUIVALENTS

SDR 1.00 - dinars (TD) 1.2245 (as of April 1989)

Official exchange rate: Dinar (TD) Per US Dollar

Period End of Period Period Average

1973 0.4451 0.42001974 0.4065 0.43651975 0.4253 0.40231976 0.4309 0.42881977 0.4121 0.42901978 0.4034 0.41621979 0.3959 0.40651980 0.4187 0.40501981 0.5157 0.49381982 0.6158 0.59071983 0.7271 0.67881984 0.8666 0.77681985 0.7570 0.83451986 0.8402 0.79401987 0.7779 0.82871988 0.8985 0.85781989 0.9446 (Sept.) 0.9642 (Sept.)

Source: IMF, International Financial Statistics, July 1989

FISCAL YEAR

January 1 to December 31

FOR OMCIL USE ONLY

GLOSSARY OF ABBREVATIONS

APB Association Professionnelle des Banques(Professional Association of Banks)

BCT Banque Centrale de Tunisie(Central Bank of Tunisia)

Billets de tresorerie Commercial paperBons d'Equipement Treasury Bonds (Government bonds)Bons du Tresor Treasury billsCD Certificate of depositCENT Caisse d'Epargne Nationale Tunisienne

(National Savings Bank)CMT Complexe Mecanique de TunisieCNEL Caisse Nationale d'Epargne-Logement

(Housing savings fund)CPG Compagnie des Phosphates de GafsaEmprung national Savings bondsGC Groupe ChimiqueIRC Imp6t sur les revenus des creances

(Tax on income from credit)IRVM Imp6t sur les revenus des valeurs mobilieres

(Tax on income from marketable financial instruments)PPG Public and publicly guaranteedSNCFT Societd nationale des chemins de fer tunisiens

(National Railways company)STEG Societe tunisienne de l'electricit6 et du gaz

(Electricity & Gas Company of Tunisia)STIA Socidt6 tunisienne d'industrie automobile

(Tunisian automobile industry)VAT Value added taxUNDP United Nations Development ProgramWPI World Price Index

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

COUN1TRY DATA SIINZT FOR 1988

General

Area (km2) (Thou.) 163.6

Population (millions) 7 8Growth rate (latest decade) 2.6% p.a.

Density (per kW2) 91

Social Indicators

Population CharacteristicsCrude Birth Rate (per 1000) 32Crude Death Rate (per 1000) 9

HealthInfant Mortality (per 1000 live births) 8Population per Physician (Thou.) 3.6Population per Hospital Bed (Thou.) 0.5

Income Distribution (% of national income)Highest Quintile N.A.Lowest Quintile N.A.

Distribution of Land OwnershipX Owned by Top 10% of Owners N.A.% Owned by Smallest 10% N.A.

Access to Safe WaterX of Total Population 89% of Urban Population 98X of Rural Population 79

Access to Electricity I/X of Total Population 34X of Urban Population 68X of Rural Population 6

NutritionCalorie Intake as X of Requirements 111%Per Capita Protein Supply (g/day) 77

EducationAdult Literacy Rate (%) 62%Primary School Enrollment(X of relevant age group) 118%

1/ Latest figures available are for 1975.

-OSS m Lrr -

1988 1988 Armnutl Growth Rate- 2 n.a. 1980 Price?)

US$Z4 % of GNP 1976-81 1981-86 1987 1988

GNP at Mtarket Prices 9536 100.0 6.22 3.3Z 5.7Z 1.41Gross Domestic Investmbnt 1914 20.1 6.6X -4.3t -9.5% -8.92Gross National Savings 1937 20.3 11.98 -7.1X 37.4X -2.4%Current Account Balance 23 0.2Exports of Goods & NFS 4732 44.4 8.52 1.4Z 14,0% 19.52Imports of Goods & RIS 4227 44.3 10.8S -2.4X -4.22 16.2%GNP per capite (US$M) 1210

WTPUT, 8ELOIn, A PRD EaTVITY

Value Added F.C. Labor Forcein 1988 in 1988

UM$M 2 of Total Thousands 2 of Total

Agriculture 1174 13.4 481 24.4Industry 2e92 33.1 678 34.4Services 4667 53.5 811 41.2

Total/Average 8734 100.0 1970 100.0

w_v ne

Central GovernmentMill. Diners 2 of GDP

1988 1988 1983

Current Receiits 2482 28.8% 31.2XCurrent Expenditures 2011 23.32 25.3X

Current Surplus 471 5.5% 5.9XCapital Expenditures 934 10.8% 13.92

MHNEY, CREDIT, AND F8ICES

1983 1984 1985 1986 1987 1988 (November)(millions of Dinars, outstanding, end of period)

I

i Money Supply 1/ 2431 2715 3091 3266 3713 4137Credit to Government 354 451 554 627 721 616

* Credit to Economy 2558 2908 3381 3635 3878 4148

* 1983 1984 1985 1986 1987 1988! (percentage or index numbers)

Money as I of GDP t/ 44.2 43.5 44.7 46.5 46.4 47.9General Price Index (CPI) (1980-100) 136.6 148.0 159.5 169.3 183.3 196.4Annual parcentege changes in:General Price Index (CPI) 9.5 8.4 7.8 6.2 8.2 7.1Credit to Government 15.5 27.3 23.0 13.2 15.0 -14.6Credit to Economy 19.9 13.7 16.3 7.5 6.7 7.0

BALANCE aF PAYMTS

1984 1985 1986 1987 1988(millions of USS)

Exports of Goods & NFS 2721.04 2699.94 2721.91 3374.08 4232.21Imports of Goods & NFS 3659.24 3207.07 3363.98 3490.41 4226.74Resource GOp (doficlt = -' -933.21 -50?.13 -e42.07 -11'43 5,47

Interest Payments -264.28 -269.29 -330.56 -357.73 -420.25Otber Net Factor Payments 10.03 -82.42 -91.10 -111.44 -82.08Net Private Transfers (incl. WR) 317.07 270.22 358.82 486.91 519.77of which: Workers' Remittances 316.56 270.58 361.59 486.30 511.63

Current Account Balanceexcl. Net Official Transfers -875.39 -588.62 -704.91 -98.59 22.91

Net Official Transfers 28.58 36.55 40.55 34.51 52.33Current Account Balaceincl. Net Official Transfers -846.81 -552.07 -664.36 -64.08 75.24

Direct Private Foreign Investment 205.97 139.48 155.04 92.31 110.47Net MLT Loans (DRS) (excl. IMF) 358.47 307.56 265.00 61.93 60.05Disbursements MLT PPG 767.58 744.39 785.51 718.51 805.38Repayments MLT PPG 409.11 436.82 520.51 656.58 745.33

Other LT inflows NG (net) 82.00 24.51 3.96 -24.30 9.30

Other Net Capital & Capital n L .i. 50.65 -32.13 48.04 50.58 93.79Total Change in net reserves 149.72 112.64 192.32 -116.45 -348.84

Gross Reserves (incl. Gold) (IFS) 463.95 293.85 378.40 616.03 985.00

1/ Money and quasi-money of Monetary Survey only.2/ Change in net reserves from Tunisian BOP; including use of IMF Credit.

r25 UDI8G P2YRS (AVAGF. 1984-88)

Value(millions of USS) I of Total

Agriculture 132.9 6.7Fuel 567.6 28.9Phosphates 32.7 1.7Manufactured Goods 1231.9 62.7

Total Merchandisc 1965.1 100.0

kmTE w

Annual Averages End Period1986 1987 1988 Jan.-Mar.1989 March 1989

USS1.00 - Tunisian Dinars 1.2594 1.2067 1.1658 1.0711 1.0502Tunisian Dinar 1.00 - US$ 0.7940 0.8287 0.8578 0.9336 0.9522

ESTE=&L MT, D UXmEI 31, 1988

US$M

Public Debt, incl. Guaranteed 5776.6Ron-Guaranteed Private Debt 235.0Use of IMF Credit 276.8Short-term 274.7

Total Outstanding & Disbursed 6563.1

DEBT SERVI R3O FM 1s8

Percentage

Public Debt Dncl. Guaranteed (incl. IMF) 23.7Pon-Guaranteed Private Debt 1.2

Total OutstandLng & Disbursed t/ 25.3

1/ Including Interest payments on abort-term debt.

iDiIDA LMDB (12/31/8S) (IIS)

ZDRD IDA

Outstanding & Disbursed 1019.0 62.1Undisburs*d 689.2 0.0

Tot,sj Outstanding inl. Undisbursed 1708.2 62.1

REPUBLIC OF TUNISIA

COUNTRY ECONOMIC MEMORANDUM:THE ROAD TO AN OUTWARD-ORIENTED ECONOMY

TABLE OF CONTENTS

Page no.

COUNTRY DATA

MAP IBRD 18707

SUMMARY & CONCLUSIONS .i... . . . . . . . . . . . . . . . . . . .

I. ECONOMIC DEVELOPMENT: 1980-1986. . . . . . . . . 1A. The 1970s: Oil Exports and a Growing Public Sector . . . . . . 1B. 1980-84: Nearing Crisis . . . . . . . . . . . . . . . . . . . 3C. 1985-86: Avertir,g Crisis . . . . . . . . . . . . . . . . . . . 7D. Growth Performance .10

II. STABILIZATION AND ADJUSTMENT .. 11A. The Need for Change . . . . . . . . . . . . . . . . . . . . . 11D. Thc R-sou-ce Pcsition . . . . . . . . . . . 12C. 1987-89: Growing Exports and Declining Domestic Absorption . 14

III. POLICY REFORMS FOR IMPROVED ECONOMIC EFFICIENCY . . . . . . . . . . 22A. Outline of the Reforms ......... ... .. ... .. . 22B. The Reform Program ............ .... ..... . 22C. Creating Competition .......... .... ... ... . 31

IV. INVESTMENT WITH ECONOMIC ADJUSTMENT . . . . . . . . . . . . . . . . 39A. The Issues of Lower Investment & Higher Efficiency . . . . . . 39B. Public Sector and Household Investment . . . . . . . . . . . . 41C. Private Enterprise Investment ... . . . . . . . . . . . . . . 44D. The ICOR and Efficiency Gains ... . . . . . . . . . . . . . . 53

This report is based on the findings of an economic mission, whosemembers were: Mr. S. Rahim (mission leader and author of the mainreport); Mrs. M. de Melo (author of Annex 1); Mrs. A. Akin-Karasapan (co-author of Annex 3 and the Appendix to the main report); Ms. S. Razamara(responsible for Annex 4, co-author of Annex 3 and the Appendix to themain report); Mr. G. Caprio (author of Annex 2); Mr. J. Parks (co-authorof Annex 3); and Mr. B. Hubert, who covered private sector investment.The main mission took place in February/March 1989, with subsequentmissions occurring in October 1989 and January 1990.

REPUBLIC OF TUNISIA

COUNTRY ECONOMIC MEMORANDUM:THE ROAD TO AN OUTWARD-ORIENTED ECONOMY

TABLE OF CONTENTS

Page no.

V. MACROECONOMIC POLICIES FOR THE MEDIUM TERM: 1989-1997 . . . . . .55A. The Policy Framework . . . . . . . . . . . . . . . . . . . . . 55B. Macroeconomic Balances .... . . . . . . . . . . . . . . . . 61C. Summing Up .6.6.. . . . . . . . . . . . . . . . . . . . . . . 66

APPENDIX I: A DECOMPOSITION OF TUNISIA'S CURRENT ACCOUNT BALANCE:1980-1988 ......................... . 69

TILES

Thble 1 Economic Performance: 19701.979 . . . . . . . . . . . . . . . ITable 2 Budget and Current Account as percent of GDP . . . . . . . . . 2Table 3 Resource Balances and Current Account

as percent of GDP: 1980-1984 . . . . . . . . . . . . . . . . . 4Table 4 Financing of the Current Account

in US$ Million: 1980-1984.. 5Table 5 Central Government Budgets as percent of GDP: 1980-1984 . . . 6Table 6 Wages and Prices: 1985-1984 . . . . . . . . . . . . . . . . . 7Table 7 Resource Balance and Current Account

as percent GDP: 1984-1986 . . . . . . . . . . . . . . . . . . 7Table 8 Financing of the Current Account in US$ Million: 1984-1986 8Table 9 GDP Growth in percent: 1980-1986 . . . . . . . . . . . . . 10Table 10 GDP Growth in percent: 1986-1989 . . . . . . . . . . . . . . 14Table 11 Resource Balance and Current Account Deficit

as percent of GDP: 1986-1989 .. 15Table 12 Financing of the Current Account in US$ Million: 1986-1989 16Table 13 Budget and Current Account

as percent of GDP: 1986-1989 . . . . . . . . . . . . . . . . 18Table 14 Fixed Investment by Agent as percent of GDP: 1980-1988 . . . . 42Table 15 Budget and Current Account as percent GDP: 1988-1997 . . . . 59Table 16 Fixed Investment by Agent as Percent of GDP: 1988-97 . 62Table 17 Resource Balance and Current Account Deficit

as percent of GDP: 1988-1997 .. 63Table 18 Fi:.ancing of the Current Account in US$ Millions: 1988-1997 . 64Table 19 GDP Growth in Percent: 1988-1997 . . . . . . . . . . . . . . 66

.

l

SUMMARY AND CONCLUSIONS

The Maior Issues

1. Tunisia has surmounted the difficulties brought on by largemacroeconomic imbalances in the early 1930s and is now addressing the issuesof the efficiency and level of investment, on which macroeconomic stabilityand economic growth will in the long run depend. The imbalances were notcharacteristic of economic management in Tunisia; rather they were the outcomeof domestic political circumstances leading to high l,els of investment andrapid consumption growth at a time when earnings from oil exports werefalling. Normally macroeconomic management has been prudent and this prudencehas reasserted itself since 1986, when the balance of payments came close to acrisis. The issue now is to achieve adequate sustained rates of growth ofconsumption and employment while maintaining macroeconomic stability.

2. The main condition for such long term growth is an improvement inthe efficiency of investment. If the 5-year non-oil ICOR is taken as anindicator, there was a substantial decline in the efficiency of investment inthe late 1970s and early 1980s, when this ICOR rose over 6 from levels ofaround 4 in the early and mid-1970s. This was manifested in levels of fixednon-oil investment of around 30 percent of GDP from the mid-1970s to 1984,without a noticeable acceleration in the rates of economic growth or jobcreation. Such high levels of investment, and even big increases in realwages and consumption, could be financed as long as Tunisia's earnings fromoil exports continued to increase, as they did through the late 1970s. But,when these earnings began to fall after 1980 and Tunisia failed to cut backits expenditures, large current account deficits developed that could not besustained. With an efficiency of investment that results in an ICOR over 6,adequate growth rates require rates of saving and external capital inflow thatwould be hard to sustain.

3. A considerable improvement in efficiency can be achieved throughreforms aimed at making the economy more outward oriented and at increasingthe role of the private sector. This is the major objective of the program ofecoromic reforms that the Government began to formulate in 1986. The programhas been constantly broaderv-d since, despite an easing of economic pressuresbecause of an unexpectedly good performance by the economy. Both the deficiton the balance of payments current account and that on the budget have beenmuch smaller than they were before 1986. And lower investment does not yetappear to have noticeably affected economic growth, though transitory factors,especially droughts, have.

4. But investment has fallen lower than compatible with long rungrowth and employment creation, given the probable limits to efficiencyimprovement, and, unless it recovers, the economy will increasingly facecapacity constraints. In particular, private investment declined continuouslyfrom 1983 until it increased modestly in 1988. Although fixed investment willnot need to reach the same shares of GDP as in the early 1980s, it will stillneed to be around 23-24 percent of GDP to yield long run annual growth rates

- ii -

of around 5 percent, whereas it has been around 18-20 percent. The increasewould have to come from the private sector, since the Government's policy ofincreasing the private sector's economic role also implies limiting publicsector investment. The chnllnga for the Tunisian authorities is to attaintheir policy objective in a manner that induces private enterprises toincrease their investment to almost double its present share in GDP over themedium. term.

Macroeconomic Management: The Ouest for Stability

5. The fall in investment and the tight restraint on wages andconsumption, which started in 1985, were the effect of resource scarcities,which had been developing since 1980 and threatened to get worse. Oil exportearnings had begun to decline in 1980, initially because of the depletion ofTunisia's reserves and later because of the fall in world oil prices. Withthis decline, cutbacks ': diomestic expendituye and a devaluation became moreand more necessary, but E' : postponed. As a result, the current accountdeficit varied between 4. and 10.9 percent of GDP from 1980 to 1984 and,since the government drew revenue from oil that declined with the value of itsexports, budget deficits were also high, ranging from 3.4 to 7.6 percent ofGDP. Over the same period the ratio of external debt to GDP rose from 40percent to 51 percent and the debt service ratio from 14 percent to 22percent.

6. It was clear that if the trend continued the balance of paymentswould be in crisis. By 1985 the Government had begun encouraging andfacilitating exports, cutting back on investment, limiting wage increases,reducing the budgetary cost of consumer subsidies, and devaluing the Tunisiandinar. But bad harvests due to poor rainfall and the drop in world oil pricesbrought the economy close to crisis in 1986, from which it escaped onlythrough more drastic measures: imports were severely curbed, governmentinvestments were sharply reduced, and the Tunisian dinar was devalued again,this time by 10 percent. By the end of 1986 Lhe real effective exchange ratewas 17.5 percent below its level at the end of 1984.

7. Since then the balance of payments has recovered unexpectedly welland the budget deficits have also improved. Exports played a large part, butso did a fall in domestic absorption. The measures taken in 1985 and 1986 ledto a rapid growth of exports of manufactures, which is continuing, and allowedtourism to expand considerably as well. Exogenous circumstances helped; apartfrom strong world demand and the absence of the violence in the region thathad deterred tourists before, there was a large unanticipated inflow ofvisitors from neighboring countries in 1988. The average rate of growth ofexports of manufactures in 1987 to 1989 was 16 percent p.a. and that oftourism 24 percent p.a.. The deficit on the current account, which had risento 10.9 percent of GDP in 1984 was stij1 8.3 percent in 1986. fell to0.9 percent in 1987 and was slightly in surp.us in 1988, despite a disastrousdrought that year necessitating increased food imports. The counterpart tothe growth of exports was a gradual decline, between 1984 and 1988, in thevolume of domestic absorption as a result of restraint on consumption, mainly

- iii -

due to wage restraint, and a decline each year in the volume of fixedinvestment. Imports consequently also declined in volume, except for a spurtin 1988 to meet tourist demand. In 1989 the number of visitors fromneighboring countries fell sharply and continued drought renewed the need forlarge food imports, but the current account deficit was kept to 3.8 percent ofGDP, a level Tunisia has no difficulty to finance. Although the improvementof the deficit of the government budget over the period 1986-89 was not asmarked, it still fell to around 4 percent of GDP.

8. The growth of exports was strong enough to prevent the restrainton consumption that began in 1985 from causing a serious drop in GDP growth,though weather remained a major determinant of output. Over 1980-84 domesticconsumption had grown fast, on average at 6.9 percent p.a., whereas GDP annualgrowth rates ranged around 5-7 percent if the drought year 1982, when GDP fellslightly, is left aside. An excellent harvest in 1985 kept GDP growth at5.6 percent, despite a drop in consumption growth to 2.9 percent. Thedifficult year was 1986, when world oil prices fell, drought caused a badharvest, and rapid growth of exports had not yet begun. Once this difficultpassage had been navigated the situation eased, though consumption continuedto be restrained. Exports of manufactures and tourism became majordeterminants of growth in industry and services, and the pattern of economicgrowth was, to a large extent, the combination of growth due to exports inthese sectors and fluctuations, due to weather, in growth in agriculture.When there was good rainfall, as in 1987, growth was high overall, and whenthe drought occurred in 1988, causing a 24 percent loss in agriculture output,growth still remained positive (1.5 percent). In 1989 there was a shrinkageof tourism, because the number of visitors from neighboring countries fellwhile traditional tourism grew slowly, and consequently the services sectorstagnated. With another drought preventing a rebound in agriculture, GDPgrowth of 3.0 percent was largely due to growth of exports of manufactures,though consumption grew faster than population (at 2.8 percent) for the firsttime since 1985.

Policy Reform: The Ouest for Efficiency

9. At the same time that it grappled with the immediate pru'lems ofthe balance of payments and budget, the Government began to address the longerterm issue of the economy's overall efficiency. Over time, but especiallywhen oil gave the State large amounts of revenue, the Tunisian economy hadbecome highly protected and regulated, with a large and growing public sector.This was an environment that made private investment attractive, since itassured good financial returns, but it was not conducive to efficiency, sinceit gave small scope to competition or price signals. Through elaborateadministrative controls over prices, imports, entry into economic activity,and the allocation of resources, the authorities attempted to reconcilenumerous competing interest, in particular protecting producers arnddistributors from competition while protecting the consumer from exploitationby monopolies. Since the authorities also aimed to keep inflation moderateand to prevent a big external debt burden, at least during the 1970s, seriousmacroeconomic imbalances did not occur. In fact the system was more

-iv -

successful than might have been expected during the 1970s in permitting highi economic growth, a considerable expansion of non-oil exports, remarkably high

levels of education and health services, and a distribution of incomeconspicuously more even than in most developing countries.

10. A return to the status guo ante was ruled out by deterioration inTunisia's resource position since 1980 and by the difficulty of applying theold dirigiste policies in the more complex economic environment of today.Comparing Tunisia's external resource position in 1986 with that in 1980, theloss of earnings from oil exports amounted to 10.4 percent of GDP and the debtservice ratio had risen from 13.9 percent to 27.9 percent. The external debtalso included a substantial amount of bank loans and suppliers' credits, whic'were unlikely to be repeated until the country's longer term prospectsimproved, especially given the cautiousness of banks in a time of world-widedebt problems. The budget was also affected: government revenues from oilfell from 6.0 percent of GDP in 1980 to 5.6 percent in 1986, and the fallwould have been greater but for the depreciation of the Tunisian dinar. Thebudgetary cost of servicing government debt rose at the same time from3.7 percent of GDP to 9.0 percent.

11. Tunisia also faced more complex problems than it had faced in theearly 1970s, when the panoply of administrative controls had appeared to workwell. Apart from the fact that the economy became more complex as it evolved,there were now a number of enterprises of low efficiency in both the privateand the public sectors. Thus public enterprises, as a rule, were unable togenerate sufficient resources to carry out investment, and the gross budgetarytransfers to them for investment and to cover operating losses in 1986 reached11.8 percent of GDP, far above the revenues the Government received from theenterprises. Numerous private firms were protected from import competitionthrough import restrictions, raising doubts about their real contribution tothe nation's income. The system for protecting the poor had also becomecostly and inefficient, price subsidies on several basic items of consumptionand fertilizers had reached the equivalent of 3.3 percent of GDP in 1986, butbenefited the not-so-poor more than the poor. Furthermore, Tunisia would indue course need to regain access to international financial markets and toattract foreign investment since the inflow of official assistance that itcould reasonably expect would not suffice for its longer term development.Given the smallness of its own markets, its success would be determined by howmuch the economy opened up.

12. To achieve the greater efficiency it aims for, the Government hasdirected its reforms primarily to making the economy more outward oriented andexpanding the role of the private sector. This implies allowing morecompetition, both within the economy and from abroad, and consequently theremoval of many administrative controls that have restricted competition. Thereforms allow greater scope to price signals, notably through the decontrol ofdomestic prices and the replacement of import restrictions by tariffs. As anecessary accompaniment, the direct and indirect tax systems have beenundergoing reform as well. Administrative controls had been especially tightin the financial sector; but the pace of reform has been such that only a few

v

controls remain that need to be removed, and competition is now coming fromthe development and diversification of financial and capital markets.

13. The main ways that administrative controls restricted competitionwere by creating barriers to entry into economic activities and by interferingwith the operation of the price system. One barrier to entry that has beenremoved is the need for prior authorization of investment, which not onlyconstituted a major bureaucratic obstacle to investors, but failed to allocateinvestment efficiently. Another barrier to entry, the requirement for priorCentral Bank authorization for most loans, has been dropped as part of thereforms of the financial sector. On the other hand, entry into wholesaledistribution is still tightly controlled and, apart from unnecessarilyprolonging the need for control over distribution prices to protect consumers,this discourages investors who may fear becoming captive to one group ofsuppliers or distributors. Anti-trust legislation is under preparation as anecessary complement to measures to allow free entry into economic activities.

14. Since controls over domestic prices protected consumers frommonopolistic practices by suppliers while restrictions on imports protectedenterprises, and therefore jobs, from external competition, the decontrol ofdomestic prices and the removal of import restrictions need to be combined insuch a manner as both to allow imports to create competition and to giveenterprises the opportunity to adjust to the new competition. Decontrol ofproducer prices began in 1988 as the first of several stages in theGovernment's program to remove controls on all but a handful of these pricesby 1991. Decontrol of wholesale margins is similarly scheduled to occur instages to cover at least 50 percent of prices by 1992. Import tariffs havebeen reduced to a maximum of 41 percent and their range has been narrowed.The Government's program is to reduce the maximum tariff further to 35 percentover the medium term. However, most domestic production is protected fromexternal competition by import restrictions, so that the Government's program,to remove these restrictions on all but a handful of subsidized consumer goodsand luxuries before the end of 1992, faces considerable resistance. To giveenterprises that can do so viably the opportunity to restructure to facecompetition from imports, and thus reduce opposition to trade liberalization,the import restrictions can be replaced by temporary, supplementary tariffs,exactly as the Government envisages for infant industries. The Government isalso establishing anti-dumping and safeguard procedures to protect domesticproducers against unfair foreign competition, though it is important thatthese procedures not be used as a disguised form of protection.

15. Taxation has undergone major reform to reduce distortions and tosimplify taxes, though some distortions remain and will need to be removedover the medium term. A valued added tax was introduced for production otherthan agriculture in July 1988 and was extended to all wholesale, except inbasic foodstuffs, in October 1989. Its extension to large-scale retail isunder study. But there are, in addition, consumption taxes that were kept toavoid an immediate shortfall in revenue and which are to be gradually narrowedto a few luxuries. A new direct tax law took effect from January 1, 1990.Its maximum rates are lower than in the previous system, but its incidencewould be broader. The highest marginal rate of 35 percent on personal incomes

- vi -

is much below the highest rate of the old tax, but fringe benefits that wereexempt before are now being taxed. The corporate tax has been reduced to tworates, a normal rate of 35 percent, and a low rate of 10 percent foragriculture, small scale enterprises, and certain special ventures, such asretail cooperatives. This new law simplifies direct taxation, which will makeit easier to tax professional incomes and profits that escape taxation. Butthe gain is limited by the existence of several schemes of special investmentincentives in various sectors, which provide a diversity of tax coneessions.Not only do these schemes perpetuate the distortions the new tax is designedto remove, but they compete among themselves in attempting to attractinvestment, without a clear overall gain.

16. Reform in the financial sector has gone far to transform what wasa limited and closely regulated sector to one in which competition anddiversification are becoming increasingly important. The Government now facesthe delicate task of fostering competition between banks while enabling thebanks to provision adequately for the numerous low quality loans theyaccumulated before the reforms. The main reforms have been to drop therequirements for Central Bank authorization, which applied to the great bulkof lending; to free interest rates, with the major exception of a cap on banklending spreads; and the development of a money market. A new environment hasresulted in the financial sector with much greater scope for competition thanin the past, but, so far the banks have tended to be cautious and even toenter into cartel arrangements to keep deposit rates down.

17. Competition in banking must above all consist of innovation and asearch for a wider range of customers. The money market, itself, impliescompetition through innovation, since the certificate of deposit andcommercial paper that it offers did not exist before 1988 in Tunisia andcompete directly with bank deposits. As it is extended and secondary marketsfor longer term securities are revived and expanded, the bariks as a whole willface more competition. They will need to diversify their services, includingbecoming active in the new financial markets. They will also need to bebolder in their search for borrowers. Here they are inhibited by the cap ontheir lending spreads over the money market rate, which confines them just tosafe, low cost borrowers and needs to be removed, or at least relaxed. Banksalso appear to be cautious in their lending, because they already havesubstantial low quality loans and are risk averse. They are now provisioningfor these loans much faster than before, but the tax treatment of provisionsis ungenerous, despite recent improvements, and should be revised to encourageprovisioning more.

Private Investment: Decline and The Need for Recovery

18. In addition to the increase in efficiency and labor intensity ofinvestment, and the changes in the incentive structure these reforms willbring about, there will be an increase in efficiency brought about by a risein the share of private enterprises in total investment. At present privateinvestment is low as a result of a persistent decline since 1983, althoughthere was a modest recovery in 1988. The issue is to stimulate a strong

- vii -

recovery within the context of the reform program. If private investment doesnot recover sufficiently, apprehension over the consequences for economicgrowth and employment will strengthen pressures to halt or reverse thereforms. But an increase in investment, whether private or public sector,without an improvement in efficiency would mean that Tunisia had failed toadjust to the loss of its oil export earnings and its greater debt burden.

19. Although the initial decline in private enterprise investment in1984 was due to resource scarcities, the persistence of the decline since hasbeen due largely to uncertainties associated in the minds of entrepreneurswith the changes in the economic policy environment, as well as to weakdomestic demand and difficulties in obtaining financing. The uncertainty overthe Government's policy objectives on the medium term level of importprotection to be expected could be removed by a clearly enunciatedliberalization program. A schedule for the removal of individual importrestrictions could be prepared and announced, and the procedures governingtemporary supplementary tariffs and infant industry protection could bespecified clearly.

20. With its liberalization policies made fully explicit and betterunderstood by the public, the Government could stimulate investment on abroader basis. Although investment in export activities, where policies arebetter established and where demand has been strong, has been growing rapidly,it is still too small a part of total investment to generate adequate growthand employment by itself. Domestic demand has been weak, as seen from thefact that total consumption had been growing more slowly than population since1985, until in 1989 it grew slightly faster. As the medium-term analysis inChapter V indicates, per capita consumption could be allowed to grow at around2 percent p.a. in real terms, which could be achieved by allowing modestincreases in the real wage. But this presupposes that import competinginvestment occurs in a framework that ensures its economic efficiency.

21. Financing has also been a problem for many investors, especiallythe small ones. Banks tend to be averse to risk and are encouraged in this bythe cap on lending spreads, which limits the range of their clients, and bythe large amount of borrowing by the Government, which provides an alternativesource of income that is both safe and remunerative. On the other hand equityfinancing is discouraged by lax accounting requirements for enterprises andthe consequent lack of reliable information on enterprise finances for theshareholders not controlling the enterprise. The supply of equity is alsosmall because of a strong tendency for investments to be made by families orgroups of investors. Removing the cap on lending spreads, or at leastrelaxing it, would encourage banks to be more active in seeking small and lesswell established clients. The adoption of better accounting practices couldbe encouraged by downgrading loans to enterprises that do not meet specificstandards, thereby discouraging bank lending to these enterprises.Privatization of public enterprises could be used to provide a supply of newequity and stimulate the stock market. The development of this market isalready being helped by an IFC/UNPD training program.

- viii -

Medium-Term Prospects

22. Analysis of Tunisia's medium-term prospects indicates that thecountry would attain its objective of adjusting to the loss of oil exportearnings and its higher external debt service by an increase in efficiency interms of a gradual decline of the 5-year ICOR from its level of over 6 in theearly 1980s to around 4 in the mid-1990s. A gradual increase in the CDPgrowth rate from 4.5 percent in 1991 to a steady 5.0 percent in the mid-1990swould be achieved with a level of total investment moderately higher than therate of 19 percent of GDP in 1988. Part of the decline in the ICOR would bedue to an increase in the share in GDP of private sector investment, whilethat of public sector investment would fall. And part would also be due tochanges in relative prices, notably the rise in real interest rates that hasoccurred as part of the banking sector reforms and the increase in the cost ofcapital relative to wages due to the devaluation of the Tunisian dinar in1986.

23. The lower level of investment needed to achieve the above growthrates, as compared to the levels in the late 1970s and early 1980s, wouldresult in current account deficits small enough for Tunisia's debt indicatorsto improve steadily. Tunisia's non-interest current account would be close tobalancing after 1991 and the current account itself, after reaching3.4 percent of GDP in 1990, would decline slightly to 2.6 percent in 1995.External debt would decline to 48 percent of GDP in 1995 and the debt serviceratio to 16.6 percent, from 66.5 percent and 26.F percent respectively in1990. Since a balance on the non-interest current account is equivalent to azero net resource transfer, Tunisia's external debt will grow in nominal termsover the medium term, though declining relative to GDP and exports. Much ofthe growth will be from borrowing in financial markets as the country regainsaccess in the coming years on the basis of its good credit standing.

24. Because of the decline in oil revenues, there will be greaterpressure to restrain budget deficits by limiting transfer for publicenterprises and price subsidies. Creating money to finance the deficits isruled out by the smallness of the money base and the consequent risk of highinflation. The alternative of reducing the deficits by increasing taxation orreducing recurrent expenditures are inherently difficult in Tunisia. Anotheralternative, devaluation of the dinar, had a favorable net budgetary effect inthe past, but is unlikely to have one in the future. This is due to factthat, on the one hand, the positive effects of devaluation on revenues will beless as dollar denominated budgetary oil revenues will continue to decline andimport taxes have been reduced since 1986, and, on the other hand, the adverseeffects of devaluation on foreign debt service will offset the positiveeffects. Consequently, the size of the deficit must be determined taking intoaccount the economic costs of financing through borrowing and of lowertransfers for public enterprises. The costs of borrowing are primarily thepotential crowding out of private investment and the risk, if government debtis allowed to grow large, of economic instability. The cost of lowertransfers to public enterprises is postponement of the economic benefits ofrestructuring. Price subsidy reductions are politically sensitive, but more

- ix -

efficient targeting could reduce the financial cost and the politicalsensitivity.

25. It may seem trite to say that Tunisia must increase the efficiencyof its investment to grow faster, but this reflects the fact that the countryhas, through good management and a modicum of luck, avoided falling into manyof the difficulties that other developing countries face. Now Tunisia isbetter protected from exogenous uncertainties, other than the weather, thanmost developing countries, and its future economic development will thereforebe determined directly by the policies pursued. It is not expected to requiredebt relief, so it is free of the associated uncertainties over resourceflows; most of its debt is at fixed interest rates, so it is not sensitive tointerest rate changes; and oil is no longer a major export, so there is lessrisk of terms of trade effects. One major uncertainty is rainfall, whichdetermines a large part of agricultural production. Analysis of the effectsof a single drought comparable to that of 1986 indicates that GDP growth wouldbe reduced for a year and that the deficits in the current account of thebalance of payments and on the budget would increase briefly. However, theeffects of the resulting increased debt would be insignificant. The impendingeconomic unification of Europe in 1993 and the recent changes in EasternEurope are new sources of uncertainty, whose effects on investment, especiallyin export activities, cannot yet be predicted. The uncertainty is, however,at the moment the same for all countries that rely on the European market andmay result in gains as much as in losses to these countries. It will be theeconomies that can most quickly seize opportunities and adapt to circumstancesthat will make the most of the gains. This apart, however, and if droughtsare not frequent or as severe as in 1988, with appropriate economic policiesTunisia can look forward to acceptable increases in per capita consumption andemployment over the long term.

CHAPTER I

ECONOMIC DEVELOPMENT: 1980-1986

A. THE 1970s: OIL EXPORTS AND A GROWING PUBLIC SECTOR

1. The 1970s were a period of marked progress in which growing Stateactivity was assisted by substantial earnings from oil. The annual growth ofthe economy averaged 7.4 percent and was well distributed over the sectors.Manufacturing grew at 11.0 percent and agriculture at 5.4 percent. By 1979the share of manufacturing in GDP had reached 11.6 percent and of agriculture13.5 percent. Consumption grew at an average of 8.0 percent p.a.. Greatemphasis was placed on social development and the results were equallystriking. Between the late 1960s and 1980, the number of absolute poordeclined from 33 percent of the population to 12.9 percent, infant mortalityfell from 131 to 83 per thousand, life expectancy at birth rose from 54 to 62years, and the average calorie intake rose from 96 percent to 111 percent ofminimum standard requirements. Adult literacy rose from about 24 percent to62 percent and the gross reproduction rate declined from 3.2 percent to2.4 percent.

Table I

Economic Performance: 1970-79

Average AnnuaL Average AnnuaL Share of Manuf. Share of Exports Oil exports asgrowth rate of GDP growth of consumption in GDP in X in GDP in X X of GDP

in X p.a. in X 1970 1979 1970 1979 1970 1979

7.4 8.0 8.4 11.6 22.0 39.0 3.5 12.1

2. That these results were achieved vithout serious macroeconomicimbalances was due to prudence in macroeconomic policy and the windfalls fromrising oil prices. Investment, which was the main source of economic growth,rose from about 20 percent of GDP to about 30 percent over the decade, whileconsumption also grew rapidly. Yet there was sufficient restraint to avoidhigh inflation and balance of payments problems. Deficits on the balance ofpayments current account averaged 3.5 percent of GDP, which Tunisia couldfinance sustainably, except for a brief episode in 1976-78, when, followingdeclines in the world prices of phosphates and oil, they ran at 9-11 percentof GDP. This performance was helped by an almost uninterrupted decline in thereal effective exchange rate. The bulk of the financing came from officialsources, mostly on concessional terms. Otherwise a significant portionconsisted of direct foreign investment by oil companies corresponding to grossfixed capital formation in oil extraction. Tunisia increased its recourse tofinancial markets in 1976-78, but was saved, by the resurgence of oil pricesin 1979, from making the difficult choice between increasing its external debt

- 2 -

on market terms and sharply cutting expenditures, which restored the currentaccount to its normal levels. In that year oil exports were equivalent to12.1 percent of CDP.

3. Emerging from the 1970s it seemed that the economic policiespursued had been remarkably successful. Nonetheless, there were alreadyindications that presaged difficulties. The most striking feature of thesepolicies was the pervasive influence exercised by the State, both as aneconomic agent itself and in controlling economic activity. The State's roleas an economic agent grew through the decade. Budget expenditures increasedfrom about 26 percent of GDP at the beginning to over 34 percent towards theend. Nor was this increase entirely due to increases in oil revenues, sinceroughly half the increase of government revenues from about 22 percent of GDParound 1970 to 29 percent in 1979, arose from increased non-oil revenues.Both recurrent and capital expenditures from the budget increased, the formerrising from 17 percent of GDP to 20-21 percent and the latter from 9 percentin 1970 to a peak of 14 percent in 1977 before declining to 13 percent in1979. Thus Tunisia became a high tax economy with the State playing a large,direct role. The State also played a major indirect role through the rapidlygrowing public enterprise sector. Precise data are not available, but it iscertain that well over half of gross fixed capital formation of the economy inthe late 1970s was accounted for by the budget or by public enterprises.Budgetary restraint was, however, by and large maintained: deficits were keptto 3-4 percent of GDP, except for the period 1975 to 1978, when they ranged ashigh as 8 percent, the greater part being financed in most years from externalborrowing, while borrowing from the Central Bank remained negligible.

Tabte 2

Budaet and Current Account as percent of GDP el

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979

Governvment Revenues 22.8 21.7 21.0 22.4 23.0 24.9 24.2 25.6 27.4 29.1Govermnent Net Expenditures a/ 26.5 26.0 23.4 26.0 26.2 29.5 30.5 33.4 34.5 33.2Overall Net Deficit -3.7 -4.3 -2.5 -3.6 -3.2 -4.7 -6.3 -7.9 -7.1 -4.2

Current Accowit Deficit -6.5 -2.4 -1.9 -3.5 -0.2 -4.9 -9.3 -11.1 -9.8 -4.8Real Effective Exchange

Rate (WPI) (1980=100) b/ 121.1 124.9 122.9 121.6 110.5 120.0 117.6 115.8 108.2 101.1

a/ Expenditures net of amortizationsb/ Decrease implies depreciation

4. The State's regulatory role matched this trend. Investment wasdirected into favored activities by a combination of widespread importcontrols, high tariffs, requirements for approval by the Investment PromotionAgency, and the need for Central Bank credit authorization. In numerousactivities entry was restricted to avoid duplication. Elaborate pricecontrols were used to prevent monopoly rents. An extensive system ofsubsidies was used to provide the most commonly used foods and :ertilizers atlow and stable prices. Wages were determined through a bargaining processbetween the State and the trades unions, with the public sector leading theway. And enterprises were obliged to set up committees with workers'representation in a complex system that depended on the enterprises' size. Asocial security system evolved, to which employers and workers contributed,and, though, on the whole, it functioned well, it had distortionary effectsbecause enmployers' contributions were determined by locality so as to giveincentives to investments in less developed areas. The fact that such asystem did not run into difficulties earlier was largely due to the highquality of the civil servants and their success in spreading the benefitsacross the population so as to avoid extreme concentrations of wealth andcorresponding poverty.

B. 1980-84: NEARING CRISIS

5. Despite the satisfaction over what had been achieved, someeconomists in the Government were aware that major problems had developed.First, it had been foreseen that oil extraction would begin to diminishbecause the depletion of reserves and the growth of domestic consumption wouldmake Tunisia a net importer around 1991. Second, it was apparent that anumber of industries were economically inefficient or in financialdifficulties. Some were highly protected assembly operations, such as themotor car assembly plant, STIA, and the tractor assembly plant, CMT. Butthere were also the phosphate mining and related chemical enterprises 'CPG andGC), major industries based on low grade ores that made losses when worldprices were depressed. Third, there was the stubborn problem of unemployment,which was estimated at about 13 percent, and which especially affected youngentrants into the labor force. In part, at least, it could be blamed on thecapital intensity of the public sector investments. But the growth of thelabor force of around 3.0 percent p.a. raised disquieting questions for thefuture.

6. Around 1980, at the time of the preparation of the 6th Plan(1982-1986), the economic planners proposed to respond to the situation bycutting back on investment, restraining the growth of budgetary expenditures,increasing the emphasis on exports, and promoting more labor intensiveinvestment. These were adopted as objectives of the Plan (1982-1986) but inpractice they were not pursued until balance of payments difficulties becameimminent. From 1980 to 1984 investment continued at around 30 percent of GDPand budgetary expenditures reached 41 percent of GDP. The exchange rate

- 4 -

appreciated 4 percent in real effective terms and major public sectorinvestments were initiated with little economic justification or permanentemployment effect.y

Table 3

Resource Batances and Current Account as percent of GDP: 1980 - 1984

1980 1981 1982 1983 1984

Gross Domestic Saving 24.0 23.8 21.2 20.9 20.3Investment 29.4 32.3 31.7 29.5 32.0Resource Balatce -5.4 -8.5 -10.5 -8.6 -11.7Exports GNFS 40.2 41.3 36.9 35.4 33."Import GNFS 45.6 49.8 47.4 44.0 45.6Net Factor Income P -3.3 -3.6 -3.6 -3.3 -3.2Net Private Current Transfers ' 4.0 4.4 4.7 4.4 4.0Current Account Deficit -4.7 -7.7 -9.4 -7.5 -10.9

Memo item:Total Debt/GDP kJ 40.5 42.9 46.5 50.3 51.1Total Debt/Debt Service Ratio 13.9 15.2 16.1 19.2 22.3TotaL Debt service (X of GDP) 6.2 7.1 6.9 7.8 8.7

Real Effective Exchange RateIndex (CPI) 1980=100* 100.0 99.1 98.5 97.4 97.3

a/ Workers remittances are included under Current Transfers.b/ Including PPG, IMF, MLT non-guaranteed and short-term debt.* Decrease implies depreciation.

7. The period was one of growing macroeconomic imbalances, much as in1976-1978, except that the economy was not saved from the need for austeritymeasures by an increase in oil prices. On the contrary, the fall in oilprices when the balance of payments was tight in 1985 and 1986 made recoveryconsiderably harder. Although GDP growth in 1980-84 declined to an average of4.5 percent per annum, both private and government consumption continued togrow rapidly to give an annual average growth of total consumption of6.9 percerLt. Gross domestic saving fell from 24 percent to 20 percent of GDP.With investment hovering around 30-32 percent of GDP, the resource gap widenedto 11.7 percent of GDP, which was reflected in a steady increase In imports

V Using the wholesale price index to deflate. Using the consumer priceindex, there was real effective depreciation over this period. This isthe only period when the two measures of the real exchange rate moved inopposite directions and reflects the growing importance of pricecontrols and subsidies in keeping the prices of the main articles ofhousehold consumption down.

while exports stagnated in volume and there was virtually no change in theterms of trade. The resource gap was partly compensated by an increase inworkers' remittances to around 4 percent of GDP, a little more than interestoa external debt, so that net factor incomes generated a small surplusthroughout the period. As a consequence, the deficit on the current accountreached a maximum of 10.9 percent of GDP in 1984.

Table 4

Financing of the Current Account in USS Mittion: 1980 - 1984

1980 1981 1982 1983 1984

Current Account Deficit -414.1 -649.1 -767.4 -603.3 -875.4Net Direct Foreign Investment 236.1 367.2 402.2 223.8 206.0Official Grants 41.5 20.3 19.0 25.3 28.6Amortization Payments PPG El -247.0 -315.6 -288.7 -375.6 -407.7Multilateral Gross Disbursement s 81.6 108.0 119.7 130.1 113.8Bitateral Gross Disbursement 241.5 273.9 253.2 236.0 371.1Private PPC Grass Disbursement 250.5 274.2 251.2 538.4 283.5Others ti -156.3 13.3 37.9 -189.6 130.4Change in Gross Reserves -33.7 -92.1 -27.1 14.7 149.7(- implies increase)

a/ Including IMF.b/ Others are net disbursement of short term debt, MLT non-guaranteed and capital NEI.

8. The financing of the deficits entailed greater recourse tointernational financial markets, with two major consequences: Tunisia becamevulnerable to the impending world debt crisis and its debt indicatorsdeteriorated. Borrowing from private sources, namely financial markets andexport credits, had in fact increased in 1978, when the current accountdeficit was large, and 1980-84 merely continued the trend. The cumulativetotal of the current account deficits in 1980-84 came to US$3,309 million andgross disbursements from private sources were 39.4 percent of this, i.e.,US$1,304 million. But by 1984 Tunisia began to experience, as had othercountries already, effects of the world debt crisis on the financial markets.In 1983 disbursements from private sources had reached a peak ofUS$465 million as compared to US$20 million in 1975, but in 1984 they droppedto US$251 million. The borrowing from private sources was reflected in thedebt service ratio, which rose from 12 percent in 1979 to 22 percent in1984.Y Already, nearly 6 percentage points of this increase were due to

1 If exports had continued to grow in volume at the rate of the previousfive years, the same debt service would only' have been 13 percent oftheir value.

- 6 -

private lending, though it accounted for only about 24 percent of debtoutstanding and disbursed in 1984. The increase of over 4 percentage pointsfor servicing of debt owed to official sources reflected the gradualaccumulation of such debt, high world interest rates, and the lapses of graceperiods, more than an increase in borrowing.

Table 5

Centrat Government Sudgets as Percent of GDP: 1980 - 1984

1980 ¶981 1982 1983 1984

Total Revenues 28.8 29.3 32.0 31.6 34.0

Government Expenditures s 32.2 34.6 37.9 39.2 40.7Government Consumption f 13.4 13.0 14.6 14.7 14.5Government CapitaL Expenditure 12.4 12.4 12.9 13.9 14.9Interest Payments 1.6 1.6 '.8 1.9 2.1Other Expenditures (inc. Transfers) 4.9 7.7 8.6 8.7 9.3

overall Government Net Deficit 3.4 5.2 6.0 7.6 6.7Foreign Net Borrowing 0.9 2.3 3.8 5.0 3.6Domestic Net Borrowing 2.5 2.9 2.2 2.6 3.1

a/ Expenditures net of amortizations.b Government Consumption incLudes Salaries and Consumption of Goods and Services.

9. The excessive growth of demand was propelled mainly by rapidgrowth of public sector expenditures and wages, although by 1984 efforts werebeing made to curb them. Total government budgetary expenditures grew in realterms at an average of 8.9 percent, current expenditur4s alone growing at9.8 percent. Revenues grew almost as fast, at an average of 7.9 percentannually in real terms. The overall deficit, after having been reduced to3.4 percent of GDP in 1980 from the excessive levels of 1976 to 1978, reached7.6 percent of GDP in 1983, and 6.7 percent in 1984. The high level of grossinvestment was maintained to a great extent by the growth of investment bypublic enterprises as well as by investments from the budget. Together theygrew in real terms at 3.4 percent p.a.. The rapid growth in privateconsumption that accompanied the growth of government consumption and ofinvestment, arose from steep real wage increases. In 1983 the average realwage was 23 percent above its level in 1979 (using the CPI) and the nominalwage had almost doubled. Some of the real increase had been due to budgetarysubsidies on food (deflating by the WPI gives a smaller increase--17 percent),but attempts in 1984 to reduce the subsidies by raising prices provokedwidespread protests. Nonetheless, the increase in nominal wages wasrestrained that year and the real wage fell 6 percent.

-7 -

Tabte 6

Wages arnd Prices: 1980-84

1980 1981 1982 ,l9U 194

Average Annual Nominal Wages in Dinars 1201 1408 1740 1976 2015Real Wages Index: 1980 a 100 (CPI) 100.0 107.7 117.1 122.0 114.7CPI Growth Rate in X 2 10.0 8.9 13.7 9.0 8.5WPI Growth Rate in X V 10.8 12.5 16.9 6.6 7.1GDP Deflator Growth Ratio in X 12.8 11.4 16.0 9.3 7.3

I_J CPI and UPI from International Financial Statistics - IMF.

C. 1985-86: AVERTING CRISIS

10. In 1985 and 1986 the Government took strong measures to preventthe imbalances from precipitating a balance of payments crisis. Grossreserves at the end of 1984 were down to seven weeks' imports and werefalling. With the volume of oil exports 30 percent below its peak of 1980 andworld oil prices beginning to weaken, it was likely that financial markets,already concerned by the worsening debt problems of the d.'veloping countries,would revise their ratings of Tunisia's creditworthiness f the currentaccount deficit were not quickly reduced. In the event, ;he Government'smeasures succeeded in sharply reducing the deficits and tiereby induced thefinancial markets to maintain their lending.

Table 7

Resource Batance and Current Account as cercent GDP: 1984-86

1984 1985 1986

Gross Domestic Saving 20.3 20.4 15.9Investment 32.0 26.5 23.5Resource Balance -11.7 -6.1 -7.6Exports GNFS 33.9 32.6 30.9Imports GNFS 45.6 38.7 38.5Net Factor Income -3.1 -4.3 -4.8Net Private Current Transfers P 3.9 3.3 4.1Current Account Deficit -10.9 -7.1 -8.3

a Workers, Remittances are included under Current Transfers

- 8 -

11. Several exogenous factors considerably affected the outcome, somefavorably and others unfavorably. The main favorable circumstance was theunprecedentedly good agricultural performance in 1985, thanks to abundantrain, which reduced the import of foodstuffs by US$134 million 1. ow theamount in 1984. Another favorable development was a jump of 24 percent in thevolume of tourism which had steadily declined since the peak in 1980 to alittle above the previous peak, resulting inman increase of US$38 millioLu inearnings over 1984. Otherwise circumstances were unfavorable. Oil priceswere beginning to weaken and, with the loss in output, caused oil exportearnings to drop by US$74 million. A dispute, which has since been resolved,with Libya led to the repatriation of 30-35,000 Tunisian workers from thatcountry and the loss of that export market. Workers' remittances in 1985 wereUS$46 million below the 1984 level. 1986 was an especially hard year.Tourism declined marginally because of disturbances in the region; and droughtcaused an exceptionally poor harvest, which raised food imports byUS$28 million over the 1985 level and reduced GDP by 1.6 percent in realterms. Worst of all was the decline in oil prices, leading to a further lossof US$295 million in oil exports in 1986. Oil price movements were primarilyresponsible for a terms of trade loss of 1.6 percent of GDP in 1985 and anadditional 3.8 percent in 1986.

Table 8

Financing of the Current Account in USS Million: 1984-86

1984 1985 1986

Current Account Deficit -875.4 -588.6 -733.5Net Direct Foreign Investment 206.0 139.5 155.0Official Grants 28.6 36.5 40.6Amortization Payments PPG 1) -407.7 -435.1 -498.4Multilateral Gross Disbursement 1/ 113.8 157.9 421.4Bilateral Gross Disbursement 371.1 250.1 218.4Private PPG Gross Disbursement 283.5 317.3 310.1Others ti 130.4 9.8 69.7Change in Gross Reserves 149.7 112.6 16.7(- implies increase)

Memo Items:

Total Debt/GDP S 51.1 59.1 67.1Total Debt Service Ratio 1 gy 22.3 24.5 27.9

Real Effective ExchangeRate Index (CPI) 1980 = 100* 97.3 96.7 82.9

a/ Including PPG, IMF, MLT non-guaranteed and short-term debt.b/ Others are net disbursements of short term debt, MLT Non-Guaranteed and

capital NEI.c/ Total Debt including MLT non-guaranteed and short term debt._/ Debt service ratio is calculated over exports of goods and services including

Workers' Remittances.* Decrease implies depreciation. i

-9-

12. The Government's actions consisted of restraint on expendituresand more direct actions to promote exports and restrict imports. Restraint onexpenditures resulted in a fall in the resource gap from 11.7 percent of GDPin 1984 to 6.1 percent in 1985 and 7.6 percent in 1986. This was achievedpartly by a fall in investment, from 32.0 percent of GDP in 1984 to23.5 percent in 1986, the main cause of the fall being the reduction ingovernment's capital expenditures, whose share in GDP fell from 14.9 percentin 1984 to 12.1 percent in 1986. Direct government investment fell littlerelative to GDP, but investment by public enterprises, which depended heavilyon budgetary transfers, fell a: ruptly; in 1986 it was 30.4 percent less inreal terms than in 1984. Private investment had already begun a decline in1983 that was to last to 1987. Although wage restraint continued and theaverage real wage in 1986 was 4.8 percent below that of 1984, which wasalready below that of 1983, the effect on total expenditures was lessstriking. Private consumption in 1985 was 63.0 percent of GDP, slightlyhigher than the average share in the previous five years, and, because of thefall in GDP in 1986, its share that year rose to 66.7 percent, which explainsthe rise of the resource gap. But private consumption's growth slowed downfrom the average rate of 6.8 percent over 1980 to 1984 to 2.6 percent in 1985and 1.0 percent in 1986. Government consumption showed a similar trend andeven declined slightly in 1986.

13. More direct action on the balance of payments consisted ofmeasures to promote exports, though the need for immediate results promptedthe Government to apply extensive import restrictions, which have since beenrelaxed. The export promotion measures set the stage for sustained rapidgrowth of exports, the benefits of which were mainly felt in later years. Ofthese the most important was the depreciation of the Tunisian dinar in 1985and 1986, including the devaluation by 10 percent in nominal terms, in August1986, bringing the real effective exchange rate at the end of 198617.5 percent below its level at the end of 1984. Other measures taken in 1985consisted of the elimination of most export licenses (except for subsidizedgoods), partial elimination of export taxes, and a variety of measuresregarding, among other things, customs formalities, extension of temporaryadmissions, financing, repatriation of earnings, export credit insurance, andthe establishment of export companies. Some effects were felt in 1986, butthe drop in oil prices and depressed world demand for phosphates reduced theaggregate effect. Total exports increased at only 3.3 percent p.a. in volumeterms in 1985 and 5.2 percent in 1986, while the dollar value in 1986 was thesame as that of 1984. Both agricultural and manufactured exports grewsubstantially and, as already mentioned, tourism picked up. The drop inimports was more striking. Their volume fell 13 percent in 1985 and a further2 percent in 1986, so that their value in 1986 was US$267 million less than in1984. As was to be expected, the main fall was in capital goods imports,which in 1986 were around US$200 million less than in 1984. However, thevolume of consumer goods also declined 12 percent and, though the volume offood imports in 1986 was almost as high as in 1984, Tunisia was able to obtainthem for US$106 million less. The rapidity of the fall in imports was due tothe use by the authorities of their import controls to restrict the volume ofimports. This use of import restrictions for balance of payments purposes

- 10 -

soon became superfluous because of the Government's demand management and wasabandoned, though import restrictions for protective purposes remain common.

D. GROWTH PERFORMANCE

14. Taking the period 1980 to 1986 as a whole, Tunisia maintained agood growth performance, but not sufficient to accommodate high levels ofinvestment, rapid growth of consumption, loss of oil export earnings, andincreased debt servicing without a large resource gap. The GDP grew onaverage at 3.8 percent per annum and, if the two drought years 1982 and 1986are excluded, annual growth rate ranged between 4.7 percent and 7.4 percent.The performance of agriculture was particularly striking; the sector grew atan average of 3.3 percent per annum, even though it declined 12.2 percent inthe last year, 1986. The success is largely attributable to non-cerealproduction, whose growtn stayed around 4.8 percent a year, while cerealproduction fluctuated according to rainfall. As was to be expected,manufacturing grew faster, averaging 7.8 percent a year, whereas mining barelygrew at all. The average annual growth of services was 4.5 percent. Thegrowth in volume of exports of goods and non-factor services was slow,1.2 percent per annum on average, but in these aggregate figures the growth ofmanufactured exports of 6.4 percent a year on average is masked by declines inoil and tourism. Both private and government consumption grew rapidly.Private consumption grew at an annual average of 5.3 percent, so that it was19.7 percent higher per capita in 1986 than in 1979 in real terms. Governmentconsumption grew still faster, at 5.8 percent. Since aggregate consumptiongrew at a higher annual average than GDP, the gross domestic saving ratedropped from 24.4 percent of GDP in 1979 to 15.9 percent in 1986, its lowestlevel since the 1960s.

Tabte 9

GDP Growth in Dercent: 1980-86

Average1980 1981 1982 1983 1984 1985 1986 80-86

Gross Domestic Product m.p 7.4 5.5 -0.5 4.7 5.7 5.6 -1.6 3.8Agriculture 9.9 6.5 -10.3 2.5 12.9 17.4 -12.2 3.3Industry 9.0 6.8 0.1 6.7 3.8 1.8 -0.5 3.9of which:

Manufacturing 15.2 12.4 2.8 8.3 6.7 5.0 4.8 7.8Mining (incl.Phosphate) 4.7 -2.4 -4.8 8.9 -1.5 -3.0 0.2 0.2

Services 7.7 6.6 2.4 3.8 5.1 4.8 1.3 4.5Consumption 12.7 7.4 3.8 4.9 6.0 2.9 0.6 5.4Gross Domestic Investment 0.9 15.1 -0.7 -2.2 8.7 -12.6 -18.3 -1.9Exports GNFS 0.0 3.5 -6.9 0.9 2.7 3.3 5.2 1.2Imports GNFS 4.5 13.0 0.9 -2.2 5.7 -13.0 -2.1 0.7

- 11 -

CHAPTER II

STABILIZATION AND ADJUSTMENT

A. THE NEED FOR CHANGE

15. Since 1986 there has been a reversal in Tunisia's balance ofpayments situation, but the basic issue that confronted the economy that yearremains: unless investment becomes more efficient, growth rates comparable tothose of the late 1970s and early 1980s will require levels of investment thatwill only be achievable through a combination of higher saving rates andgreater capital inflows that will be hard to sustain. Part of the balance ofpayments improvement was due to a decline in total expenditures in real terms,including a drop in investment. As was seen in Chapter I, in the late 1970shigh levels of investment and of consumption, including the Government's welldeveloped social services, were possible because of the earnings of oilexports. In the early 1980s, when these earnings diminished, the sameexpenditures resulted in current account deficits that could not have beenfinanced had they continued. Moreover, the investment was too capitalintensive to bring down Tunisia's persistent high rate of unemployment. Wereinvestments to continue at the previous levels of efficiency and capitalintensity, any effort to generate high economic growth rates through highlevels of investment would necessitate large current account deficits or adrop in consumption, neither of which is likely to be feasible for any lengthof time. The condition, therefore, for generating economic growth that willmaintain increasing per capita consumption and reduce unemployment is thatinvestment become more effici.ent and less capital intensive.

16. Already by 1986, the awareness that the old policies were notcoping with some major problems had turned into a recognition of the need forextensive policy reform. The formulation of new policies began that year andevolved in 1987 and 1988 into a broad medium-term program of economicadjustment. The magnitude of the change that had to be effected could begauged by comparing 1986 with 1980. Between these two years, the decline inoil export earnings and the growth of debt servicing had been substantial andalso affected the government budget. It is true that 1980 was not an averageyear since oil exports were at their highest then, but it was the culminationof a trend of increasing oil earnings and, as has been seen, both aggregateexpenditures and the efficiency of investment in the late 1970s and early1980s were more in line with the resources of that year than with those of theyears that followed.

- 12 -

B. THE RESOURCE POSITION

17. A level of efficiency had to be reached that would maintain anacceptable rate of economic growth despite the change in Tunisia's externalresource position, and all that it implied for the public finances, due to theloss of earnings from oil exports and the increase in external debt. Oilexports had dropped from US$1,347 million in 1980 to US$428 million in 1986, aloss equivalent to 10.4 percent of GDP and to 33.8 percent of exports in thelatter year. Over the same period external debt had increased from US$3,541million to US$5,918 million. The ratio of this debt to GDP increased from40.5 percent to 67.1 percent, but, more telling, since it expresses the actualcost in resources, is the ratio of external debt servicing to GDP, which rosefrom 6.2 percent to 9.9 percent. The ratio of the debt to exports rose from90.5 percent to 190.2 percent and the debt service ratio went from13.9 percent to 27.9 percent.

18. Both the loss of oil export earnings and the higher debt serviceaffected the budget. Government revenues from oil stagnated; in 1980 they hadbeen the equivalent of US$522 million, whereas in 1986 they wereUS$494 millionY Measured as a percentage of GDP, the loss was mitigated bythe devaluation of 1986. Nevertheless, these revenues went from 6.0 percentof GDP to 5.6 percent. The Central Government accounted for a high proportionof external borrowing, in addition to which it guaranteed servicing of nearlyall the external debt of the rest of the economy, most of which was owed bypublic enterprises, which often called upon the government to fulfill itsguarantee. External debt servicing in the budget became, as a result, a majorbudgetary expenditure. It already had exceeded the overall deficit in 1980,when it was the equivalent of 3.7 percent of GDP, as compared to 3.4 percentfor the deficit. By 1986 it had become 8.9 percent of GDP whereas the deficitwas 5.5 percent. In dollar terms, the increase was from US$322 million toUS$790 million.

19. Domestic government borrowing constituted almost all of theremainder of the financing of the budget deficit since there was practicallyno borrowing from the Central Bank.V Much the greater part consisted of theissue of Treasury bonds (Bons d'eauipement) with maturities of 10 years.Otherwise this borrowing consisted of a small amount of saving bonds (Emnruntnational) introduced in 1986; loans from the National Saving Bank (CENT); and

This relatively small fall, as compared to the fall in oil exportearnings, is due to the revenue sharing agreements with theinternational oil companies that extract and export the oil.

The budgetary effects of government borrowing are analyzed in more depthin Annex 1.

- 13 -

.

use of the float of the postal checking systom and deposits with the Treasury,the last being mostly by state-owned institutions. Roughly half the bondswere held by the deposit banks, which are obliged to hold up to 20 percent oftheir deposits in this form, and roughly a quarter were held by the statesocial security system, which, too, was obliged to hold them. Leaving asidethe borrowings from the Treasury and postal checking system, on which nointerest was paid, the domestic debt of the government rose fromTD 421 million in 1980 (11.9 percent of GD2) to TD 1,102 million (15.7 percentof GDP) in 1986, by when interest payments had reached TD 63 million, or0.9 percent of GDP.

20. Two other major categories of budgetary expenditures developedthat do not directly affect Tunisia's aggregate resource position, butrepresent economic inefficiencies and have since proved difficult to reduce.One was the transfers to public enterprises to cover a variety of uses,including operating subsidies, financing of liabilities, and investmentY In1986 they amounted to TD 828 million, equivalent to 11.8 percent of GDP. Theother was the price subsidies on a number of widely consumed items, of whichcereals were by far the most important, but which included sugar, vegetableoil and fertilizers. In 1986 they were TD 207 million or 2.9 percent of GDP.

21. The changes in Tunisia's resource position between 1980 and 1986that have been described are not a typical case of "external shock", eventhough they were the result, directly and indirectly, of the loss of earningsfrom oil exports (see Annex 1). First, the direct loss to the balance ofpayments and the budget from the fall in earnings from oil exports occurredafter these earnings had been high for a relatively brief time. As can beseen in Table 1, oil export earnings more than tripled their share in GDPduring the 1970s. Moreover, the decline in oil extraction that began after1980 had already been foreseen in the late 1970s. But, as shown in Chapter 1,expenditures had risen to match the resources made available by oil.Consumption and investment, both private and government, had risen to levelsthat entailed substantial balance of payments and budgetary deficits when theearnings from oil fell and led indirectly to a worsening of Tunisia's resourceposition through an ac imulation of external and domestic debt. Second,unlike many other counv--ies that suffered major losses of earnings because ofexternal circumstances, Tunisia maintained its economic growth and, as will beseen in the next section, greatly improved its balance of payments and budgetdeficits in the years after 1986.

However, since money is fungible, the budgetary classifications do notsuffice to determine the amounts in each use.

- 14 -

C. 1987-89: GROWING EXPORTS AND DECLINING DOMESTIC ABSORPTION

22. External trade. The unexpectedly strong export performance thatunderlay the improvement of the resource balance was attributable mainly tothe devaluation in 1986 and the Govermnent's actions to promote exports, whichtogether enabled the economy to take advantage of the strong demand in OECDmarkets. Total exports grew 42 percent in volume over 1987-88. All theimprovement was due to manufactures and tourism, while primary productsdeclined in volume, as expected, because of the diminution of oil extraction.Not only did the volume of exports of manufactures, which were 43 percent ofexports of goods and non-factor services, grow rapidly, by 21 percent in 1987and by 16 percent in 1988, but they became less concentrated on textiles(including apparel) and chemicals (phosphate fertilizers) than in the past.Textiles grew 21 percent in volume over the two years and chemicals25 percent, but their growth was outdone by machinery, which grew by40 percent and other manufactures, which grew almost fivefold. The combinedshare of machinery and other manufactures thus rose from 17.3 percent ofmanufactured exports in 1986 to 22.5 percent in 1988. The growth of tourismwas even faster. The number of visitors grew 39.3 percent in 1987 and83.8 percent in 1988, though this exaggerates the actual volume growth in 1988since there was that year a large and unforeseen number of visitors from Libyawho spent few nights in Tunisia. These visitors came mainly to purchase goodsand services that were scarce in their own country (e.g., spices, repairs ofvehicles and appliances) and are estimated to have spent about US$400 million.The decline in exports of primary products had been foreseen since theseexports consisted largely of oil, whose extraction had been declining.

Tsble 10

GDP Growth in percent: 1986-89

1986 1987 1988 1989(preLm)

GDP -1.6 5.8 1.5 3.0AgricuLture -12.2 17.5 -23.9 4.1Industry -0.5 -0.2 2.3 3.3

of which:Manufacturing 4.8 4.1 6.9 6.8Mining (incl. phosphate) 0.2 -3.9 -1.2 -0.8

Services 1.3 6.5 8.2 2.6Consumption 0.6 1.2 1.1 2.8Gross Domestic Investment -18.3 -11.7 -19.7 30.9Exports GNFS 5.2 14.2 24.5 -1.3Imports GNFS -2.1 -5.7 16.2 11.1

- 15 -

23. Imports stagnated in 1987 but, in 1988 they rose sharply becauseof the input requirements of the burgeoning exports and the poor agriculturalresults. In 1987 the only significant change in the volumes of the differentcategories of imports was a 28 percent drop in the volume of imports ofcapital goods. In 1988 food imports rose 50 percent, accounting for41 percent of the total volume increase in imports. Imports of other consumergoods rose 18 percent in volume, of which a substantial part was for purchasesby tourists, in particular the visitors from Libya. Imports of intermediategoods in 1988 and imports of capital goods rose for the first time since 1984,though the capital goods imports remained below the volume of 1986.

l

24. GDP growth and absorption. Overall GDP growth in these two yearswas primarily the outcome of the different effects of strong export growth,restrained domestic demand, and extreme variations in climatic conditions.Exports, including tourism, were responsible for most of the growth ofmanufacturing and services since domestic consumption grew slowly andinvestment declined. In contrast, agricultural production fluctuated as aresult of climatic conditions. In agriculture the recovery in 1987, due toexceptionally good rainfall, from the poor results caused by drought in 1986added 2.3 percent to GDP. In contrast, drought and a locust invasion in 1988caused a drop in agricultural production equivalent to 3.5 percent of GDP.The drought was the worst in fifty years and caused losses to trees andlivestock that will be felt for several years to come. For instance, aboutone third of Tunisia's almond trees died and water reserves were seriouslydepleted. On top of this, locust swarms invaded the Maghreb countries andcaused extensive damage in the south of Tunisia. Mining production in Tunisiacontinued to decline as a result of the depletion of oil reserves.

TabLe 11

Resource Balance and Current Account Deficit as oercent of GOP: 1986-89

1986 1987 1988 1989(prelim)

Gross Domestic Saving 15.9 19.3 19.3 19.4Investment 23.5 20.3 18.8 23.9Resource Balance -7.6 -1.0 +0.5 -4.5Exports GNFS 30.9 35.1 42.5 41.9Imports GNFS 38.5 36.2 42.0 46.4Net Factor Income -4.8 -4.8 -5.0 -4.7Net Private Current Transfers Al 4.1 5.0 5.6 5.4Current Account Deficit 8.3 -0.9 +1.1 -3.8

a/ Workers' remittances are inctuded under Current Transfers.

- 16 -

25. Total expenditures at constant prices fell in both years and, eventhough the falls were reflected in an improvement in the resource gap, theyaroused concern in Tunisia because they were due to falls in investment, whichmore than offset the small increases in consumption. Consumption grew at lessthan the population growth rate to give a considerable increase in the savingrate from 16 percent in 1986 to over 19 percent in 1987-88. Underlying thiswas continuing wage restraint, which led to a fall in real average salaries of2.9 percent in 1987 and a rise of 1.2 percent in 1988.P' The fall ininvestment was partly due to the Government policy of bringing public sectorinvestment down. But the disquieting aspect was that investment by privatefirms and households also fell each year. Private enterprise investment hadfallen every year but one since 1981, so that its volume in 1988 was barelyhalf that of 1981, while household investment, mainly consisting of housing,had fallen since 1984. Since the Tunisian authorities had expected privateinvestment, in particular by enterprises, to increase so as to provide theeconomic growth and employment that were foregone by the declining publicsector investment, the issue of how to revive them became a major policyconcern. It is discussed in Chapter IV.

Table 12

Financing of the Current Account in USS Million: 1986-89

1986 1987 1988 1989(prelm)

Current Account Deficit -733.5 -81.6 106.1 -385.4Net Direct Foreign Investment 155.0 92.3 104.9 125.0Official Grants 40.6 34.5 46.6 62.5Amortization Payments PPG 2 -498.4 -663.2 -673.0 -756.2MultilateraL Gross Disbursement 421.4 335.7 355.7 573.7Bilateral Gross Disbursement 218.4 216.4 338.3 425.6Private PPG Gross Disbursement 310.1 182.3 210.8 180.9Others J 69.7 53.0 -91.0 -71.4Change in Gross Reserves 16.7 -169.5 -398.5 -154.7(- implies increase)

Memo Items:

TotaL Debt/GOP I 67.1 70.3 66.5 70.3Total Debt Service Ratio g 27.9 28.1 23.3 25.7

Real Effective ExchangeRate Index (CPI) 1980 = 100* 82.9 71.2 69.9 69.8

a/ Including IMF.bo others are net disbursements of short term debt, MLT Non-Guaranteed and

capital NEI.c/ Including PPG, IMF, MLT non-guaranteed and short-term debt.d/ Debt service ratio is calculated over exports of goods and services including

Workers' Remittances.* Decrease implies depreciation.

These figures used the CPI as deflator. Using the WPI gives smallincreases.

- 17 -

26. External debt. The reduction in external borrowing consequent onthe improvement in the balance of payments has begun an improvement of debtindicators that is expected to continue. Net disbursements of PPG loansdeclined substantially, from US$452 million in 1986 to US$71.2 million in 1987and increased to US$231.8 million in 1988. This was largely due to a drop inborrowing from private sources, whose net disbursements became negative,-US$134 million in 1987 and -US$88 million in 1988. The debt to GDP ratioreached its highest level in 1987, partly as a consequence of the devaluationin 1986, and then declined in 1988. The debt service ratio declined in 1988,while the ratio of debt to exports, which had reached 190.2 percent in 1986fell to 137 percent in 1988.

27. Government budget. Although further progress was made in reducingthe Government's overall budget deficit, it was limited on the one hand by thedecline in revenue relative to GDP and, on the other, by difficulties incompressing transfers for public enterprises and consumer subsidies. Thescope for increasing tax revenues has been narrow because of reforms oftariffs and indirect taxation that the Government has been implementing aspart of its adjustment program and which are discussed in Chapter III.Moreover, the Government has been reluctant to increase tax rates, since theyare already high in Tunisia, and has preferred to rely on better collection,which would be facilitated by the reforms it is implementing or preparing.Tariffs on imports were reformed in 1987 to bring the maximum tariff down to41 percent from over 200 percent in 1986. A value-added tax onnon-agricultural production was introduced in July 1988, and, until it hasbeen firmly established, which includes extending it to distribution, raisingits rates will be difficult. The Government is also currently preparing areform aimed at simplifying direct taxation and lowering rates, which willmake it easier to improve collection. Direct tax rates are high, but, becauseof problems of collection, the yields in Tunisia are well below those of mostmiddle-income countries.

28. These reforms, the stagnation of imports in 1987, and declines innominal revenue from direct taxes, have been largely responsible for the slowgrowth of total revenues in nominal terms. In 1987 the nominal increase intax revenues was negligible, a small increase in the indirect tax revenues,largely from domestic sources, being offset by a decline in direct taxes.There was a small increase in total nominal revenue due to non-tax revenues.These revenues accounted for 27.5 percent of total revenues in 1986, and halftheir increase came from the effects of the devaluation of 1986 on oilrevenues, which constituted roughly half of non-tax revenues. In 1988 taxrevenues increased in nominal terms largely because the new VAT yielded higherrevenues than the taxes it replaced, whereas most of the revenue effect of theincreases in imports was offset by the reduction in tariffs. Direct taxrevenues fell again by a small amount, while non-tax revenues increased, withoil revenues once more yielding half the increase.

- 18 -

29. Restraint on government consumption and investment continued in1987 and 1988, but transfers to public enterprises and consumer subsidiesincreased in the latter year enough to result in a higher deficit than in1987. The main restraint on government consumption was on the salary bill,which fell from 11.1 percent of GDP in 1986 to 10.6 percent in 1987 and 1988.In each year the increase in the nominal average salary was below theinflation rate, while the increase in government employment over the two yearswas 4.4 percent. Nominal expenditures on goods and services also grew lessthan the inflation rate. Among the government's capital expenditures, directinvestment by the State fell from 4.1 percent of GDP in 1986 to 4.0 percent in1988.?] The remaining capital expenditures were mainly transfers to publicenterprises, which, together with current transfers to these enterprises,declined in nominal terms to fall from 11.8 percent of GDP in 1986 to7.9 '.ercent in 1987. But in 1988 they rose again to 9.3 percent of GDP.Consumer subsidies, rose sharply in 1988 after what appeared to be a promisingstart in reducing them the previous year. The outlay in 1987 wasTD 197 million, after having been TD 207 million in 1986, but the coincidenceof droughts in Tunisia and in the US obliged Tunisia to purchase unusuallylarge amounts of cereals at a time of high prices, raising the outlay in 1988to TD 273 million.

Table 13

Budget and Current Account as percent of GDP: 1986-89

1986 1987 1988 1989(prelm)

Government Revenues ;1.9 29.7 30.7 30.1

Government Net Expenditures / 37.4 32.8 34.7 34.2Government Consuption kI 15.1 14.3 14.1 14.2Government Capital Expenditures 12.1 9.1 9.4 7.6Interest payments 2.7 2.9 3.0 3.2Other Expenditures (inci. Transfers) 7.5 6.4 8.1 9.3

Overall Net Deficit 5.5 3.0 3.9 4.2Foreign Net Borrowing 3.0 0.7 1.7 2.0Domestic Net Borrowing 2.5 2.3 2.2 2.2

Current Account Deficit -8.3 -0.9 +1.1 -3.8

a/ Expenditures net of amortizations.b/ Government Consunption includes Salaries and Consumption of Goods and Services.

These figures exclude local authority investment, which was about0.5 percent of GDP in 1988.

- 19 -

30. Virtually none of the deficit was financed by borrowing from theCentral Bank, though there was increased recourse to domestic borrowing.Gross of amortization, the deficit in 1987 was TD 702 million, and in 1988,TD 840 million, while domestic financing was TD 353 million andTD 373 million, respectively, as compared to TD 317 million in 1986. Net ofamortization, domestic borrowing financed over 78 percent of the deficit in1987, and about 58 percent in 1988. However, largely because interest rateson domestic debt were lower than on external debt, domestic debt servicing wasonly 32 percent in 1987 and 1988 of the total budgetary cost of debtservicing, which was 9.2 percent of GDP in both years.

31. Monetary policy. The improvement in the balance of paymentspermitted an increase in reserves while prompting the Central Bank to reducethe liquidity in the economy. At the same time the monetary authorities tookthe first major steps in the reform of the financial sector. In 1986, theCentral Bank had increased its net credit to financial institutions byTD 160 million as foreign exchange reserves were used to finance the currentaccount deficit. By the end of that year gross reserves had fallen to1.3 months' imports. But in 1987 there was a jump in the liquidity of theeconomy (deposits, capital accounts, and certain other items) fromTD 288 million in 1986 to TD 508 million, to which the Central Bank respondedby reducing net credit to financial institutions by TD 140 million. In 1988there was, nonetheless, a further increase in liquidity to TD 615 million andthe monetary authorities reduced their credit to financial institutiolns by afurther TD 283 million. These decreases were accompanied by smaller falls inCentral Bank credit to the Government. By the end of 1988 foreign exchangereserves had risen to 2.8 months' imports. Inflation was also restrained; thegeneral consumer price index rose 7.2 percent in 1987 and 6.3 percent in 1988.Nevertheless, the financial system was highly liquid still and enabled theGovernment to finance its deficits through borrowing from the banks and thepublic without squeezing out private borrowing; the money market rate, atwhich the Central Bank accommodates the liquidity requirements of the depositbanks, fell from around 11 percent in late 1987 to 8.5 percent in late 1988.The fall in the cost of bank loans was greater, because certain taxes on loanswere reduced or eliminated (see paragraph 106). These were years of extensivechange in the way the financial sector operated, discussed in paragraphs 52 to58 and in greater depth in Annex II.

32. The economy in 1989. The data are preliminary, but they indicatethat the modest economic growth of 3.0 percent in 1989 has owed more to anincrease in domestic consumption than it has for several years: agriculturaloutput stayed low because of another drought while the unusually rapid growthof exports of 1988 could not be maintained. A recovery of agriculture to anaverage level would have added 2 percent to GDP, but the actual growth of4 percent adds only 0.6 percent. Neither exports of goods nor tourism couldhave been expected to repeat the growth of 1988, though exports nfmanufactures have been growing faster than the rather cautious forecast of the

- 20 -

Tunisian authorities. This and a slightly bigger increase in consumption thanin 1988 have allowed most branches of manufacturing to maintain their 1988growth rates. The exceptions were the food industry, which was affected bythe repetition of drought, and chemicals, which lost some exports ofphosphatic fertilizers because of market disturbances. Traditional tourismgrew modestly, though, in view of how much tourism in other Mediterraneancountries suffered in 1989 from a drop in British tourism and the bicentennialcelebrations in France, Tunisia seems to have fared well. The disappointmentwas that the number of Libyan visitors and their expenditure fell more thanhad been expected. As compared to an expenditure of TD 430 million in 1988and a forecast of TD 230 million in 1989, the actual expenditure in 1989 wasonly TD 130 million. The growth of services was correspondingly low. Non-manufacturing industries grew slightly faster than in 1988 mainly because arise in government investment increased the demand for public works; otherwisepetroleum continued to decline and other mining stagnated.

33. Domestic absorption increased in volume for the first time since1984. Unlike in 1988, when consumption hardly changed, investment declined,and stocks fell substantially, in 1989 consumption increased by 2.8 percent,fixed investment by 8.5 percent. and stocks rose considerably. Privateconsumption increased as fast as population for the first time since 1985,mainly because of an increase in public sector salaries. Governmentconsumption increased slightly faster, because of the salary increase andbecause of an increase in expenoiture on goods and services. The preliminaryfigures for investment are especially subject to later correction, but atpresent they indicate that there was an increase in fixed investment for thefirst time since 1985. It was, however confined to the public sector, whileprivate investment declined again. There was a considerable build-up ofstocks, both to replenish stocks that had been depleted by the unexpecteddemand arising from Libyan visitors in 1988 and in anticipation of furtherpurchases, which turned out to be disappointing. It is believed to be themain reason that the volume of imports continued to grow fast (11.1 percent),though less than in 1988, causing the resource gap to rise to 4.5 percent ofGDP.

34. The resultant deficit on the current account, equivalent to3.8 percent of GDP, will reverse some of the sharp improvement in debtindicators that occurred in 1988, but is still consistent with a trend ofoverall improvement in these indicators. The ratio of external debt to GDP isexpected to reach at the end of 1989 the peak level it reached in 1987,whereas the ratios of debt service to exports and to GDP in 1989 and 1990 areexpected to remain below the levels of 1987, though higher than in 1988.Looking at the current account in a medium-term context (See Chapter V) agradual diminution in the deficit relative to GDr suffices for the debtindicators to improve steadily over the next ten years. In 1989 the deficitwas less then interest payments on external debt and is expected to remain sofor several years. The deficit is entirely financed from official sources and

- 21 -

direct investment. It amounts to US$385 million and net disbursements of MLTloans to US$414 million, but net official disbursements amount toUS$613 million, of which roughly 3/4 are from multilateral sources, and directforeign invesament to US125 milliorn Foreign private creditors receive a netamortization of US198 million, the great bulk going to markets or banks givingexport credits.

- 22 -

CHAPTER III

POLICY REFORMS FOR IMPROVED ECONOMIC EFFICIENCY

A. OUTLINE OF THE REFORMS

35. When it began to formulate its reform program in 1986, theGovernment recognized that the direct way to reduce Tunisia's externalimbalances permanently with the least fall in long-term growth of consumptionlevels was to orient the economy along its comparative advantages and to relyincreasingly on the private sector. The increase in efficiency of resourceallocation would to some extent offset the loss in oil exports and higher debtservice. This implied a reform of price incentives; ensuring that governmentexpenditures, especially on public enterprises, did not crowd out the privatesector; and removal of a number of restrictions on private sector activity.Considerable progress has already been achieved, but a substantial part of thereform process still lies ahead. Moreover, since the economy has always beenhighly controlled by the State and competition limited, measures will beneeded to overcome some of the barriers to competitive behavior that remain.

B. THE REFORM PROGRAM

Price Incentives

36. The realignment of price incentives has consisted primarily oftariff reform, freeing of domestic prices, and revision of the tax system.The Government's medium term objective is to reach a fairly uniform rate ofprotection of about 25 percent with a maximum nominal tariff of 35 percent.It has come close to it by reducing the maximum tariff, which was 236 percentin 1986, to 41 percent and raising the minimum tariff from 5 percent to15 percent. The customs formalities tax, which was a uniform 5 percent, hasbeen incorporated into the new tariffs. As a result, the average tariff hasfallen from 36 percent to 27 percent. The simplification of the tariffstructure within tariff groups has contributed to the drop in the standarddeviation from 26.4 percent in 1986 to 12.5 percent in 1987.

37. The Government's medium-term objective regarding price controls isthat, by 1991, all producer prices in agriculture and manufacturing, exceptbasic items of consumption whose prices are subsidized and natural monopolies,i.e., at least 75 percent of production, be free and at least half ofdistribution margins be free. Since 1986, when 95 percent of agriculture andmanufacturing prices were controlled, the proportion of free producer priceshas been raised to over 60 percent and distribution margins corresponding to

- 23 -

10 percent of production have also been freed. By 1991 the complex set ofprice regimes, with different procedures for changing prices, would have beenreplaced by a system where prices are either free or fixed for producers andcontrolled ex post for controls on distribution margins. Interest rates werealmost entirely fixed by the Central Bank up to 1986 and have in great measurebeen free since, with the exception of a cap on lending rates and limits oncertain deposit rates. The liberalization of the financial system, of whichthis is part, is discussed below.

!

38. Tax reform. The tax system was the outcome of a long history ofamendments of and additions to basic legislation that originated from wellbefore Tunisia's independence and became economically distortionary,complicated, and often unfair. The Government's medium-term objective is toreplace it with a system that is simple, transparent, and economicallyefficient. It has introduced a value-added tax on production, which itintends gradually to extend to distribution, and replaced the complicateddirect taxes by a simpler and fairer single tax.

39. The value-added tax on production, introduced in July 1988,replaced a system of three turnover taxes with partial deductibility and anexcise tax, which gave rise to many rates spread over a wide range. Theturnover taxes alone generated thirteen different rates and an excise addedanother fifty or so going up as high as 500 percent. The value-added tax hasthree positive rates, a basic rate of 17 percent, a low rate for essentialsand professional services of 6 percent, and a rate of 29 percent for luxuries,while exports pay a zero rate and agriculture is exempt.Y There was a dangerthat the reform would cause a loss of revenue, so, instead of abolishing theexcise altogether, it has been replaced by a simpler consumption tax whichwill gradually be restricted to luxuries. In October 1989 the value-added taxwas extended to all retail, excepting foodstuffs. The Government is nowstudying the question of extending the value-added tax to retailers, at leastbig retailers, such as supermarkets.

40. The introduction of the value-added tax has so far been a success,though progress to a full value-added tax will not be simple. Instead of theshortfalls of revenue that had been feared, the yield has been higher than itwould have been without the reform. The removal of some of the consumptiontaxes thus becomes easier. The tax has been well-accepted by the public,chiefly thanks to the authorities' measures to publicize and explain it well.There had been a rush in certain branches of wholesale to have the taxapplied. However, in other branches, notably foodstuffs, wholesalers expectedthat the application of the tax to them would result in price increases thatmight incite o?position. Applying the value-added tax to retail has alwaysproved difficult in developing economies and even the limited application to

I/ A zero rate means tbat a value-added tax paid on inputs is reimbursed,which is not the case for exemption.

-24 -

large-scale retail being considered in Tunisia needs to be studied andprepared carefully.

41. A new system of direct taxation was adopted by the Chamberof Deputies in December 1989 and will be applied to incomes earned from 1990on. It replaces a system that was complicated and highly uneven in itsincidence, resulting in low yields and a widely held view that ir was unfair.Only 18 percent of tax revenue in 1988 came from direct taxes in Tunisia, ascompared to 29 percent in Morocco and 50 percent in Turkey. The bulk of thetax was paid from salaries (TD 131 million in 1988), whereas the taxes onprofessional incomes brought in less than TD 2 million and the tax oncorporate profits only TD 94 million. The unifairness was made to look worseby the fact that salaried workers paid their tax at source, while others coulddelay payments and force the tax authorities to fight legal battles overseveral years, knowing that the penalties would be lower than the interestthey could earn. In addition, direct tax exemptions and reductions undervarious special incentive schemes have become widely used means of attractinginvestment into certain activities, so that highly profitable businesses oftenquite legally avoided taxes on profits.

42. The complexity and unevenness of the old direct tax system, apartfrom being distortionary, encouraged evasion and created pressures forexemptions. There were several taxes on personal incomes, with rates thatvaried according to source and could become high when combined. On an annualincome of TD 6,000, which would bring a family of five close to the averagenational income, the marginal rate was 63 percent. The top marginal rate was77 percent. This tax structure led to a proliferation of fringe benefits,such as housing and transport allowances, to protect salaries withoutexcessively raising their cost to employers. The taxation of corporateincomes was less complex, but highly distortionary of incentives. The rate ofthe tax on profits varied markedly according to activity, ranging from6 percent for agriculture and handicrafts to 44 perc'.nt for commerce. Inaddition there was a tax of 1 percent on turnover. Income from marketablefinancial instruments was taxed at 20 percent (IRVM) and interest on bankdeposits at 17.25 percent (IRC). Multiple taxation had also been common; forinstances the holder of equity paid the corporate tax, the IRVM, and incometax, though in 1988 the compounding of the corporate tax and the IRVM waseliminated through the use of tax credits. But exemptions from direct taxesunder the special incentive schemes have been proliferating and, as theybecome more numerous, they increase the incentive for more activities todemand exemptions. They also tend to compete and cancel each other out, withthe net effect of creating distortions and causing a loss of tax revenue.

43. The new direct tax system is simpler and has lower rates. It willbe more even in its incidence, although progress in this respect is limited bythe continued existence of the special incentive schemes, and is likely, overthe medium term, to permit direct taxes to grow in importance as a source ofrevenue. The personal income tax starts with a marginal rate of 15 percent atan income of TD 1,500 and reaches its maximum marginal rate of 35 percent atTD 50,000, by when its average rate is 26 percent. The tax on corporate

- 25 -

profits is levied at 35 percent, except for agriculture, fishing, handicrafts,cooperatives, and certain employment schemes, which pay 10 percent. Thenumerous taxes that made up the personal income and corporation taxes,including the IRVM and IRC, have been abolished. Double taxation of profitsis avoided by exempting the recipient from tax on distributed profits. Thereis some broadening of the tax base, notably by bringing fringe benefits intothe taxable income, though it is the employer who pays the tax on them. Thegains in simplicity and the lower rates will make it easier for theauthorities to broaden the tax base by cutting the scope of the specialincentive schemes. It will also help reduce evasion, though an essentialreform in this respect will be to simplify judicial procedures and to increasethe penalties for evasion.

44. Public enterprise reform. The Government has started a long termprogram of reform of the public enterprise sector both to increase theefficiency of these enterprises so as to reduce their heavy budgetary cost,and to move towards the goal of withdrawing from most activities that can beleft to the private sector to run competitively. The public enterprise sectoris both large and diverse. It has around 125 enterprises of a commercialnature, including utilities, public transport and railways, the oil andphosphate industries, and numerous manufacturing and assembly plants. Theprincipal objectives of the reforms are to rationalize relations between theState and the enterprises so as to allow managerial autonomy, to restructurefinancially and physically priority enterprises where it is economicallyjustified, to close those where it is not, and to privatize where feasible.The rate at which the program can be implemented will be determined bybudgetary constraints (compare paragraphs 86 & 138) and by the politicaldifficulties of job losses in the numerous enterprises where there isoveremployment or which are to be closed.

45. The burden on the budget has consisted of the heavy investmentsome of these enterprises undertook and large recurrent transfers consistingof operating subsidies and belated, often inadequate, equity contributions.During the years 1976-79, when it was at its peak in relation to GDP, grossfixed capital formation in public enterprises ran at 12-13 percent of GDP. Itdeclined to 9 percent of GDP in 1980-1984 and to 5 percent in 1988.V Most ofthis was financed by the State, although comprehensive figures are notavailable. The budgetary burden has actually been considerably greater,because of the operating subsidies many public enterprises needed. During theyears 1980-88, for which data are available, total transfers from the budgetrose from 9.8 percent of GDP in 1981 to a peak of 12.2 percent in 1984 andthen declined to 6.3 percent in 1988. However, if unobservable transfers suchas deferrals of payments of interest and principal on Treasury loans andarrears on taxes were included, the figure would be higher. Another addition

9V These figures are net of direct foreign investment, which was almostexclusively in oil.

- 26 -

to the financial cost of public enterprises would be the loans from thebanking system on which there are substantial arrears.

46. These figures reflect the financial difficulties of many publicenterprises arising from a variety of causes. The management of manyenterprises has been hamstrung by the multiplicity of objectives they havebeen obliged to try to achieve and by the need to obtain prior authorizationfrom ministries for numerous operating and pricing decisions, with the typicalresult of reducing the importance of efficiency and responsiveness to marketsignals as management objectives. This can be seen in the public transportcompanies, sugar and tobacco production, ship repair, pharmaceuticaldistribution and a number of other public enterprises. The operating costs ofpublic enterprises were also often unnecessarily high because of inadequatecapital structures, sometimes including external debt assumed at Governmentrequest, on which foreign exchange losses were incurred by the devaluation ofthe dinar, and workforces well in excess of needs. Some public enterpriseswere ill-advised investments from the start. Examples are the motor carassembly plant, STIA, and the tractor factory, both now closed. In both casesthe objective had been to increase the locally manufactured component instages, which proved uneconomical because of the small size of the Tunisianmarket. Another example was the Metro du Sahel, recently built in an areathat does not have the potential for profitable passenger traffic.

47. Public enterprise reform will be a gradual process entailingsubstantial outlays by the State on restructuring. Reform of the managementof those enterprises that will remain in the public sector, at least for thetime being, is aimed primarily at replacing prior controls with ex postcontrols and performance contracts, thus granting managers greater autonomywhile clearly defining enterprise objectives. Legislation to set up anappropriate structure, in particular to regulate relations between the Stateand managers, was adopted on February 1, 1989. Outlays will be necessary forthe financial and physical restructuring of public enterprises and theretirement or redeployment of excess labor. Sales of enterprises to theprivate sector will bring in some offsetting receipts, though not enough todiminish the outlays on recurrent subsidies and restructuring over the mediumterm. Investment in new capacity, however, is expected to continue todecline. Some sales of public enterprises have already occurred, notably ofhotels and textile factories, but these were financially relatively soundoperations, whereas in the future many privatizations will requirerestructuring prior to sale. Budgetary constraints will, therefore, determinethe pace at which restructuring and privatization can occur. So will the needto moderate the rate at which jobs are lost. A unit established in the PrimeMinister's office is responsible for overseeing the whole program of publicenterprise reform and the individual restructuring and privatization program.This unit is small and operates efficiently, with the necessary expertise.

48. Three major public enterprises, for which the Government hasspecific restructuring programs, will remain in the public sector for the

- 27 -

foreseeable future. One is the railway, SNCFT, whose financial losses arelargely due to uneconomic investments reflecting misplaced efforts to competewith road transport for passengers and non-bulk merchandise. Itsrestructuring involves redirecting its activities to where it is competitive,revision of its tariffs, and injections of equity financing to make itfinancially viable over the medium term. The other two are the phosphatemining company, Compagnie de Phosphates de Gafsa-CPG, and the related chemicalindustry, Groupe Chimique-GC. The CPG was poorly managed, operated severalunprofitable mines, and had large amounts of excess labor. The GC's capitalstructure includes an excessively large amount of domestic and external debtwith correspondingly high financial charges. Both the CPG and the GC arehandicapped by the low grade of Tunisian ore and both have been hurt by thedepressed world prices and the effects of devaluation on the cost of theirexternal debt. Restructuring must take into account the fact that the CPG isthe main source of income in its relatively underdeveloped region, while theGC needs to make a large investment to combat the environmental damage it hascaused through air and marine pollution. Restructuring involves gradualclosure of unprofitable mines, creation of alternative employmentopportunities in the area of the CPG, retirement of personnel, and equitycontributions by the State. The Government has also drawn up an environmentalprogram for the GC, for which it is seeking external financing from officialsources.

Reducing Regulatory Constraints

49. Direct controls over economic activity took a wide variety offorms, of which the three most important were restrictions on imports,authorization requirements for investments, and the regulation of thefinancial sector by the Central Bank. The medium term objective of theGovernment is to eliminate these controls to the extent permitted by theconsumer subsidies to protect the poor and special incentives for a fewpriority investments.

50. Import restrictions: Controls over imports fulfilled a variety ofpurposes, including limiting imports for balance of payments reasons,protecting domestic producers, and administering price subsidies. Since theGovernment has adopted the policy of managing the balance of payments throughmacroeconomic management, it has taken advantage of the strong balance ofpayments position that developed in 1987 to dispense with controls for balanceof payments purposes. Consequently, even though regulations give control overimports corresponding to 90 percent or more of domestic production, theiractual application is lower. Nevertheless, controls for protective purposesremain considerable and present a more difficult challenge. A number ofactivities, mainly assembly operations, that need to be restructured to meetexternal competition or closed have been classified as "poorly integrated",and the imports of raw materials, semi-manufactures, and capital goods forthese remain controlled. However, no list of these activities is availableand no strategy has been developed for determining their future. Policyregarding infant industries has been more clearly defined; enterprises in new

- 28 -

activities may be classified as infant industries and be given protection fora maximum of three years through higher tariffs than the present maximum of41 percent or, in exceptional cases, restrictions on imports. With these twoexceptions, imports of all capital goods have been freed and, with theexception of "poorly integrated" industries, imports of all raw materials andsemi-manufactures have also been freed. All inputs for industries exportingmore than 15 percent of output are also free of import duty.

51. Investment authorizations. Up to 1987 investment authorizationrequirements were linked to a complex system of incentive schemes as a meansof directing investment into favored activities. Since then, the incentiveschemes have been limited to a few areas, namely agriculture, exports, anddisadvantaged regions, and authorization requirements are no longer needed,except where benefits under the schemesi are sought. Under the IndustryInvestment Code adopted in October 1987, tax holidays on profits ranging fromthree to seven years, exemption from import duties on capital goods andfinancing at preferential rates are obtainable almost automatically forinvestments in exports ,r disadvantaged areas. Distinctions between newinvestments, replacement, and expansion, which were important before and allof which required authorization, have been removed. An Agricultural Codeadopted ir. 1988 provides analogous benefits and a new code for services,especially tourism, is under preparation.

52. The financial sector. Reform of the financial sector, which hadbeen especially tightly regulated, began in early 1987 to create, over themedium term, a banking system in which competition would stirmulate innovationand diversification of the financial instruments available. Progress has beenespecially rapid in this sector and what has been achieved so far lays thebasis for attaining the objective, though constraints that remain and thesegmentation of the banking system still limit the scope of the market.

53. The core of the reforms has been a reduction in the controls overbanking decisions and the establishment of a money market. Deposit banks nolonger need prior Central Bank authorization for loans, whereas before 1987they needed them for all loans unless they were short-term for less thanUS$1 million or medium-term loans to priority sectors. They are also freed ofthe obligation, whiich they often did not fulfill, of lending the equivalentof 43 percent of deposits in specified proportions to the public sector or aslong-term loans, though they are now obliged to lend at least 10 percent ofdeposits to priority sectors at preferential rates and invest up to 20 percentin Treasury bonds. These preferential loans are rediscounted by the CentralBank at rates low enough for the banks to cover their costs. The cost ofpreferential loans has been raised to at least the short term rate foragriculture, currently 7 percent, and is being progressively brought to atleast the money market rate. There is a cap limiting deposit bank lendingrates, otherwise, interest rates have been freed, with minor exceptions,whereas before 1987 they were all fixed or confined within narrow limits.Officially the cap restricts the spread over the money market rate on deposit

- 29 -

bank loans to 3 percentage points, though in late 1988 the authoritiespersuaded the banks to reduce it informally to 2 1/2 points. In alllikelihood it discourages lending to all but the safest projects (seeparagraph 73). The other exceptions are minima placed on the rates forspecial saving accounts and for convertible dinar accounts of Tunisiaaisworking abroad.

54. The money market, which had long existed in embryonic form, hasbecome the focal point of the financial sector. It is the channel forCentral Bank intervention, its interest rate determines most other interestrates, and it has so far been the site of the main innovations. The CentralBank has ceased rediscounting in its old form, except for preferential creditsand loans contracted before the reforms. Instead, it takes bids from thedeposit baeiks each week for seven day credits against assets that are held inthe banks. The interest rate on these credits is the money market rate.

55. The importance the money market has acquired arises from theCentral Bank's adoption of a policy of setting monetary targets and from theintroduction of non-bank lending. The Central Bank accepts the deposit banks'weekly bids up to the amount needed to meet the week's monetary targetfollowing an auction procedure described ;n Annex 2 (paragraph 25). InFebruary 1990 it also began a practice of announcing its monetary targets forthe year. Interest rates have become more responsive to policies andexogenous factors as a result of these changes. Thus the money market ratewas kept at 9 1/2 - 10 percent, i.e. 2 1/2 - 3 percentage points aboveinflation, until late 1988, when, because of low investment and the highliquidity of the banks, it fell to around 8 1/4 percent. But the growth ofmoney supply was bigh and, in the Summer of 1989, the Central Bank began toreduce the liquidity it was willing to supply, causing the money market rateto rise to around 11 1/2 percent.

56. Non-bank lending widens the money market's influence over interestrates. Two new money market instruments permit non-bank lending, thecertificate of deposit (CD) and commercial paper (billet de tr6sorerie), apartfrom which the Government started to issue 13 week Treasury bills (bons duTresor) in September 1989. CDs quickly exerted competitive pressure on theinterest rates banks offered on deposits, at least for the larger deposits.They are issued in multiples of TD 500,000, with maturities from ten days tofive years, and have become a popular investment for enterprises. The amountoutstanding has fluctuated around TD 200 million since the first half of 1989.Commercial paper has not been as popular; almost none was issued until mid-1989. However, in June 1989,the denomination was reduced from the same as forCDs to multiples of TD 100,000, the longest maturity was increased from 180

MU Although it has not yet occurred, the Central Bank would also rediscountloans to finance cash flow problems due to foreign exchange losses ofenterprises that are otherwise viable.

days to five years, and a bank line of credit as backing was allowed as analternative to a bank guarantee. Although the banks have little motive toencourage the use of an instrument that competes with their depositfacilities, and hence charged high premia for their guarantees, commercialpaper has begun to be issued and about TD 40 million was outstanding inFebruary 1989.

57. Other measures also have been taken or are being taken to developmarkets, or, where not possible, to find surrogates that permit appropriatepricing. The establishment of an inter-bank market and the issue of 13 weekTreasury bills have already been mentioned. Bills for 26 and 52 weeks areexpected to be issued during 1990. Although a secondary market for thesebills does not exist, they can be bought and sold by the public through thebanks. A secondary market in Treasury bonds does exist in theory in the stockexchange (bourse), but at present the artificially low coupon on themprecludes any trade. Banks were partly compensated for having to hold thebonds by partial tax exemptions. Now that the reform of direct taxation hasremoved these exemptions, the way is open for issuing Treasury bonds on termscompetitive with those of other financial instruments and allowing thesecondary market to develop. The Central Bank started forward selling of thecurrencies of Tunisia's main trading partners for commercial transactions andlater added the sale of options. Since the beginning of 1989 it has extendedthe sale of options to capital transactions, i.e. debt servicing, andlengthened the maximum period from eight to twelve months. Similar extensionsof the forward sales are under preparation.

58. Apart from the restrictions already mentioned, the segmentation ofthe banking system remains the major institutional obstacle to the developmentof financial markets. The regulations governing the eight development banksare different to those for the twelve deposit banks. The development banksmay not take deposits, althoughi they have empressed a strong desire to do so,nor may they lend short term. But they have been exempt from many of therestrictions on the deposit banks. Some of the exemptions, however, are moreformal than effective. For instance, the preferential credits the depositbanks must provide force the development banks to forego this business orcompete for it at unremunerative rates. These banks also do not operatedirectly on the money market, but must use deposit banks as intermediaries.The deposit banks, however, may not lend longer than seven years except inspecial circumstances of little significance. One step recently taken thatwill broaden the deposit banking system has been the conversion of the housingfinance agency, CNEL, into a deposit bank, the Bangue de l'habitat, whileretaining its specialization.

- 31 -

C. CREATING COMPETITION

59. The success of libcralization will depend on how well competitivebehavior develops. The authorities face two quite different sorts of issues.One, which particularly affects manufacturing, is the competition withdomestic production caused by imports. Since tariff reductions have precededthe removal of import restrictions, the removal of any individual restrictionswill plunge affected producers from high to low protection overnight. The useof supplementary temporary tariffs may help many enterprises manage thetransition to low protection. Even under the best of circumstances, the plantclosures and losses of jobs that liberalization will cause will be a politicalburden to the Government, but the burden will be much greater if theliberalization appears to be managed without trying to minimize the cost.The problem could be still worse if the public believes that liberalizationopens the economy even more than now to unfair competition from abroad. Toavoid this a system of safeguards needs to be established that is seen toueigh the interests of producers and consumers impartially and not to providedisguised protection. The second sort of issue is that of increasingcompetitive behavior in the domestic economy. In many activities the numberof participants is small, often because the authorities have restricted entry,and there may be a tradition of collusive behavior. In a number of these,especially manufacturing, import liberalization will increase competition, butseveral, notably services, will be less affected. Freedom of entry must, ofcourse, be the basic source of competition, but there will also be need foranti-trust legislation and better consumer representation. And someactivities will pose special issues that need to be addressed specifically,i.e., banking.

60. Competition from imports. There is concern in Tunisia that manyenterprises will be in difficulties when the Government attains itsmedium-term objective of eliminating most import restrictions and reducing themaximum tariff to 35 percent. The concern is well-founded and its basic causeis that tariff reductions preceded the removal of import restrictions. As aresult, any individual enterprise faces an abrupt transition from almostcomplete protection to the proposed protection rate. Many highly protectedenterprises can make the transition through economically justifiableinvestment and restructuring, and, given reasonable time, through improvingmanagement and product lines. These should be given the chance to do so toprevent waste of capital stock and losses of jobs. Those that cannot shouldbe closed.

61. But it is difficult to know in advance to which category anenterprise will belong. One way to alleviate the abruptness of the loss ofprotection and give enterprises the best chance of making rational decisionsas to whether to try to adapt to liberalization or close doors will be a moreflexible tariff policy. Import restrictions could be replaced by temporarysupplementary tariffs, in addition to the present maxima, with a schedule fortheir gradual removal. The removal of restrictions would be accelerated to

- 32 -

avoid unduly extending the transition period. An advantage would be that therent arising from import restrictions would be captured as government revenue.

62. The Tunisian authorities at first hesitated over the introductionof flexible supplementary tariffs. The concept of "poorly integrated"industries has not been developed enougtn to be the basis for an import policy.There is no definition of "poorly integrated" that could provide a criterionfor determining these industries, i.or is there an authoritative list ofenterprises concerned. It is also not clear what the purpose behind theconcept is; it is not merely protective, since in excluding imports of inputs,capital goods, and spare parts for "poorly integrated" enterprises from thegeneral liberalization of these types of goods, the Government has retainedthe power to control the production and investment of the enterprises. Theconsideration behind the hesitation of the authorities over introducingsupplementary tariffs was that, the Goverrament having declared its commitmentto tariff reductions, such tariffs could be interpreted as a weakening of theGovernment's resolve. The hesitation implies doubts over how well theGovernment's policies are understood by the public, from which it follows thatthere is a need that economic and business decision-makers, at least, bebetter informed. The authorities are now of the view that supplementarytemporary tariffs are the best way to alleviate the transition to lowerprotection, but have not yet made it a part of their declared policy. Theneed is inescapable since the infant industry policy is based on supplementarytariffs on the principle that they are greatly to be preferred to importrestrictions.

63. Domestic competition. As against the threat of too muchcompetition from abroad, the authorities are also concerned that there is notenough competition between domestic enterprises. One cause has been thepolicy in the past of discouraging new entrants into non-export activities inwhich the number of participants was considered adequate, while importrestrictions limited foreign competition in the case of tradeables. Thus innumerous activities there were few participants and the authorities resortedto price controls on a cost-plus basis to prevent monopolistic pricing. As aresult, consumers were protected from overt exploitation and suppliers wereassured their profits without great risk of being displaced by less costly ormore innovative competitors. The drawbacks were that the incentive fromcompetition .o be efficient and innovative was lost and Tunisia'sinternational competitiveness was neglected. The small size of the Tunisianeconomy reinforced the tendency to concentration since it permitted a fewsuppliers to saturate domestic markets for certain goods and services,especially if there were increasing returns to scale.

64. Removal of barriers to entry will be essential for creatingcompetition where competition from imports will be limited, that is foruntradeable goods and services, or where import liberalization is delayed.The removal in 1987 of investment authorization requirements in industrycreates the conditions for the development of competition from new entrants

- 33 -

into the sector. Services supplying the domestic market, i.e., excludingactivities related to tourism, usually have less scope for competition fromimports. Here there has been no relaxation of constraints on entry comparableto what occurred in industry. In particular, most of wholesale remainsclosely regulated; entry requires authorization and margins are fixed by theMinistry of Economy. The tendency for cartels to arise may be accentuated bythe Ministry, as in the recent example of the creation of a cartel of tirewholesalers. This policy has widespread effects: it can result in indirectprotection from import competition and may deter prospective investors, whojudge that they will be hostage to cartels for some of their inputs and thedistribution of their outputs. There seems to be no justification for thispolicy and, in v4ew of its harmful effects, it should be reconsidered.

65. Dumping. Coping with unfair foreign competition is an issuedistinct from protection against fair competition, and, in Tunisia's case, themeasures to be taken are entirely institutional and legal. The main form ofunfair competition in the experience of Tunisian businessmen and officials isthe dumping by large European firms of remnants of product lines that arebeing discontinued. Tunisia, being close by, is a convenient outlet for suchgoods and, being small has difficulty absorbing them without marketdisruption. However, the authorities are also concerned with the practice ofsome multinationals of dumping to prevent new domestic competitors fromestablishing themselves.

66. Tunisia could establish its own procedures for preventing dumping,or, since it joined the GATT in February 1990, it could accede to the GATTconvention on dumping. As in the great majority of developing countries, theTunisian authorities prefer the former course and have initiated a study todevise clear criteria for determining dumping, set up institutions to whichdumping cases can be referred, and design procedures for remedies orsettlement of disputes. To be successful, the anti-dumping measures must beimpartial, which depends on their not being used as a disguised form ofprotection, e.g., through the use of "reference prices". Hence, the criterionof dumping should follow the lines of the GATT procedures, and be directedagainst sales below cost and against export subsidies.

67. Anti-trust legislation and consumer representation. But therewill remain cases where freedom of entry and import competition do not sufficeto ensure competition. There will still be need for anti-trust legislation,consumer representation, and actions specific to certain activities, of whichthe most prominent is banking. The Government intend3 to present in 1990legislation on competition that will embody the findings of studies on thetype of anti-trust legislation that will be most appropriate for Tunisianconditions. These studies would compare the laws and practices of the U.S.and several European countries with a view to assessing how effective theywould be in Tunisia. But whatever the model adopted, its effectiveness willto a great extent depend on how well private and public organizations canrepresent the interests of consumers. The illusion has been less prevalent in

- 34 -

Tunisia than in many other countries that assuring consumers of productstandards and granting them the right of redress was a luxury that developingcountries could not afford. It should therefore be easier to promote healthyconsumer representation. Such representaticn would also be of long-termbenefit for exports or import competition by reducing the disparity betweenthe quality standards of goods destined for domestic and foreign markets.

68. ComDetition in the banking sector. The major activity in whichcompetition raises special issues is banking. Liberalization of the financialsectors since 1986 has left few formal constraints on competitive behavior;competition has in consequence increased and innovation has begun. But thereare still institutional obstacles as well as habits of collusion that willprevent competition from intensifying quickly. Moreover, if bank earnings arelowered by competition on interest rates, it will be harder for them toprovision for the non-performing assets they accumulated beforeliberalization. The focus of competition should rather be on diversificationof the financial system and on more vigorous search by banks for clients,which will require that constraints on lending rates of deposit banks berelaxed. Since the pattern of determination of interest rates within thelimitations of the cap on lending spreads, is in most respects economicallysound, the priority of the authorities is to watch that spreads are notwidened excessively by the banks in collusion when the cap is removed. A morecomplete analysis of these issues is presented in the annex on the financialsector (Annex 2).

69. The accumulation of doubtful loans has been at least partly due tothe fact that the Central Bank had to authorize the great bulk of lending,which the banks took to imply that the loans would be discounted andultimately made good if the need arose. With the main lending decisions takenout of the hands of bank managers, it was inevitable that credit managementand supervision were given insufficient importance, which resulted in thebanks acc.-.mulating significant numbers of doubtful assets. Although theseassets do nc- appear to present a risk of major insolvencies, it would takeseveral years ti provision adequately for them. Apart from that, pressure tolend to priority sectors resulted in an accumulation of loans to highlyleveraged borrowers. Now that rediscounting has been severely limited, banksneed to provision over several years to avoid difficulties in the future. TheCentral Bank instituted at the end of 1987 an effective system of loanclassification that enables it, among other things, to advise banks of thecredit situation of their clients. Through that and on-site supervision ofthe banks' portfolios, it feels that it has reliable knowledge of the banks'doubtful assets.

70. Certain state-owned investment banks also need to provision tocover losses on their liabilities arising from external borrowing, often atthe behest of the State. These losses were caused both by the depreciation ofthe dinar and the appreciation of the currencies in which much of theborrowing was denominated, in particular the German mark and the Japanese yen.

- 35 -

Before the balance of payments entered into difficulties insufficientattention was paid to the possibility of a depreciation of che dinar.External loans -ere incurred whose cost to the banks rose sharply with thedevaluation of 1986 and the repeated small nominal devaluations that haveoccurred periodically since. An exchange rate equalization fund (fonds deperequation de change - FPC), financed through a tax of 0.5 percentage pointson bank loans and meant to cover foreign exchange risk losses, was quicklyexhausted and a considerable part of these losses are still borne by thebanks. Since the fund has proved inadequate and its financing is a tax onbank loans unrelated to the foreign exchange risk that the individual loansincur, the Government has stopped providing cover through it, except for loansfor which there was a commitment before August 15, 1988, and as thesecommitments are mez the fund will be phased out. However, investment banksstill borrow from official sources at the behest of the State. In these casesthe State takes over the foreign exchange risk for a premium paid by thebanks.

71. The need for provisioning is one reason why the price of bankintermediation is unlikely to be reduced by competition. Another reason isthat the cost of iLt_-mediation has been kept artific'ally low by restrictionson the salaries of bank staff. Banks are provisioning much faster than theywere a few years ago and, in the view of the authorities, who consider thatprovisions are not yet adequate, will need to continue for some time. Thedeposit banks increase their provisions by TD 30-35 million a year and theiraccumulated provisions totalled TD 200 million in late 1989, as compared toTD 2 million in 1981. Bank margins, after tax and provisioning, are not high;they are only slightly higher than in OECD countries, even though the risksare probably greater, and thLs difference would be redaced or disappear ifsalaries of bank staff were not kept artificially low by the Government.There is a temptation to avoid increasing the cost of intermediation, butgiven the more demanding conditions that the banks now operate in, greaterpriority should be attached to attracting high quality staff and rewardinggood performance.

72. The tax treatment of provisioning was extremely ungenerous andstill needs improvement, despite recent reforms. It does much to explain thelow level of provisioning in the past. Provisioning was tax deductible onlyup to 10 percent of profits spread over five years, until the limit was raisedto 20 percent in December 1988, and was not permitted until the banks hadexhausted all legal means to collect on their loans (despite a backlog in thecourts). Consequently, the least profitable banks, which were often thosethat most needed to provision, had the least incentive to do so. Now, underthe new direct tax, banks need only demonstrate that they have started legalaction and the five year requirement has been dropped. But this improvementdoes not go far enough. A bank's decision to provision should depend on itsjudgement of the chances of recovering its loan, without the need to institutecostly and possibly futile legal proceedings. The 20 percent limit shouldalso be lifted. Both measures would reduce the banks' costs. Banks rarelytake advantage of tax concessions to overprovision since that would reduce

- 36 -

their profits, and are especially unlikely to do so in Tunisia, where bothbank managers and the authorities are reluctant to reduce dividends on thegrounds that would create an exaggerated impression of the banks' problemswithout adding significantly to the provisions. But dividends are being paidout at around TD 10-12 million a year and do give scope for some modestincrease in provisioning.

73. The cap on the margin over the money market rate that depositbanks can charge on loans excludes higher cost borrowers and deters banks fromseeking new clients. The authorities judge that, if it were removed, bankswould collude to raise lending rates so high as to discourage investment. Butthe issue is not so much the level of interest rates as the range of ratesbanks can offer according to their assessments of their clients. To encouragedeposit banks to be more active in seeking new clients, they must be allowedto match interest rates against cost and risk. Banks in Tunisia in generalseem averse to risk, in part because of anxiousness arising from their owndoubtful assets, and will be reluctant to take riskier clients or small onesentailing higher administrative costs, without recompense in the way of higherinterest rates Although more boldness might be desirable, this cautiousnessis much to be preferred to the gambles that banks in several other countrieswith asset problems have taken to escape from threatening crises. Anintermediate step to removing the cap would be to have a cap on the averagespread, so that higher interest could be charged on some loans, matched bylower interest on others. It does not require a high level of computertechnology and should not pose a problem for the banks. Since the largeborrowers are often fairly secure clients, this may permit many smallborrowers to have the access to bank financing that they have so far lacked.The average spread should, however, be at least 3 percentage points andpreferably more.

74. The authorities do, however, have good cause to be wary ofcollusive behavior by banks. The degree of regulation before the reforms leftfew decisions to bank managers. But it gave predictability and, on paper atleast, assured profits. In this respect the situation in the banking sectorresembles that described earlier for other non-export activities. Theattitudes this system bred were not directed towards competition. Althoughthe concentration of assets, as measured by the Herfindahl-Hirshman index isnot especially high, the banks do collude and are helped in this by theBankers' Association (Association Professionnelle des Banques - APB), whichacts both as forum and as representative for the banks. Moreover, theconcentration of deposits among the deposit banks is high; three banks have69 percent of all deposits.

75. Thus, the deposit banks did try to collude on the interest theyoffered on deposits, and part of the reason that their success was limited wasthe advent of new competitive pressures from the money market. The attempt atcollusion was the response of the deposit banks to the freeing of these ratesin 1986, which gave rise to a brief period of fierce competition. It

- 37 -

consisted of an inter-bank agreement (accord de place) arranged by theBankers' Association to limit the interest the banks would offer on deposits.Competitive pressures between the banks, intensified by the new money marketinstruments like the certificate of deposit, soon undermined the agreement;the agreement still holds and is still respected in the formal sense, but inpractice the banks have devised ways of circumventing it. Collusion can bemade yet more difficult by allowing development banks to take deposits orletting them issue short-term debenture in small denominations.

76. Even though there is no analogue to the money market for creatingcompetitive pressures on bank lending, it is far from certain that banks wouldcollude in raising their lending rates if the cap on their lending marginswere to be removed. Nor do the authorities themselves appear certain sincethey raised the money market rate in 1989; if they had been certain thatcollusion would occur, they might as well have raised the cap on lending (seeparagraphs 107-108). In any case the authorities would watch the lendingrates of the banks closely, and would reserve the right to take action if thebanks were to collude. They could also stimulate competition by requiring thebanks to post their lending rates and fees, much like the prime rate in theUnited States. Clients would be induced to shop around by such a measure.Hence, it would be preferable to test how the banks react to a relaxation ofthe cap on lending margins rather than continue with a policy based onassumptions that are open to doubt.

77. The main form of competition will be in extending the range ofservices the banks offer. The financial sector is already much morediversified than it had been before 1987, when the range of services wasnarrow for a country of Tunisia's level of development, and, as theauthorities progress towards their objective of a more integrated domesticfinancial market, diversification will continue. As already mentioned inparagraph 57, Treasury bonds can be traded on the stock exchange, but, forthis secondary market to become active, the yield on these bonds must beconsistent with that of other financial instruments. A revived market ingovernment bonds would be part of the effort to revive the moribund stockmarket, which the authorities plan to make more active through a series ofreforms. Subsequent steps would be to allow non-government paper to be tradedand to allow Treasury bills to be traded on the money market, and not justbought and sold through the banks. These markets will give banksopportunities to provide new services, apart from which there are manyservices, such as factoring and cash-management, that banks could providewithout institutional change.

78. The skills of the banks, however, are mainly suitable for thesmall number of services they offer and the pace of change will depend on howquickly they can acquire the more varied skills that are needed. Such skillsare usually only acquired through training with other banks or obtainingspecialized staff, and the authorities should encourage banks to invest insuch efforts. Foreign banks can stimulate competition since they can

- 38 -

introduce services in which they have expertise but which are not found inTunisia. There are no institutional or legal obstacles to the establishmentof foreign banks in Tunisia and one offshore bank opened an onshore branch inNovember 1989.

- 39 -

CHAPTER IV

INVESTMENT WITH ECONONIC ADJUSTMENVY~

A. THE ISSUES OF LOWER INVESTMENT AND HIGHER EFFICIENCY

79. The demand restraint and cutbacks on public sector investment haveresulted in an unintended, protracted decline in investment by privateenterprises that has aroused concern among the Tunisian authorities andpublic. The Government had aimed at reducing the share in GDP of publicsector investment, but it had expected that private enterprise investmentwould pick up to generate the economic growth and employment by the cutback ofpublic sector investment. However, from its peak level of over 10 percent ofGDP in 1981-82 private enterprise investment fell to 4.3 percent in 1987 and5.6 percent in 1988, while total investment, which ran close to 30 percent ofGDP in the late 1970s and early 1980s has declined to below 20 percent in 1987and 1988. One concern of the authorities is that these levels of investmentare too low to ensure that economic growth at rates of 4-5 percent p.a. can besustained. Another, is that losses of jobs due to the closures of inefficientplants and restructuring of public enterprises will not be compensated quicklyby the creation of new jobs. Both these concerns could undermine support forthe adjustment process.

80. However, one of the principal adjustment objectives is thatinvestment should increase in efficiency so as to reduce the amount needed toachieve a given economic growth rate. Unless substantial progress is made inthis respect, Tunisia is unlikely to be able to generate long term growth inper capita consumption and a reduction in unemployment. Relative to GDPinvestment is not now especially low in Tunisia by middle-income countriesstandards; it merely fell from unusually high levels. But it has beeninefficient and capital intensive, and, unless it improves in these respects,continuation of the present levels of investment will lead to slower GDPgrowth and increasing unemployment. Alternatively, as noted at the beginningof Chapter II, if the objective were to reach GDP growth rate around5 percent, the necessary combination of higher saving and greater capitalinflows would be hard to sustain. As yet economic growth has remainedsatisfactory, if allowance is made for droughts and locust invasions, largelybecause of increasing capacity utilization. In large measure it has beenpulled by the rapid growth of manufactured exports, which have accounted forroughly 25 percent of GDP growth since 1986. But this source of growth islikely to reach its limit soon and it has not been enough to prevent someincrease in the unemployment rate, and capacity utilization is likely to reachits limits soon.

flv From here on "investment" is used to mean gross fixed capital formationother than in oil extraction.

- 40 -

81. Along with increasing the efficiency of investment, there is,however, a need to increase the level of investment by private enterprises.Analysis of the macroeconomic prospects of the economy (Chapter V) indicatesthat an overall level of investment of 23-24 percent of GDP would beappropriate for the long term. At the same time it is expected that publicsector investment will decline relative to GDP, mainly because of a decline inthe expansion of capacity in public enterprises, while household investmentshould remain fairly stable. According to these trends investment by privateenterprises should rise from 5.6 percent of GDP in 1988 to 8.4 percent in 1992and continue rising to reach 10.9 percent by 1997. The rise would not beabrupt, but it would, nonetheless, be in sharp contrast to the trend since1982 and would occur in a very different policy environment.

82. The policy environment for private enterprises has changedmarkedly since the days when they invested heavily, and both increasing theirinvestment and ensuring that it is economically efficient will depend onremoving any misconceptions over the policy objectives that have led to thechanges and uncertainties over how they will be implemented. In particular,enterprises catering to the domestic market will face more competition fromnew domestic entrants and from imports. What the permanent level ofprotection they can expect and how the transition to it will be effected needto be specified. The transition from the high level of protection afforded byimport restrictions to the lower level afforded by the permanent tariffstructure could be eased by the use of temporary supplementary tariffs, asalready envisaged in the existing policy for infant industries. The presenteconomic environment also differs from that before 1985 in that domesticdemand is depressed. This was inevitable, given the balance of paymentsdifficulties Tunisia faced and the recent droughts, but a somewhat highergrowth in the volume of consumption could be sustained while respectingmacroeconomic constraints and would be necessary to encourage investment.Investment in exports suffers much less from uncertainties or misconceptionsover policies and weak demand, as a result of which it has been growingrapidly recently. But it is not yet large enough to provide the overallincrease needed to raise private investment to levels that will generateadequate economic growth and employment. The banks are also in a changingpolicy of environment because of the recent liberalization and diversificationof the financial system and are still in the process of adapting to change.In particular, decisions on lending have passed from the authorities to thebanks, whose project evaluation capabilities need to be strengthened to enablethem to consider lending more to unfamiliar and higher cost borrowers. Butthey are also deterred by the cap on lending spreads, which needs to beremoved, or at least greatly relaxe-d. Equity financing is still insignificantin Tunisia, but reforms are under way and could progress fast enough to havean effect on investment financing in the medium term.

83. These issues apart, the conditions in Tunisia for investmentappear good. Tunisia is less afflicted with uncertainties arising fromexogenous circumstances than most other developing countries. Since the

-41 -

country is not expected to require debt relief it is free from the associateduncertainty over resource flows; most of its debt is at fixed interest ratesand debt servicing is consequently not sensitive to interest rate changes; andoil has lost its importance as an export, reducing the risk of terms of tradeeffects. There are exogenous uncertainties that Tunisia does not escape. Oneis the fluctuations in rainfall, which affect output, public finances and thebalance of payments. Another is the shape of European unification in 1992 andthe eventuality of protectionism, which had already aroused apprehension inTunisia. But it has always existed and cannot be blamed for the decline ininvestment. Another is the shape Europe, Tunisia's main trading partner, willtake in the coming years; the goal of economic unification in 1992 created abig unknown for Tunisia, but the recent events in Eastern Europe may havecreated an even bigger one. Any effect on investment these unknowns wouldhave would be felt most in investment in exports, but at present theseinvestments appear to be growing rapidly.

B. PUBLIC SECTOR AND HOUSEHOLD INVESTMENT

84. As Table 14 indicates the fall of the ratio of investment to GDPfrom the levels of 1981-84 has been large, but it is a fall from abnormallyhigh levels to levels normal to middle income countries. Part of the fall wasdue to the direct foreign investment in public enterprises and a more usefulpicture for policy decisions is obtained by excluding this investment since itwas confined to the oil sector, where the levels of investment and theireffects on GDP and employment are determined more by technical factors than bypolicy decisions.M With this modification, the total fall in investment and,in particular, the fall in public enterprise investment, become lesspronounced, though still large. As compared to the present share ofinvestment in GDP in Tunisia of 19 percent, the average for middle incomecountries over 1977-86 was 22 percent.

,/ The remainder of the discussion excludes direct foreign investment inpublic enterprises.

- 42 -

Table 14

Fixed Investment by Asent as Percent of GDP: 1980-88

1980 1981 1982 1983 1984 1985 1986 1987 1988

Private Enterprises 8.5 10.4 10.4 8.7 8.1 7.2 5.4 4.3 5.6Public Enterprises 1 7.3 7.2 8.8 9.5 9.5 7.7 7.4 6.7 5.0Government 5.4 5.1 5.1 5.6 5.3 5.5 4.9 4.1 4.1Households 4.8 4.4 5.0 5.5 5.5 5.1 5.1 4.7 4.2Total Fixed Invest. 26.0 27.1 29.3 29.3 28.4 25.5 22.8 19.8 18.9

Memo Item

Gross Direct ForeignInvestment in Fuel 2.4 3.8 4.6 2.6 1.8 1.3 1.2 0.8 0.8

a/ Excluding Direct Foreign Investment in oil sector.

85. Since the mid-1970s the public sector has consistently accountedfor more than half of total investment except for 1980-82. The cutbacks ofpublic sector investment beginning in 1985 were matched by the fall in privateinvestment. Much the greater part of the fall was due to enterprises, publicor private, whereas investment by public administration and householdsremained relatively stable. The cutbacks were part of the Government'sactions to reduce imports as a means of lowering the excessive deficits on thecurrent account of the balance of payments and could be achieved because ofthe Government's high degree of control over investment decisions. Apart fromits direct authority over public administration investment and publicenterprises, it controlled private firms' investment through the system ofauthorizations required for investments and for bank credits. Householdinvestment, which is mainly housing, could also be controlled, though to alesser extent, by controlling credit; the housing finance agency, CNEL, wasstate-owned and lending for housing by the deposit banks was also subject toauthorization. Moreover, the CNEL had overstretched its resources and wouldhave been forced to cut back in any case. But much of housing construction isnot financed by the formal financial sector and as a result householdinvestment fell less than that of private firms.

86. Public enterprises. Being financed mainly or entirely out of thebudget, which is itself constrained, both public enterprise and publicadministration investment face severe resource constraints and will continueto do so in the future. As noted earlier, the Government's policy is todivest itself of public enterprises in competitive sectors, and, therefore,limit investment in public enterprises mainly to restructuring candidates forprivatization or to public utilities. Investment in restructuring would beaccompanied by expenditures for recapitalizing firms and for retiring andredeploying labor. Since the enterprises in need of restructuring are lesslikely to attract financing from banks or private business, most of it isassumed to be financed from the budget. To the extent that viable

- 43 -

restructuring programs are ready, there will be a trade-off in any given yearbetween implementing these programs and limiting the outlays from the budget.A further constraint will be the private sector's ability to finance theacquisition of enterprises; heavy reliance on bank financing will revive thewidespread problem of undercapitalization many enterprises have had, whereasequity financing is limited because of the underdeveloped state of the capitalmarket.

87. Public administration. Investment by public administration wouldalso be limited by the Government's policy of withdrawing from direct economicactivity in favor of the private sector. Although the share in GDP has beenmore stable than that of public enterprises, it has been declining whichappears to be in great measure due to the approach to completion of largeinvestments, including dams and related conduits and irrigation works, thathad been started in the early 1980s. No major new projects were included inthe Government budget for 1988 and 1989. But Tunisia intends to undertake amajor long term investment program for management of water resources, soilconservation, desert control, and afforestation. It is not likely, therefore,that the share of public administration in GDP will decline below 4.0 percentof GDP.

88. Housing. Housing, which constitutes most of household investment,has an apparent stability that belies the sector's intractable problems. Asthe Government progresses in overcoming these problems, the rate of householdinvestment might gradually increase. Housing construction is in theory highlyregulated, but in practice the regulatory framework, standards, andinstitutions are so far removed from economic needs as to have been bypassedby a large proportion of the sector. Thus the prospective house owner hasfaced two sets of constraints: one was that of either obtaining a legal houseor plot, or circumventing the regulations, the other that of obtainingfinancing. One consequence was that many clients able to get cvedit could notfind housing, while many who could find housing were unable to get credit.

89. Housing regulations were designed for larger plots and higherstandards than space and incomes allowed. Moreover, Tunisia has a long-standing problem of land registration due, in the main, to outmoded legalprocedures, so that only 50 percent of plots are registered and only 3 percenthave up-to-date titles. The results have been that much of lower incomehousing is te-chnically illegal because plots have been unofficially sub:.ividedand standards not met, and that mortgages lose much of their use ascollateral. Consequently the banks lend little to housing and, the littlethey lend is to the well-to-do.

90. The housing finance agency, CNEL, which functioned on a highlypopular contractual saving scheme, began increasingly to lend in advance ofits contract requirements to meet the demand of people who had found housingand needed credit. Those who could not find housing were disappointed in

-44 -

their saving objectives and therefore deposits with the CNEL began to decline.The CNEL obtained financing from the budget through a Government housing fund,while making little use of long-term loans that deposit banks were obliged togive it under the "global ratio" requirements. The transformation of the CNELinto a bank (Banque de l'habitat) in 1989 has put housing finance on a sounderfooting and, being more flexible, the bank will better match credit to housingpurchases.

C. PRIVATE ENTERPRISE INVESTMENT

Persistent Decline

91. The decline in private investment has been cause for specialconcern among the authorities and the public in Tunisia because, although itwas started, as with Government and public enterprise investment, by resourceshortages, it has persisted even after the overall resource constraint haseased. Resource constraints affected private investment before they affectedthe public sector; beginning in 1983 private investment had to diminish toaccommodate the growing public sector demand for investment resources, thoughthe resource gap was around 8.6 percent of GDP. Since then it has diminishedin volume continuously until there was a small increase in 1988. (TheTunisian authorities anticipate an increase in 1989 as well, but, given thepreliminary nature of the data, this is still uncertain.) In 1987 overallresource constraints were no longer binding and it became evident that thecontinuation of the decline in private enterprise investment was due to othercauses.

Change and Uncertainty

92. In enquiring into the causes of the sluggishness of privateenterprise investment in recent years, despite the country's easier overallresource position, a partial answer is obtained by examining the differencesbetween the recent period and that of the late 1970s and early 1980s whenprivate investment grew to substantial amounts. One major difference has beenthat the close controls that had in the earlier period limited competition,both domestic and foreign, are now being loosened. In this changing policyenvironment entrepreneurs must now adapt to a different structure ofincentives to that to which they had been accustomed. Moreover, there arenaturally uncertainties associated with such extensive economic reforms,which, in the case of Tunisia, have been greater than need be because, eventhough the principles of the reforms are well understood and accepted, someaspects of their implementation have not been defined clearly.

93. Liberalization to increase competition within the economy and fromabroad is progressively removing the immunity from competition that hadprovided a strong incentive to invest in activities directed to the domestic

- 45 -

market. Investments in these activities have been the main determinant ofprivate investment, of which they usually constituted three quarters or more.As noted in Chapter III (paragraphs 50 & 63), they were heavily protected fromcompetition whether domestic or external, and were thus to a high degreeassured of their profitability. The elimination of prior authorizationrequirements for investment, except where special advantages under theinvestment codes or preferential credit schemes are sought, has implied thepartial removal of the mechanism whereby the authorities ensured thatcompetition within any activity between domestic producers was limited. Andthe declared intention of the Government to liberalize imports in stagesintroduces a new source of competition that is beset with questions of timingand degree.

94. For the representative entrepreneur, investment decisions hinge onknowing when foreign competition in particular activities will occur and onthe level of protection he can expect, on both of which there is stilluncertainty. Many entrepreneurs are still vague over what the Government'sstated objectives for the medium term are. This often leads to the beliefthat liberalization will lead to the virtual elimination of all tariffprotection. Moreover, the Government's declared intention of removing importrestrictions on all goods except those with consumer price subsidies merelyassures the entrepreneur that the restriction on the import of any particulargood will be lifted some time in the medium term, and the Government'sdeclared tariff policy assures him that he will then be protected by a nominaltariff of at most 41 percent, and eventually at most 35 percent. In themeantime in an enterprise that is highly protected by import restrictions adecision to invest in physical restructuring to meet external competition whenimport restrictions are removed, assuming it to be justified, would depend onwhether or not there would be temporary supplementary tariffs to ease thetransition to a level of protection limited to the permanent tariff structure,and on what the final tariff could be. The same would be true ofentrepreneurs contemplating establishing new enterprises or expanding capacityin existing one in activities directed to the domestic market. Theentrepreneur envisaging investment in an infant industry would be free of theuncertainties related to import restrictions, since he would have negotiatedtemporary supplementary protection with the authorities, though that would notnecessarily tell him what the permanent tariff on his product would be.

95. The second major difference between the period before 1983 andthat of 1987 onwards is that domestic demand was growing strongly in theformer whereas, in the latter, the restraint begun in 1985 has continued.This, too, deters investment in activities catering to domestic demand. Asalready noted in Chapter II, the late 1970s and early 1980s were a period ofrapidly increasing real wages and consumption. From 1977 to 1983 average realwages grew at an annual average of 4.3 percent and consumption at 6.3 percent.But, the measures taken to restrain aggregate demand kept the increase inconsumption between 1985 and 1988 to a total of 2.9 percent and that of theaverage real wage to -4.8 percent. The data for 1989 are preliminary, butthey indicate that, although consumption growth has been higher, it is still

- 46 -

barely above the population growth rate. The domestic economy of Tunisia hasbeen depressed, though this has been partly masked by the growth of exportsand, more recently, of imports. This was especially marked in 1988, whentourism increased sharply, in particular because of the large number ofvisitors from Libya, whose demand for a wide range of goods and serviceswithin Tunisia led to rapid growth of imports. Imports have continued to growfast in 1989, apparently to replenish stocks and in anticipation of morepurchases by Libyan visitors, though these fell short of expectations.

96. The third major change has been that the financial sector has beenliberalized to a large extent and is growing more diverse. Decisions onfinancing investments, which had rested with the authorities, have beenshifted to the banks, which, not having had motive in the past to develop theexpertise and habits for sound investment lending, are now more cautious intheir lending then they used to be. In addition the cap on the lendingmargins of the deposit banks deters them from lending to all but safe, low-cost borrowers, often to the exclusion of potential new, small-scale investorswho may be unfamiliar to the banks. The formal capital market is not yet asignificant source of financing, though it could become one in the mediumterm, i.e., soon enough to play a part in bringing private investment to thelevel needed to sustain adequate long-term growth.

Reviving Investment in a Time of Economic Reform

97. Managing change. There has been rapid growth of investment inexport activities since 1987, which can be expected to continue. But, sincethis form of investment has constituted only about one quarter of totalinvestment by private enterprises, by itself it would take several years tobring total private investment to desirable levels. Consequently, thechallenge before the authorities is to revive investment in activitiesdirected to the domestic market while pursuing the implementation of theeconomic reform program. Only through reform of the structure of incentives,especially through greater domestic and external competition, can they ensurethat there will be enough gain in efficiency in this form of investment toreconcile adequate economic growth over the long term with macroeconomicconstraints.

98. The relatively fast growth of investment in export activities hasbeen possible because this form of investment is not affected by the changingdegree of competitiveness within Tunisia or the remaining uncertainties overpolicy implementation. The regulation of competition is rarely an issue forexports, unless the country has a monopoly on international markets, which isnot Tunisia's case. Uncertainties over policy implementation are of minorsignificance for exports since the Government's commitment to encouragingexports in expected to remain. Moreover, there is a long record of pragmaticexchange rate policies from which entrepreneurs in Tunisia can infer that theTunisian dinar will continue to move so as to keep their exports competitive.At present the incentives for exports are sufficiently good for it to be

- 47 -

rarely worthwhile to postpone investments to take advantage of furtherimprovements. A rough estimate, on the basis of stated investment intentionsof the volume growth of investment in export activities in 1988 is 15 percent.

99. It would, nevertheless, be overoptimistic to assume that exportsalone could bring private investment to the levels aimed at in the mediumterm. Supposing that investment in export activities were to continue toincrease at 15 percent a year in volume, total private enterprise investmentin 1995 would only be 6.4 percent of GDP, as compared to 9.9 percent in themacroeconomic projections, assuming the growth in 1989 indicated by thepreliminary data to be confirmed. It would also be imprudent to assume thatinvestment in export activities will maintain their 15 percent growth rate;although diversification is taking place, it will need time for investment inexport activities to cease to be concentrated in tourism, textiles andapparel. Investment in these branches may also slow down, especially ifeconomic unification in Europe in 1993 leads to more protectionism there.Moreover, an industry like tour4 sm can easily be affected by regionaldisturbances outside Tunisia's control.

100. To revi,7e investment on a broader basis requires that changescontinue and, at the same time that uncertainties over policies be reduced.Change is now a fact of economic life in Tunisia and policies for revivinginvestment can only succeed if they take account of that. For example, anattempt to put the clock back by restoring the protective environment andrestraints on competition of the past would be unlikely to elicit highinvestment as it did in the past; it would merely be another change, thoughone that greatly increased the uncertainties in the view of entrepreneurs overthe intentions of the authorities.

101. Having formulated their medium-term policy objectives, the nextstep for the Tunisian authorities would be to ensure that they are clearlyunderstood and to remove uncertainties over their timing and scope. First, asalready suggested in Chapter III (paragraph 62), there is a need to ensurethat economic and business decision-makers are better informed of thegovernment policy objectives, in particular of the possibility that temporarysupplementary tariffs will be used to ease the transition from protection byimport restrictions to protection by permanent tariffs. Second, theuncertainties that the potential investor faces over when his particularproduct may be subject to import competition and what protection he will havein the period before the Government has reached its tariff objectives could bereduced by fixing and announcing in the near future a schedule for removal ofimport restrictions and specifying the level and duration of the supplementarytariffs to replace them. This would also remove doubts that may have beencreated by the preference of the Ministry of Economy, whose jurisdictionincludes industry, external trade and internal commerce, for an industrialstrategy going beyond the announced infant industry policy in making greateruse of protection, as well as subsidies and other special measures, and onwhich a study is under way.

- 48 -

102. Managing demand, Private investment directed to the domesticmarket is best encouraged by steady growth of per capita consumption at ratesthat have good prospects of being sustainable, rather than the extremesexperienced since the mid-1970s. This is an issue of macroeconomic managementthat depends directly on government wage policies since the State, through itsinfluence over salaries in public administration and public enterprises, bothinfluences year to year movements in the private sector and affects theassessment by entrepreneurs of the future growth of demand. In recent yearsrestraint on real wages and consumption was uxiavoidable in view of the balanceof payments difficulties of 1985 to 1986 and the droughts in 1988 and 1989.But Tunisia has now reached a situation which, as discussed in the nextChapter, permits sustained consumption growth at moderately higher rates ifthere are no major exogenous adverse changes of circumstance. Such growthshould be as steady as possible to avoid the uncertainties that largefluctuations introduce into the outlook of entrepreneurs. It should becompatible with a prudent assessment of medium- and long-term macroeconomicconstraint and should not vary in response to year to year fluctuations, inparticular in the balance of payments (e.g., in the current account).

103. Bank financing. Increasing bank financing of investment requiresthat banks be driven by competition, that they improve their capabilities forevaluating loans, and that the cap on lending spreads be relaxed, if notremoved. As already discussed in Chapter III (paragraphs 68-78), competitionbetween banks should take the form of more active search for clients, betterservices, and greater diversity in the financial instruments they use. Thisapplies both to their lending and to their mobilization of resources. Theestablishment by an offshore bank of an onshore deposit bank in November 1989will help, especially if, as expected, the bank sets higher standards ofservice and expertise. So will the threat of more competition from newentrants, both Tunisians and foreign.

104. The need for improving the banks' capabilities for evaluatingloans was discussed in paragraph 78. In its role as the supervising authoritythe Central Bank can exert considerable influence and perhaps instituteconcrete incentives, though ultimately it must be the banks themselves thatwish to take the initiative. Given the importance of this activity, theresponsibilities involved, and the rather low salaries paid to bank staff,higher salaries should be used to attract competent staff and reward goodperformance. Here, too, the State can lead the way by deregulating salariesin the banking sector.

105. Increasing competition between banks, strengthening their loanevaluation capabilities, and allowing them large spreads on their lending arethree mutually dependent measures. The longer the last measure is delayed,the longer it will take for the other two to be effective. Conversely, thefirst two would go far to ensuring that banks do not abuse their freedom tocharge higher interest rates. It would, therefore, be advisable to remove or

- 49 -

relax the cap, as suggested in paragraphs 73-76, while for some time retainingthe ability to restore it at a higher level than at present if the needarises. The influence of the Central Bank and the State's own shares in someof the major banks should prevent the need from actually arising.

106. Despite their apprehensions that banks would abuse a relaxation ofthe cap on their lending margins by raising their lending rates, theauthorities have, themselves, recently raised the money market rate. It mighthave been better to raise the cap instead. At first the cost of loans wasreduced in late 1988. Taxes to finance the exchange risk fund, now restrictedto commitments taken before August 15, 1988, and preferential credits added1 1/8 percentage points to the cost of loans in 1987. A tax on services (taxede prestation de services) was levied at 14.3 percent of the cost of theloans, adding roughly 2 more points. During 1988 the former taxes werereduced to a total of 0.8 percentage points, while the latter, after beingconverted into a value added tax, was suspended. The money market rate alsofell from around 10.5 percent in 1987 to a little over 8 percent in early1988, thus reducing the real interest rate on borrowing from 8-9 percent toabout 4 percent.

107. But in the Summer of 1989 the money market rate began to riseagain, and reached 11.5% before the end of th'v year. The effects it will haveare difficult to predict. It is unlikely that it will have any effect onfinancial saving, and what effect it will have on the cost and volume ofborrowing depends both on how the banks regard it as affecting their averagecost of fund and how borrowers respond to interest rate increases. Sincedeposit rates are not tied to the money market rate, except for a few largedepositors who can negotiate their terms or place their liquidity in moneymarket instruments, and since the banks may regard the increase as transitory,hence of limited importance for their medium term costs, the increase in thecost of resources as seen by the banks may be considerably less than theincrease of two percentage points in the money market rate. At best, then,the higher interest rate may actually simulate a higher cap. Theliberalization of the banking system having been so recent, there is no goodprecedent to say how the banks will react.

108. It is also not clear whether borrowers are much influenced bychanges of tha~ magnitude in interest rates. Direct investment by the Stateis clearly not affected. Only a small part of investment by publicenterprises, if at all, may be affected, namely the part that is neitherrestructuring financed from the budget nor a component of longer termexpansion programs, suc'i as those of the electricity company (STEG) or theairline (Tunis Air), which are in any case partly externally financed. Howprivate enterprise investment responds to changes in interest rates is amatter of debate in most economies, but in Tunisia it is not the Government'sintention to discourage investment further. And investment in housing doesnot seem to be more than marginally affected. The level of stocks could beaffected, though there is no evidence that the level of stocks is high, and,

- 50 -

even if it were, that would be because they rose in expectation of sales tovisitors from Libya and would not need an increase in the money market rate toinduce a reduction. Given these uncertainties, it would be better if arelaxation of the cap on bank lending margins partly substitute for the higherinterest rate in the near future.

109. Banks would be less deterred by the cap on their spreads ifsatisfactory collateral were more easily available, in which case the risk tothe banks would be lower. But the main form of collateral for small borrowersis usually land and houses, which the lack of up-to-date titles and thefrequently illegal state of the houses render unattractive to banks. Legalprocedures for recovering loans or collateral are also cumbersome and casesmay take fifteen years. Banks regard the legal system as being weightedagainst them by the courts' sympathy for the borrowers against the banks,which are regarded as rich and profitable. Because the expected return on anypiece of collateral is so low, banks typically over-collateralize, which alsohas the effect of binding clients to their tanks.

110. The caRital market. In common with many other developingcountries, the Tunisian financial market outside the banking sector is quitesmall. Longer-term capital markets and especially equity markets requiregreat amounts of reliable information--yet it is precisely this type ofinformation that is in short supply in developing economies. Even afteradjusting for the small size of the Tunisian economy, the capitalization ofthe Tunisian equity market is low relative to the countries classified asemerging markets by the IFC. In fact, the capitalization to GNP ratio isabout one-tenth the size of the smallest figure in that group. Numerousfactors account for the underdevelopment of the equity market and of Tunisiancapital markets in general. First, the institutional investor market is nothelped by the existence of a generous but underfunded social security system.Horeover, insurance companies have been making serious losses over the pastfew years inasmuch as premia are set by the Government at an artificially lowlevel, relative to the generous disbursements set by the judicial system.Also, the savings instruments which the insurance industry can offer arelimited to 200 to 550 basis points below that on savings accounts with banks.

111. Second, in common with many developing countries, thoughsurprising given Tunisia's relatively high per capita income in that group, isthe absence of well-defined accounting standards and the lack of"transparency." Even more so than with lending, the development of equitydepends crucially on the availability and reliability of informationsufficient for the continuous mc4itoring of the health of the underlyingasset. But in Tunisia businesses develop their own sets of accounts--often,many of them, for various purposes--as the need arises. Shareholders havelittle evidence that the published results have any bearing on the true stateof the firm. Investment banks often take equity positions along with theirloans but with great reluctance. They are virtually compelled to do so, sincewithout taking an equity position they are at a disadvantage given the

- 51 -

commercial banks lower cost of funds. However, they usually attempt toextricate themselves as soon as possible since, without ownership control,their investment is often poorly remunerated. Not surprisingly, the few casesin which the investment banks have gained control are regarded as being quitesuccessful for the investment banks.

112. Finally, until recently equity financing suffered severe taxdisadvantages relative to debt financing. Until 1984, dividends were tripletaxed, in that in addition to the double taxation of distributed dividendsseen iTI the United States, the Imp6t sur le Revenu de la Valeur Mobiliere(IRVM) was collected without credit. Since then, equity earnings have merelybeen double-taxed. The lower relative cost of debt financing was encouragedas well by the maintenance of negative real interest rates for a varietyinvestments until the mid-1980s. As noted above, special savings accounts andgovernment debt continue to have tax advantages that make the growth of aviable equity market difficult. The authorities are putting in place taxcredits both for the IRVM (the credit d'imp6t) and for dividends received(avoir fiscal, a 45 percent credit), both of which move in the direction ofcreating a more level playing field for equity and debt financing.

113. By improving auditing and transparency and perhaps with the helpof further tax incentives, the Tunisian equity market could grow rapidly.Already a training project with UNDP/IFC is well advanced, which will in thelong run help eliminate one brake on development. Although equity marketreforms are typically thought to have a long gestation period, Koreanexperience suggests that a rapid return on these reforms is possible. Therethe number of stocks listed rose from 24 at the start of 1968 to 356 a decadelater and capitalization soared commensurately. As is the case in Tunisia,firms initially relied on bank loans and foreign financing, while equityfinancing was small-scale and primarily family-based. There was not even agovernment securities market, as government debt was allocated by quotas amongfinancial institutions. However, in 1968 a series of laws and reforms werelaunched to foster the development of capital markets, including the requiredauditing of listed corporations and a variety of inducements to make listingfinancially attractive to issuers and stockholding appealing to investors.These inducements included favorable prices for stock purchase of publiclyheld corporations, especially by employees, little or no taxation of corporatedividends at the individual level (0 to 5 percent, compared with 20 percentfor dividends from unlisted corporations), less favorable tax treatment forreal assets, and reduced corporate tax rates and more generous depreciationrules for listed companies. The latter may have been necessary only tocompensate for the excessive pressure on corporations to price initial issueswell below market. Financial support also was provided to underwritinggroups. Rather than a blueprint for fostering equity market growth, theKorean case demonstrates the possible pace of development once disincentivesare removed.

- 52 -

114. With tax distortions substantially alleviated, the lack oftransparency and a limited supply of equities remain the most seriousrestraints on market growth. As an alternative to granting fiscal incentivesto foster the spread of standard accounting systems, the Government, throughthe Central Bank, may want to encourage the banks to require standard andaudited financial information from their clients. For example, loans notsupported by audited standard accounts could lead to the downgrading of abank's portfolio or higher required provisions. Since audited statementswould be required for loans, the current disincentive to being listed on theequity market would be eliminated. Privatization also would help: of the 50enterprises listed last year, most were owned entirely or in part by thepublic sector and hence were little traded. The ending of the extreme taxadvantages available to individual holders of government debt--especially theability to offset other income with interest earnings--as well as morerealistic pricing of such debt will provide a more receptive market forequities.

115. Special incentives for investment. The Tunisian authorities havealso taken measures that are appropriate in the present situation to reducesome of the costs of investment, but the elaborate system of specialincentives has become excessively generous and needs to be revised toconcentrate on a few clear priorities. The reforms of recent years haveincluded the permanent elimination of prior authorization requirements orinvestment, except where special incentives are sought, thus reducing thecumbersome procedures to which all investments are suhbject. The import dutyon capital goods has been reduced from 15 percent to 10 percent and the value-added tax on lending, which added two percentage points to the cost of loanshas been suspended. The obligation to pay the VAT on imported capital goodshas been permanently removed, since the tax would in any case have beenrefunded, thereby lightening the cash flow of investors. But specialincentives under various investment codes are proliferating. A new industrialinvestment code adopted in October 1987 helped narrow the range of activitiesfor which special incentives, notably tax holidays, were available and camecloser to levelling out differences between priority and non-priority branchesin industry. However, it was followed by an analogous code for agriculture,while codes for tourism, services, and commerce are in preparation. If thesecodes could ensure higher levels of investment without loss of efficiency,their temporary use would be justified. But they have not done so yet to anysignificant degree, nor are they likely to since their main attractions areexemptions from direct taxation for long periods (usually 10 years) whichshould not make the difference between profitability and losses.

116. An economically efficient system of special incentives for Tunisiawould avoid sectoral distinctions in favor of measures to promote specificobjectives for the long run development of the economy, such as theestablishment of small enterprises, the faster adoption of new technology, andthe development of disadvantaged regions. The effect of having severalsectoral codes is merely competition between the sectors for the advantagescodes offer and, hence, the cancelling out of the advantages. Because of the

- 53 -

long tax holidays they offer, these codes also result in effect in a directtax system parallel to the basic system and negates some of the benefits ofthe reform of direct taxation under way. They are also easily abused; forinstance, an enterprise car. close down at the end of the tax holiday andre-open as a new enterprise to begin the tax holiday all over again. Certainactivities also benefit from preferential credits at rates below the moneymarket rate. In some cases such as agriculture, there may be social reasonsfor an element of subsidy in lending, but there is, for instance, lessjustification for subsidies on short-term credit to exports when the exportsector is flourishing. The authorities have been conscious of this issue andtheir policy is to bring the interest rates on preferential credits to themoney market rate over the medium term. This would, however, still entail asubsidy, since that rate is below the cost of bank loans, and a desirableobjective would be to confine these subsidies to one or two priorities,notably agriculture, and possibly the activities supported by a reformedinvestment code. Ultimately, special incentives should be confined to asingle investment code with limited tax holidays, preferably graduated todecline over time so as to remove the motive for closing an enterprise whenthe tax holiday expires. In keeping with the objective of minimizinguncertainly, the reform should be precisely formulated and announced.

117. There are a number of issues as well that cannot be classed ascauses of the continued decline in private enterprise investment in the samesense as the causes already mentioned, since they existed before, wheninvestment was thriving, and have, if anything, been subject to improvement bymeasures taken by the authorities over recent years. But they createobstacles and distortions and, though they may not have been acute enough todeter investment when profitability seemed virtually assured, they reduceeconomic efficiency and impede recovery now. Such issues include laborlegislation and its enforcement, obstacles to closing enterprises, and thebankruptcy laws. The most complex is labor legislation. The basiclegislation dates from 1966, with addenda from 1973. It has been criticizedas being outdated and rigid, but it is a compact between workers' andemployers' representatives and, hence, its very existence ensures a measure ofindustrial peace. In revising the legislation, or applying it more flexibly,account needs to be taken of complex issues of conditions of short term versuslong term employment, conditions under which workers can be laid off,compensation for loss of employment, agreement on performance standards, anddetermination of pay by performance or seniority.

D. THE ICOR AND EFFICIENCY GAINS

118. The adjustment policies Tunisia is implementing would improve theICOR through three mechanisms. First, there would be a decline in the publicsector's share in investment. Although data do not permit ICORs to becalculated separately for public and private sectors, the public sector's ICORwas markedly higher than that of the private sector since much of public

- 54 -

investment consisted of large and highly capital intensive projects. Second,changes in relative prices would encourage more labor intensive investment.The devaluation and wage restraint have reduced the cost of labor relative tothat of capital goods, especially imported capital equipment, whichconstitutes most of the investment in a typical industrial enterprise and alarge part in most others. Moreover, the real cost of borrowing has increasedas compared to the late 1970s and the years 1980-83, though it is below thelevels of 1985-88. Partly this is due to the increase in bank lending rateswhich occurred in steps between 1978 and 1987 and, partly to a fall ininflation rates from an average of 12 percent between 1978 and 1983 to 7-8 percent since then. The higher real rates of 1985 to 1988 were only insmall measure the effect of higher nominal bank lending rates; the main causeswere the drop in inflation and the existence of taxes on lending which couldadd over three percentage points. These taxes have since been reduced to 0.8percentage points. Third, increasing competition from imports will directprivate investment away from capital intensive activities that require higherlevels of protection. Such investments, especially in assembly operationswith low value added, were encouraged by import restrictions.

l

- 55 -

CHAPTER V

MACROECONOMIC POLICIES FOR THE MEDIUM TERM: 1989-199723/

A. THE POLICY FRAMEWORK

119. Analysis of Tunisia's medium term macroeconomic prospects leads tothe conclusion. that, having avoided some of the difficulties that afflictedmany other developing countries, Tunisia faces two major issues: increasingthe efficiency of investment and adjusting budget expenditures to the loss ofoil revenues. As already mentioned, in paragraph 83, Tunisia is fairly wellinsured against some of the major exogenous uncertainties: it is free fromthe need for debt relief and its attendant uncertainties, its debt servicingis not sensitive to world interest rate movements, and its exports aresufficiently diversified for it not to be sensitive to the price changes of asingle commodity. The country is, therefore, in the position of being fairlycertain that improvements in economic efficiency will be felt as higherconsumption or faster growth.

120. An improvement in the efficiency of investment would be reflectedprimarily in a fall in the volume of investment needed to generate a givenincrease in GDP and, hence, in a lower share of investment in GDP to generatea given GDP growth rate. Such changes are expressed in terms of changes inthe 5-year ICOR, which is not to be interpreted as a measurable technicalrelationship between value added and investment, but merely as the bestindicator of tb- change in the efficiency of investment. Its purpose is toprovide macroecanomic relationships; namely to link a combination resourcegaps and consumption rates with a given rate of CDP growth. The ICOR fails,however, to indicate the employment effects of investment, in particular theincrease in the number of permanent jobs created per unit of investment as aresult of the changes in the relative cost of investment and labor, and thecurtailment of large public sector projects that generate little permanentemployment. Although it is hard to quantify, a marked increase in the labourintensity of aggregate investment can be expected to the extent that thereforms take effect. Hence, a lower ICOR would as a rule, be associated withmore labor intensive investment and faster employment generation.

121. As the analysis presented in this chapter shows, a moderateincrease in the efficiency of investment would lower overall resource needs

L The discussion of this chapter is based on macroeconomic projectionsprepared by Bank staff for the period 1990-97 on the basis of a modelwith a flow of funds and two real sectors. A detailed presentation ofthe projections and a description of the model are given in Annex 3.

- 56 -

enough to give long term growth rates of consumption that, if not as high asin the 1970s, would be above those of recent years and compare well with thoseof most other countries, while the growth of employment could be expected toincrease faster than hitherto. The policies necessary to obtain this increasein efficiency and to raise private enterprise investment to the requiredlevels have been discussed in the foregoing chapters. This chapter presentsthe overall resource implications of a lower ICOR and the effects on economicgrowth, while outlining the appropriate macroeconomic policies. The centralmacroeconomic issue is that of finding the right balance between themacroeconomic benefits of smaller budget deficits on the one hand and the needto progress in restructuring public enterprises and to protect the consumptionof the poor on the other. Given the importance of allowing the private sectoradequate access to resources over the medium term and the risks inherent in alarge domestic debt, the issue has to be addressed with prudence. AlthoughTunisia appears to be well covered against many exogenous uncertainties, it isespecially vulnerable to drought and, hence, a discussion of the consequencesof a drought similar to that of 1986 is added.

122. The ICOR. The primary indicator of Tunisia's success in adjustingto the loss of oil export earnings and higher debt service through animprovement in the efficiency of the economy would be a decline in the ICOR,which the reform program of the Government and the measures to increase itseffectiveness, as discussed in Chapter III and IV, are designed to bringabout. Analysis of Tunisia's macroeconomic prospects is based on a steadydecline of the 5-year ICOR to about 4 in the mid-1990s, as compared to over 6in the early 1980s.!1 Such a decline would suffice to allow GDP growth toaccelerate slowly to a long term rate of about 5.0 percent p.a., with asimilar increase in the growth of consumption and a gradual improvement in theoverall debt indicators. Employment generation is, however, likely to befaster than in the 1970s because of increases in the private sector's share ininvestment and because of relative price movements that would make investmentmore labor intensive. The unemployment rate should gradually decline.Tunisia's ICOR would be in line with the ICORs of the more efficient middleincome countries and not much below the Tunisian levels in the early 1970s.

123. Were the ICOR to fall less, say because progress towards theadjustment objectives of the Government was delayed, consumption would belower, either because of slower growth of GDP or because of the higher savingand greater external borrowing needed to maintain the same GDP growth. Thus,if the ICOR were only to decline to 5.3, investment in the later 1990s wouldneed to be about 6 percent of GDP higher than if the ICOR fell to 4 to

kg4/ 5-year ICORs for middle income countries vary widely. The lower ones,including Chile, Korea and Turkey, are below 4. Some of the highest arearound 16. Tunisia's own 5-year ICOR in the late 1970s varied between3.6 and 5.4.

- 57-

maintain the same growth rate, requirtPg a combination of higher saving andgreater external borrowing that woulc more difficult to sustain.

124. External financing. The adjustment policies would also facilitatethe external financing Tunisia will require. The projections of financingfrom official sources reflect the stated intentions of donors and past trends.In part the statements of intention reflect the donors' assessment thatTunisia's adjustment program will make effective use of the resources theyprovide and maintain the country's creditworthiness. Private financing willbe less important than it was in the early 1980s, both in amount and relativeto official sources, but it will also be more difficult to obtain. Tunisiahas high standing as a borrower, as demonstrated by its access to financialmarkets in the mid-1980s, when the world debt crisis made markets reluctant tolend to developing economies in general. But sustained borrowing will requirethat Tunisia's overall macroeconomic balances are viewed as sound by financialinstitutions and that the development of the economy is viewed as adequate toprevent unrest arising from hardship.

125. The government budget. The Government budget will be underpressure because of the decline in oil revenues and the expenditurerequirements of public enterprises and consumer subsidies. Each of thealternative ways of dealing with the issue has costs that must be weighedagainst its advantages. The projections here balance the need for maintainingbudgetary expenditures against the dangers of large deficits to provide afeasible scenario that appears realistic, especially in the light of theGovernment's responses to budgetary pressures in recent years. To increaseGovernment revenues would pose political difficulties and has economicdisadvantages, while real depreciation of the dinar, though it had favorablenet budgetary effects some years ago, is less likely to have them in thefuture.

126. The reduction of budgetary expenditures must be balanced againstthe cost of postponing the benefits of these expenditures. Since theGovernment's program of restructuring and privatizing public enterprises willeventually produce budgetary and economic efficiency gains, there is atrade-off between faster implementation of the program and limiting outlays.For instance, the large operating subsidies needed by the railways, thephosphate mines and the related chemical complex, will diminish to the extentthat restructuring and management reform can be implemented. Ordinary publicadministration consumption is projected to grow slowly in real terms, i.e., atthe population growth rate, and public administration investment is kept lowas compared to the past. Consumer price subsidies have recently risen as aresult of poor harvests and high import prices of cereals, and need to bereformed by replacing price subsidies with targeted programs.

127. The scope for increasing taxation is narrow. Direct taxation hasalways been low in Tunisia as compared to other middle-income countries

- 58 -

uecause of collection difficulties. It is assumed that yields improve as taxreforms facilitate collection, but the gain will be limited. Increasingdomestic indirect taxes could be effected by raising the rates of thevalue-added tax, but, since the VAT on production was only introduced inJuly 1988 and the extension to distribution is still under way, such a stepwould risk undermining a reform that has so far been a success. Higher taxeson imports in place of import restrictions will bring in additional revenue,but these taxes would need to be temporary and would be offset by theGovernment's commitments to lowering other taxes. The projections assume afixed relationship between imports and the revenues they generate. Moreover,higher taxation is no less a transfer of resources than borrowing by theGovernment, but it has the disadvantage of being unrequited and being seen asinconsistent with the Government's stated objective of giving the privatesector greater access to the nation's resources.

128. Analysis of the effects of real depreciation of the Tunisian dinarleads to the conclusion that the net budgetary effect is neither certain norsignificant. An analysis of this issue is given in Annex I. It shows thatthe effect was favorable in the past, largely because oil revenues constituteda larger share of total revenue. However, the analysis shows that realdepreciation reduces the volume of imports sufficiently to have an unfavorablenet effect, which will offset the favorable effect of the lower deperdence onoil revenues in the future.

129. Although a rapid decline in the Government budget deficit as ashare of GDP is unrealistic, there is a minimum rate of decline needed topreserve macroeconomic stability. Tunisia has very little scope formonetizing the deficit because its monetary base is small (equivalent roughlyto 10 percent of GDP) and the inflationary effects would be correspondinglybig. Taking external financing as given, this means that the deficit will befinanced by domestic borrowing, which has to be limited to sustainable levels.Government domestic debt is projected to reach the equivalent of 19.2 percentof GDP in 1993, as compared to 18.2 percent in 1988. This is well below thetheoretical limit of sustainability, but at this level domestic debt issensitive to increases in the deficit and, since a higher debt would poseserious problems in the event of unforeseen difficulties, a margin of safetyis needed to ensure a reasonable degree of stability.

130. An indication of how the size of a deficit that is sustainable,given the levels of government debt, can vary with the cost of domesticborrowing and the real exchange rate is provided in Annex I. To maintain thegovernment debt at 18 percent of GDP and the ratio of that debt to exports at78 percent, with the real rate of interest on domestic borrowing roughly zeropercent and on foreign borrowing at 4.5 percent, the budget deficit net ofamortization and interest would have to be 0.8 percent of GDP. This assumes aconstant real effective exchange rate. If the real rate of interest ondomestic debt were 3.0 percent and there were an annual real effectivedepreciation of the dinar of 3 percent, there would need to be a surplus of

- 59 -

0.7 percent of GDP. Since interest payments on government debt are about3.0 percent of GDP, the two budget deficits would be 3.8 percent and2.3 percent of GDP. In other words, the deficits of 1988 and 1989 would leadto growing government indebtedness if the cost of domestic borrowing rose tolevels comparable to the money market rate. A similar conclusion could bedrawn for the effects of more costly foreign borrowing.

131. Both government revenues and expenditures decline steadilyrelative to GDP, but the overall deficit only begins to declin.a significantlyin 1992. The decline of revenues is almost entirely due to the loss of non-fiscal revenues from oil. The decline of expenditures is more broadly based.Government consumption decreases relative to GDP because government employmentand consumption of goods and services grow at the population growth rate,while the total salary bill grows at 3.0 percent p.a. in real terms.Government capital expenditures include financing of capital expenditures ofpublic enterprises and decrease with them, while government direct investmentstabilizes as a share of GDP. Transfers to public enterprises as operatingsubsidies are projected to remain stable in real terms and to decline relativeto GDP.

table 15

Budget and Current Account as iercent GDP: 1988-97

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997(prelm)

Government Revenues 30.7 30.1 29.5 28.9 28.6 28.2 27.4 26.9 26.4 26.0

Government NetExpenditures 9 34.7 34.2 33.2 32.0 31.2 30.5 29.8 29.3 28.6 28.0

Go'. Consumption k/ 14.1 14.2 13.8 13.5 13.3 13.1 12.8 12.5 12.2 11.9Gov. Capital Expend. 9.4 7.6 8.8 8.6 8.7 8.5 8.5 8.6 8.6 8.7Interest payments 3.0 3.2 3.3 3.1 3.0 2.9 2.7 2.6 2.5 2.3Other Expenditures

(incl. Transfers) 8.1 9.3 7.3 6.7 6.3 6.1 5.8 5.6 5.3 5.1

Overall Net Deficit 3.9 4.2 3.7 3.2 2.7 2.4 2.4 2.4 2.2 2.0Foreign Net Borrowing 1.7 2.0 1.3 0.6 0.4 0.4 0.5 0.9 0.6 0.3Domestic Net Borrowing 2.2 2.2 2.3 2.6 2.3 2.0 1.9 1.5 1.6 1.7

Current Account Deficit +1.1 -3.8 -3.4 -3.3 -3.1 -3.0 -2.8 -2.6 -2.5 -2.4

Total Government DomesticDebt/GDP 18.2 18.4 18.8 19.3 19.3 19.2 18.9 18.4 18.1 18.0

a/ Expenditures net of amortizations.b/ Government Consumption includes Salaries and Consumption of Goods ane Services.

- 60 -

132. The decline of the overall deficit ensures that the accumulationof government domestic debt does not become large. The greater part of thefinancing of the deficit is assured through domestic borrowing, mainly tnroughthe issue of Treasury bonds. All of the remaining financing is assured fromforeign borrowing. The proportion of government domestic debt to GDP reachesa maximum in 1993 of 21.0 percent, after which it begins to decline.

133. Monetary Dolicy. Demand management through monetary policy andexchange rate adjustments acquires greater importance as the economy isliberalized. The removal of import restrictions in particular makes thebalance of payments more sensitive to overall demand and relative movements ofdomestic and external prices. Liberalization has also changed the mechanicsof demand management by replacing the Central Bank's direct control overlending and its extensive rediscounting with operations on the money marketand rediscounting limited to preferential credits. A prudent monetary policywith a constant real exchange rate can keep inflation within the range of 6-8 percent that has been the norm in Tunisia.

134. The Tunisian authorities' projections. The Tunisian authoritieshave prepared projections up to 1995 that are broadly consistent with the Bankstaff projections discussed here. In particular their investment and growthfigures presuppose ICORs very close to those of the Bank projections. Butthere are two differences of significance. First, the Tunisian authorities'projections have more ambitious growth of GDP and less growth of consumption.Their gross domestic saving rate increases to 24.8 percent by 1994, ascompared to 20.2 percent in the Bank projections, and results in higherinvestment. Since the improvement in the ICOR and external borrowing are verysimilar in both sets of projections, GDP growth is higher in the Tunisianauthorities' projections, accelerating to around 6 percent p.a. after 1994, ascompared to the Bank projections of 5 percent p.a.. The Bank projections,however, allow per capita consumption to grow at over 2.0 percent p.a.,whereas in the authorities' projections it grows at an average of 1.0 percentp.a.. One difficulty of the more ambitious projections is that it is notclear what would induce the increase in domestic saving. But, even if thepropensity to save were there, the authorities' projections appear optimisticin supposing that private investment will increase more than in the Bankprojections although the lower growth of domestic consumption provides less ofa market stimulus.

135. Second, in the Tunisian authorities' projections government budgetrevenues and expenditures are lower than those of the Bank projections and theoverall deficit decrease is faster. By 1992 government expenditures in theformer projections are 2.8 percent of GDP lower than in the Bank projections.Such compression of expenditures will cause problems, especially sinceconsumer subsidies continue at close to the level of 1988, almost onepercentage point of GDP higher than in the Bank projections.

- 61 -

136. Down-side risk: drought. As already discussed in paragraph 83,the major exogenous uncertainty Tunisia faces is rainfall, which directlyaffects GDP and indirectly affects the balance of payments and the budget. Sofar the analysis of the medium term has been based on agricultural growth inline with past trends, but with steady growth representing the evening out ofgood and bad years. Unless they are calamitous, as in 1988, individualdroughts do not have significant lasting effects on the economy, i.e., theeconomy has the robustness to absorb the shock. A less extreme, though stilla severe drought, comparable to that of 1989, reduces GDP 3.8 percentagepoints below what it could be in an average year and leads to higher foodimports. Consumption and investment are unaffected, but the deficits on thebalance of payments' current account and on the government budget increase by2 percent of GDP. The increase in external debt results in a current accountdeficit increase of 0.2 percent of GDP in the following years, after which thedrought's effects on the balance of payments and the budget becomeunnoticeable. These transitory small effects may be offset, also, by aboveaverage years. However, more frequent droughts would pose bigger problems.First, the offsetting effects of good years would be reduced and there wouldbe an accumulation of external and domestic government debt. Secondly, ifdroughts are not separated by years of at least average rainfall, the effectson aquifers, trees and livestock would be more complex and severer. Such ascenario and a drought like that of 1988 would be disaster scenario ofrelatively low probability but high cost.

B. MACROECONOMIC BALANCES

137. Investment. The higher efficiency of investment and the growingrole of the private sector are reflected in levels of total investment thatare modest by the standards of the past ana in an acceleration of investmentby private enterprises. Total investment rises from its low point of18.8 percent of GDP in 1988 to 23-24 percent from 1993 on, which means that inrelation to GDP it remains well below the levels from the mid-1970s to 1985.The increase relative to GDP is entirely due to private enterprises, whoseinvestment rises steadily to over 10.0 percent of GDP after 1995, i.e., higherthan at any time since 1970 except for 1981-82, when it exceeded 10 percent.In volume terms the growth is around 16 percent p.a. up to 1992, after whichit decelerates to less than 10 percent p.a.

- 62 -

Table 16

Fixed Investm*nt by AR*nt as Percent of GDP: 1988-97

1988 1989 1L99 1991 19a 1993 1994 199S 1996 1997(prolm)

Private Enterprises 5.6 4.8 6.5 7.8 8.4 9.0 9.4 9.9 10.4 10.9Public Enterprises ! 4.6 6.6 6.3 6.1 5.9 5.6 5.4 5.1 4.8 4.5Government 4.1 4.6 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0Households 4.2 4.3 4.3 4.3 4.3 4.3 4.3 4.3 4.3 4.3Total Fixed Invest. 18.5 20.3 21.1 22.2 22.6 22.9 23.1 23.3 23.5 23.7

Memo Item

Gross Direct ForeignInvestment in Fuel 0.9 0.2 0.2 0.2 0.1 0.1 0.0 0.0 0.0 0.0

a/ Excluding direct foreign investment in oil sector.

138. Of the other categories of investment, the share of publicenterprises declines steadily, that of households remains roughly constant atlevels comparable with those of the 1970s, and that of public administrationremains steady after falling in 1990. In volume terms public enterpriseinvestment declines slightly as a result of the Government's policy oflimiting expansion mainly to utilities and certain enterprises that willremain in the public sector, while emphasizing the financial and physicalrestructuring of a number of enterprises where it is justified, especiallywhen there are good prospects for privatization. Apart from utilities, suchas power and telecommunications, there is likely to be long term expansion inpublic enterprises such as the national airline and agencies for managinginfrastructure like irrigation works. The share of public enterpriseinvestment, which was 5.5 percent of GDP in 1988, gradually falls to below5 percent after 1995. Investment by the public administration, whichcomprises both central and local government, is projected to stabili- from1990 on at 4.0 percent of GDP, which is roughly the average for the early1970s, though below the rates of over 5 percent for the years that followed.

139. The resource balance and current account. The diminishing ICORand the increase in investment result in an acceleration of growth of GDP andper capita consumption with only a modest increase in the saving rate, whilethe resource gap remains about 3 percent of GDP and declines to below2.5 percent after 1995. From 5.0 percent in 1990, GDP growth declines andthen recovers to 5.0 percent after 1994. Because of terms of trade effects,real per capita consumption growth fluctuates up to 1993, though it remainspositive, and then rises to around 2.4 percent a year from 1995 on. Thegrowth is entirely due to private consumption, since real publicadministration consumption grows at the same rate as population. Domesticsaving is not expected to show a rapid increase. The loss of oil revenues

- 63 -

reduces public administration saving well below the levels of the late 1970sand early 1980s, to around 5.8 percent of GDP. The reforms of the publicenterprise sector are expected, however, to increase saving by theseenterprises. The bulk of saving comes from households and privateenterprises, which increase their saving rates, to give a gradual rise ingross domestic saving to above 21 percent of GDP after 1994. Since investmentaccelerates initially souewhat faster than saving, the resource gap rises toabove 3.0 percent of GDP in the years 1990-92, after which it subsides tobelow 3.0 percent after 1993.

Tabte 17

Resource Balance and Current Account Deficit as 2ercent of GDP: 1988-97

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997(pretm)

Gross Domestic Saving 19.3 19.4 19.2 19.1 20.0 20.5 21.0 21.3 21.6 21.9Investment 18.8 23.9 22.8 22.6 23.1 23.5 23.6 23.8 24.0 24.2Resource Batance +0.5 -4.5 -3.6 -3.5 -3.1 -3.0 -2.7 -2.5 -2.4 -2.2Exports GNFS 42.5 41.9 43.3 43.6 44.0 44.4 44.6 44.9 45.1 45.3JImports GNFS 42.0 46.4 46.9 47.1 47.1 47.2 47.3 47.4 47.5 47.5

Net Factor Income a/ -5.0 -4.6 -4.5 -4.2 -4.0 -3.8 -3.6 -3.3 -3.1 -2.9Net Private Current

Transfers a/ 5.6 5.3 4.7 4.4 4.0 3.8 3.5 3.2 3.0 2.7

Current Account Deficit +1.1 -3.8 -3.4 -3.3 -3.1 -3.0 *2.8 -2.6 -2.5 -2.4

a/ Workers' remittances are included under current transfers.

140. This resource gap results in the non-interest current accountbeing close to balancing, which is to say that the net resource transfer toTunisia differs from zero by net direct foreign investment less tne increasein reserves. The great bulk of the difference between the resource gap andthe non-interest current account is due to workers' remittances, which comemostly from Europe and have proved responsive to measures to attract them withspecial facilities, such as convertible dinar accounts at attractive interestrates. However, it is not likely that these remittances will growsignificantly since emigration to Europe has become more difficult than in thepast. Consequently, it is projected that in dollar terms these remittanceswill grow at the world inflation rate. There has been a revival of labormigration to Libya, but not to the levels of the early 1980s, and ::t isexpected that remittances from this source will remain small.

141. External financing. Since there are virtually no net transfers,interest payments on Tunisia's external debt remain fairly constant in dollarterms and, since workers' remittances do the same, the current account remainclose to the resource gap. As in earlier years, interest payments differ by

- 64 -

only a relatively small amount from workers' remittances, whereas the otheritems that constitute the difference between the resource balance and thecurrent account are much smaller. Consequently, the currenz account deficitruns at about 3.0 percent of GDP from 1990 to 1992 and then declinesgradually.

Table 18

Financing of the Current Account in USS Millions: 1988-97

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997(prelm)

Current Account Deficit 106.1 -385.4 -377.0 -400.9 -403.9 -430.5 -447.1 -463.9 -488.8 -509.2Net Dfrect Foreign Investm. 104.9 125.0 158.3 172.0 186.6 202.5 216.4 234.8 254.8 276.4OfficiaL Grants 46.6 62.5 60.7 39.3 33.4 32.7 27.5 27.2 26.9 26.7Amortization Payment PPG a/ -673.0 -75(.2 -936.7 -883.4 -777.3 -763.1 -810.0 -911.1 -940.4 -1026.8Multilateral Gross Distrib. a/ 355.7 573.7 514.2 499.7 395.4 388.8 409.9 412.7 414.6 419.6Bilateral Gross Distrib. 338.3 425.6 408.2 393.9 371.7 355.5 425.8 424.0 412.4 367.5Private PPG Gross Distrib. 210.8 180.9 159.7 198.2 214.8 224.1 228.7 295.8 339.4 419.3Others b/ -91.0 -71.4 22.0 27.8 31.9 43.3 48.8 40.6 41.3 61.5Change in Gross Reserves -398.5 -154.7 -9.5 -46.6 -52.6 -53.3 -100.0 -60.0 -60.0 -35.0(- impLies increases)

Memo Items:

Total Debt/GDP c/ 66.5 70.3 66.5 62.7 58.7 55.0 51.5 48.0 45.0 42.1Total Debt Service Ratio c/ d/ 23.3 25.7 26.8 23.4 19.6 17.8 16.8 16.6 15.6 15.0ReaL Effective Exchange Rate

Index (CPI) (1980=100) 69.9 69.8 69.8 69.8 69.8 69.8 69.8 69.8 69.8 69.8

l/ Including IMF.b/ Others are net disbursements of short term debt, MLT Non-Guaranteed and

capital NEI.c/ Total Debt including MLT non-guaranteed and short term debt.d/ Debt service ratio is calculated over exports of goods and services

including Workers' Remittances.

142. These current account deficits result in slow nominal growth ofexternal debt and a steady improvement in the overall debt indicators.However, in contrast to the early 1980s and in line with the stated intentionsof the major bilateral and multilateral sources, a greater proportion of newcommitments are from official sources. Gross disbursements are projected torange up to around US$1.2 billion, with private disbursements graduallyincreasing their share. Total debt'- outstanding increases fromUS$6.7 billion in 1988 to US$9.1 billion in 1997, a nominal growth of3.5 percent p.a. on average. Since GDP grows faster and the real exchangerate is projected to remain constant, the debt to GDP ratio falls from66.5 percent in 1988 to 48.0 percent in 1995 and continues to decline after

,M Public and publicly-guaranteed debt, including IMF.

- 65 -

that. The debt to export ratio shows a larger decline, falling from137.3 percent to 98.9 percent between 1988 and 1995, and the debt serviceratio falls from 23.3 percent to 16.6 percent.

143. The fact that private sources constitute a smaller proportion ofexternal financing than in the early 1980s means that their net disbursementswill be large negative amounts initially and only eventually turn positive.The substantial inflows of private lending up to 1986 and their subsequentdiminution because of Tunisia's lower financing requirements resulted in netprivate disbursements becoming negative in 1987. By 1990 they are expected tobe -US$260 million and only become significantly positive in 1995.Consequently, the proportion of debt owed to private sources, which had beenas high as 36 percent in 1980 and had fallen to 22 percent in 1988, will fallfurther to 9 percent before beginning to increase in 1995.

144. Exports of goods and non-factor services have been growing fastand it is prudent to assume- ̀hat constraints on supply and on the growth ofmarket shares will cause the:i. to slow down. They are projected to slow downin the short term before resuming a trend growth rate of over 5 percent p.a.,while imports are expected to grow somewhat faster at first and then todecline to a similar trend rate. Since terms of trade effects are expected tobe negligible and since the resource gap in 1988 was small, it is thesemovements in volume that determine the behavior of the resource gap. Rapidgrowth in recent years has put the volume of exports above what supply andmarket constraints indicate to be the long-term trends. Hence, in 1990-91export growth is projected to be slower and to approach the trend line.Imports behave in the opposite way: because of the revival of domesticconsumption and investment, their volume growth is higher than the trend inthe short term. Since Tunisia maintains a constant real effective exchangerate, the share of exports in CDP in 1997 is about that of 1988, while that ofimports is only slightly higher.

145. The composition of exports and imports continues to changeaccording to the trends of recent past. Manufactures are the largest and mostrapidly growing category of exports, with the traditional items of textile,phosphate derivatives, and food products accounting for the bulk of thegrowth, but with some diversification due to the growth of electro-mechanicaland other goods. Exports of services, mainly tourism, is the other mostimportant category, but is projected to grow considerably more slowly than thehigh pace since 1986. Petroleum continues to decline to become finally aminor export, and the traditional raw phosphate exports grow at modest rate.Agricultural products grow briskly at rates comparable to those of the past.The composition of imports changes little. The main imports remain consumergoods and intermediate products. Imports of petroleum continue to grow, sothat Tunisia becomes a net importer of petroleum by 1990.

- 66 -

Table 19

GDP Growth in Dercent: 1988-97

1988 1989 1990 1991 192m 1993 1994 1995 1996 1997(pretm)

Gross Domestic Product MP 1.5 3.0 5.0 4.5 4.8 4.8 5.0 5.0 5.0 5.0Agriculture -23.9 4.1 8.5 4.6 4.2 4.2 4_Z 4.2 4.2 4.2Industry 2.3 3.3 4.0 4.4 5.7 2.7 3.7 4.2 4.6 4.9

of which: Manufacturing 6.9 6.8 6.9 6.9 6.9 7.5 7.5 7.5 7.5 7.5Mining(inc. Phosph.) -1.2 -0.8 -2.2 -1.2 2.8 -11.4 -9.2 -9.0 -8.8 -8.5

Services 8.2 2.5 4.8 4.6 4.4 6.3 6.0 5.7 5.4 5.2ConsuRption 1.1 2.8 5.4 4.1 3.5 3.9 4.6 4.7 5.0 5.0Gross Domestic Investment -19.7 30.9 0.6 2.8 7.1 6.0 6.0 6.0 6.2 6.1Exports GMFS 24.5 -1.3 6.6 4.6 5.3 5.1 5.8 5.6 5.7 5.6Imports GNFS 16.2 11.1 9.4 4.6 4.8 5.0 5.4 5.5 5.7 5.7

146. Much of the growth of GDP is due to exports. The fastest growingsector is manufacturing, of which over half the production is exported.Services, being the largest sector of the economy, account for roughly halfthe real growth of GDP over the period and of this 13 percent is due totourism. Agricultural growth is projected to continue at the trend rate ofthe past, while mineral production declines because of the depletion of oilreserves.

C. SUMMING UP

147. Although Tunisia still faces a considerable agenda of reforms andalthough the behavior of economic agents needs to evolve further to create acompetitive, efficient economy, the country is better placed than mostdeveloping countries to ensure satisfactory long term development. It has notneeded to seek debt relief and, given stable world economic conditions, it isunlikely to need any in the future. Hence it is free of the uncertaintiesabout its future resource availabilities that bedevil many highly indebtedcountries. Nor does it need to have a net transfer of resources out of thecountry to service its external debt. On the contrary, its standing withofficial creditors and financial markets is good enough for it to bereasonably sure of being able at least to obtain the financing needed tomaintain a balance on its non-interest current account. Although it lostincome through the fall in world oil prices and the depletion of its oilreserves, and will loose more in the coming years, its non-oil exports havegrown sufficiently for it to be much less hostage to the uncertainties ofworld price movements than before or than the numerous developing countries

- 67 -

with narrow export bases. Inflation in Tunisia has always been moderate andexpectations within the economy, based on the authorities' past policies andtheir known aversion to high inflation, are that it will remain so. Hence, itdoes not have the problems caused by high inflation in some other countries.This is a major factor not only in preventing capital flight, which is commonin high inflation countries despite c_pital controls, but also in attractingremittances from Tunisians resident abroad. Finally, the country is more atpeace politically than many; it is not racked with violent political movementsand now enjoys good relations with its neighbors and most other countries.

148. To an extent unusual in developing countries, therefore, Tunisia'sfuture economic development car. be assured by its own economic reforms. TheGovernment has drawn up and begun to implement a substantial program ofreforms and this report recommends a few more. The primary objective of allthese reforms taken together is to increase economic efficiency, in particularthe efficiency of investment, so as to enable the economy to sustain growthwith rising per capita consumption and declining unemployment. This requiresthat the economy become outward oriented and that a growing, competitiveprivate sector be able to respond to market signals.

149. The Government has initiated reform of pricing and taxation thatwill go far to allowing market signals to operate freely. These reforms needto be accompanied by measures to ensure that economic agents are free torespond to market signals and do so in a competitive manner. Importcompetition would be a crucial element in this and the Government's programfor removing import restrictions is of high economic priority. The difficultyin implementing this program and the uncertainties it creates would beminimized by the use of temporary supplementary tariffs and the announcementof a timetable specifying the dates at which restrictions on the imports ofspecific goods would be removed. Since Tunisia had relied on importrestrictions to fend off dumping by foreign producers, the Government isstudying how to set up anti-dumping mechanisms. It is important that thesemechanisms be impartial and not work as a disguised form of protection.Another obstacle to competition, including competition from imports, isadministrative restriction on entry into wholesale distribution. There is noapparent justification for it and its removal should be a priority.

150. Fostering more competitive behavior in the financial sectorthrough innovation and diversification is the most important objective in thewake of the extensive reforms already implemented in the sector. One of theprincipal obstacles to competitive behavior by banks in searching for newclients is the cap on lending spreads. Its removal would increase the rangeof potential borrowers and hence increase the financing of investment.Competition would also be fostered if the banks posted prime rates. Thedevelopment of the money market has opened opportunities for extending therange of financial instruments and has increased competition for deposits. Astep that could help develop the money market and reduce the segmentation inthe banking sector would be to allow development banks to issue short-termdebentures as an alternative to allowing them to take deposits. For thesecondary market in longer term instruments to develop, Treasury bonds need tobe issued with coupons consistent with yields on other instruments. This

- 68

could pave the way for allowing the issue and Trading of bonds ofnon-financial enterprises. The rapid evolution of the sector requires thatthe bank staffs acquire greater expertise, which in turn requires that thebanks be encouraged to develop this expertise and that salaries be determinedmore by performance and less by administrative pay scales. Banks should beencouraged to increase their provisioning by making tax deductions for iteasier and larger.

151. The overall level of investment needs to increase relative to GDP,though not to levels approaching those of the past. The increase would comeentirely from private enterprises, since the share in GDP of public sectorinvestment is expected to decline gradually. Investment in export activitiesis growing rapidly, but investment catering to domestic demand will also needto increase since it constitutes the bulk of private enterprise investment.However, it would need to take place within the context of pricing reform andincreasing competition, especially from imports. Within this context, andafter the long period of restraint on consumption, per capita consumptiongrowth at a steady, and hence predictable, rate compatible with a prudentassessment of medium term macroeconomic balances will help stimulateinvestment. A deterrent to investment is the uncertainty over some of theGovernment's policies, in particular the timing of the removal of importrestrictions and the possibility of a new industrial strategy. Investment islikely to be encouraged by clearer explanation of and commitment to theGovernment's present adjustment objectives. Enterprises would need to turnincreasingly to equity markets. Although the development of such markets willbe a long-term effort, it should begin early. One step taken in thisdirection has been a reduction in tax advantages accruing to other forms ofinvestment. Another step is a UNDP/IFC training project in the stockexchange. A major step would be to enforce well defined accounting standards.Banks could be encouraged by the Central Bank to ask for audited standardaccounts from borrowers by downgrading loans not supported by such accounts.

152. Tunisia's macroeconomic balances will depend primarily onimproverants in the efficiency of investment resulting from these reforms.Assuming a gradual decline in the 5-year ICOR to around 4 in the mid-1990s,growth rates of 5 percent would be achievable with the current account deficitaround 3.0 percent of GDP to the mid-1990s. There will be pressure, however,on the budget due to declining revenues from oil on the one hand and financingrequired for public enterprise restructuring and consumer subsidies on theother. Since the money base is small in Tunisia, all the financing of thebudget deficit would be performed through borrowing. Hence, limits to thedeficit could be determined by the level of debt that could be safelysupported by the budget and by the need to avoid crowding out the privatesector. Budget deficits would need to be kept to a maximum of 3.7 percent ofGDP in 1990 and to decline after that. These limits would need to berespected although they would have economic costs by imposing delays inrestructuring public enterprises. Consumer subsidies would need to bereduced by replacing the present system of price subsidies with targetedprograms.

C: \HJT\TUN\CM-GRAY

- 69 -

APPENDIX I

A DECOMPOSITION OF TUNISIA'S CURRENT ACCOUNT BALAiCE1980-1988

1. Purpose: In this note, the evolution of Tunisia's current accountbalance over the period of 1980-1988 is analyzed. In order to identify thedifferent factors which have affected the current account balance between1980-88, the current account is decomposed into its main line items andanalyzed applying the Balassa method. This methodology is described in Balassa(1980).! The basic principle of this methodology is to isolate price andvolume effects in the variation of exports and imports, and similarly, toseparate, if possible, price (exchange rate, wage etc.) and volume (i.e., debtvolume) effects, in factor payments and net transfers. These constitute thetotal change in the current account balance.

2. Decomposition Method: In the case of Tunisia, it was possible todecompose both the resource balance and interest payments. In the followingsections, changes in these components of the current account and workers'remittances are analyzed. The remaining categories such as the other nettransfers and other net factor payments are combined under a residual term.

3. The Resource Balance: The resource balance is decomposed into(i) pure terms of trade effect, (ii) the unbalanced terms effect, (iii) andimport and export volume effects. Moreover, exports and imports aredisaggregated further, in order t:o capture the impact of oil price shocks andthe depletion of oil resources of Tunisia on the export side, and the impactof droughts and world food price changes on the import side. Exports aredivided into oil and non-oil and each is decomposed into price and volumeeffects. Similarly, imports are divided into food and non-food imports. Thissecond level of decomposition is used to complement the first one.

4. Workers' Remittances: The change in workers' remittances issimply decomposed into the exchange rate effect and other changes. Theexchange rate effect is defined as the influence of the changes in thecross-currency exchange rates on the dollar value of workers' remittances.

For reference, see Balassa, B. (1980), "The Newly IndustrializingDeveloping Countries After the Oil Crises", World Bank StaffWorking Paper No. 437. Also see, "Yugoslavia, The Challenge ofAdjustment" vol.I and II, World Bank report No. 6353-YU; andZiller, B., 1989, "An Approach to Database Development", EM2CO,mimeo.

- 70 -

The US$/FF exchange rate index is used as a proxy since it was not possible todecompose workers' remittances by currency. Moreover, due to the lack of dataon the number of workers abroad, it was not possible to separate the volumeeffect. Therefore, other changes exclude the impact of the movements in thecross exchange rates, but includes the volume effect, i.e., changes in thenumber of workers abroad, appreciation or depreciation of the Tunisian Dinaragainst major currencies and other exogenous shifts.

5. Interest Payments: Interest payments are decomposed into twocomponents, (i) the interest rate effect, and (ii) the debt volume effect.Since cross-currency exchange rates also have an important impact on interestpayments, an alternative decomposition of interest payments isolating thecross-currency exchange rate effect was also prepared. This seconddecomposition separates interest payments denominated in four majorcurrencies: US dollars, French francs, deutsche mark and Japanese yen.Interest payments due to debt denominated in other currencies are classifiedas residual.Y

6. In the following analysis, all comparisons are made with respectto the base year, 1980. Similarly, the figures in Tables B through D, reflectchanges in each variable with respect to its value in 1980. Thus, to give anexample, the change in the resource balance in the year 1985 is calculated asthe difference between the resource balance of 1985 and 1980. Moreover, if anyvolume or price effect has a negative sign, it should be read as an effectwhich has a negative impact on Tunisia's current account, i.e., whichcontributes to the worsening of the current account.

The Evolution of the Tunisian Current Account Balance

7. For this analysis the base year chosen is 1980 when the currentaccount deficit was 4.74 percent and the resource balance was -5.36 percent,as shares of GDP. (See Table A). In the eighties, the current account ofTunisia worsened significantly between the years 1980-86 and recovered sharplyafter 1986, resulting in a small surplus in 1988. In the 1980-86 period thedeficit increased sharply from 4.74 percent up to 10.90 percent of GDP in1984, and stayed consistently above 7.0 percent throughout the period. As thistrend in the current account balance suggests, the 1980-88 period will beexamined in two sub-periods, 1980-1986, the deterioration years, and 1986-88,the improvement years.

a Specific formulations used for these decompositions are given inthe back of this note.

- 71-Table A. TIJIISIA; BALANCE OF PAYMENTS IN HILL.US DOL.LARS

1980 1981 1992 2983 1994 1985 1986 1987 1999

EAports of Goods & NFS 3517.53 3487.04 3002.03 2869.46 27121.04 2699.94 2721.91 3374.08 4266.266odf (FOB) 2395.06 2455.125 1979.69 1860.35 1901.11 1729.18 1768.01 2136.72 2396.25of *AhL14 Mdufict. 904.94 1001.92 965.13 907.79 872.17 976.81 1174.94 1441.66 1801.35Nws-F&L.to Se(wsces 1122.47 1031.79 1022.35 1009.43 919.93 970.76 953.90 1237.36 1870.02

IQurtib of Goods 'a NFS 3996.42 4200.69 38058.47 3567.18 3659.24 3207.07 '3392.57 3473.39 4217.986viiJ (FOR) 34553.33 3586.88 3217.88 2926.64 3067.71 2595.57, 2750.50 2568.71 3502.10

uf whicl.; larnuafct. '2o78.57 2254.60 2312.00 1957.04 2054.63 1712.21 1914.86 1930.78 2335.00Noiu4Fdctor Set vices 533.09 613.81 640.60 640.54 591.53 611.50 642.07 604.68 715.7a

Reuuurce 8alariLe -468.89 -713.65 -856.44 -697.70 -938.21 -507.13 -670.65 -99.32 45.38

Net Factor FIcIEme Ceedl. RR) -293.33 -302.35 -294.40 -267.38 -254.25 -351.71 -421.66 -465.719 -500.35Fdctor RKceipts 91.h0 98.42 104.11 99.69 98.74 47.93 28.09 27.39 48.03Fd,.tur Pd,gents 384.94 400.77 395.51 356.07 352.99 399.64 449.75 493.19 5,49.38of aiiclimuterest pdyments 255.~J1 238.55 231.54 225.22 2464.00 269.10 324.86 3162. 422 415.33

Net Current Trdofers sincl. MR) 348.15 366.95 383.44 3.61.81 317.07 270.22 358.82 483.53 558.06Cuf rwit Receipts 3 73%.58 397.53 409.18 388.48 338.95 291.19 377. 08 502.47 572.74

of wisksi: wotkers' resittmfLes 303.21 361.08 371.76 359. 16 316.56 270.58 361.59 486,30% 543.95

other curreftt traosf. 70.37 36.45 37.41 29.32 22.40 20.61 15.49 16.17 28.19

Cur reist Payeent6 25.43 30.58 25.73 246.66 21.88 20.147 18.26 18.95 14.69

Cu(rtet Account Balaince -414.4) -649.050 -767.39 -60 .27 -875i.39 -589.62 -733.50 -81.5.7 106.09

CdPiItal ACLOWn

Tota]lIoi.q-te.. capital iidiou 645.28 709.29 732.19 '53~.10 677.32 490.68 475.41 120.71 372.47

Direct Fo(eign Investaent 236.05 3167.15 402.213 223.79 2405.97 139.48 155.04 92.31 104.92SOB ( 0.04 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00ufticial Capital Girants 41.46 20.25 18.96 25.34 28.58 36.55 40.55 34.51 46.63NE-t nLr loanss tDRS) iexcl.IMFI 315775 340.49 335.438 528.98 360.77 290.14 275.86 18.19 211.62

latd! Disburseents MLT PPB 573.:6 656.11 624.04 904.60 768.44 725.28 774.23 601.37 894.66

!itdl Repaysenrts MIT PPG 215.83 315.62 288.66 375.62 407.66 435.14 498.37 663.18 673.05Othiet LT inflowa, NB (set2t C. X0 -18.6%0 -24.40 -25.00 82.00 24.52 3.96 -24.30 9.30A

Gtt.er Iteusiniet) -1466.27 31.90 62.30 -164.56 48.35 -14.71 65.77 77.1 "I -100.26

Nei shor t-termk Lap tal -53..70 -2.80 21.90 -4.90 37.80t 12.170 44.80 0.20 47.80Cwpi;wr & WiUets -112.57 34.70 595j 196 10.55 -727.41 20.97 77.11 -148.06

Tatal choanqe ir, net reserves 1/ -64.94 -92.14 -27.09 14.73 149.72 112.64 192.32' -116.45 -378.29

,.w of IMF credit -3.0 0.00 0.60 0.00 0.00 0.00 175.711 53.03 201

Other ies0fve Clsadlqef -3*7'4 -92.114 -217.09 14.73 1149.72 112.64 16.61 -169.49 -398.46MN ei.ltes:

lInterrIdtiOndl Resetves(1nE1.GoldHIFS, 700.44 634.;: 691.94 638.54 463..95 29.3.85 378.40 616.03 976.02-Reseryes as morntts of Iapart* 6NFS 2.11 1.81 2.15 2,15 1.52 1.10 1.34 213 21.78

Curtrent Account DeficitlSDP W) -4.74 -7.7k) -9.44 -7.45 -10.90 -7.11 -8.32 -V0.85 1.06Resource Irwlance/GDF it) -5.36 -8.47 -10.53 -8.61 -11.68 -6.112 -7.60 -1.03 0.48

…- - -- - -…-- -- - - - - - - - - - - - - - - - - - - - - - - - - -- - - - - - - - - - - - - - - - - - - - - - - - - -

1: Cha'sge in net reseves from Tunrs4ai~i B0P.

- 72 -

1980-86 Period: Deteriorating Current Account Balance

8. Between 1980 and 1986 the current account balance worsened byUS$319.4 million. About 60 percent of this deterioration resulted from anincreased gap in the resource balance (US$ -201.8 million), apart from whichinterest payments increased by US$75.1 million. On the other hand, workers'remittances increased. Table B gives the decomposition of the currentaccount.

9. 1980-84: From 1981 to 1986 the resource gap remained higher inrelation to GDP, and hence in dollar terms, than in 1980. It was particularlyhigh in the years 1982 and 1984, reaching 10.5 percent-11.5 percent of GDP. In1981-84 the terms of trade effect was positive, thanks to favorable oilprices. The volume effect, however, was more than enough to wipe out thepositive effects of the terms of trade. Not only did the import volumeincrease sharply but the export volume was lower than in 1980 for the years1982-84. Workers' remittances contributed in a positive way up to 1984, sincetheir level remained higher in dollar terms than 1980 despite the strongappreciation of the US dollar vis-A-vis European currencies. The interestpayment effect remained rather small until 1984: though an increasing externaldebt contributed to increased interest payments, declining interest rates keptinterest payments slightly lower than in 1980 until the end of 1983. In 1984however, the bigger debt started to outweigh the interest rate effect andinterest payments began to increase.

- 73 -

Tublu 8: TUNISIA, DECOMPOSITi'ON OF CHMNSES IN THE CURRENT ACCOUNT iU980-1988)

(IN MILL. US DOLLARS)

190 1981 1982 98 1984 41985 1986 1981 188AR ANACHANGE

CiNEI'N CURREN'T ACCOUNT BALANCE 0.00 -2.34.97 -3531. 2 -1279.2C0 -461.31 -174.554 -497. 433 332.5'P 520.16 651. 02

Al- CHANGE IN RESOURCE BA'LANCE iSUFS) C, Oix -244.7o -387.555 228.81 -469.2 -38.24 -201.77 369.58 517.27 64.6aTERNS OF TRADE EFFECT 0.00 151.708 Z(,2.08 327.48 246.q8 -50.83 -487.94 -687.71 -999.217 -124.91PURE TERMS OF TRADE EFFECTl 4.o 93.229 126.83 125.13 -14.84 -148.81 -515.69 -641.18 -959.87 -119.98LtNGALANC'ED !ERM$ EFFECT 0.00 58.49 175.25 202.36 261.81 97.97 27.75 -46.52 -39.40 -4.93

1-- .',0GUME EFFECT 0.00 -196.54 -669.63 -556.30 -716.30 12.59 1286.17 1057.28 1516.54 189.51EXPORT VOLUME EFFECT C0.W0 1122.22 -1429.8B -98.27 -5.93 110.12 299.75 842.47 1912.84 239.10IMPORPT VJOLUMlE EFFECT Ui.00 -518.77 -559.75 -458.02 -710.37 -97.53 -131.56 4214.81 -39o.30 -49.34

11- -'4NSE IN NET NORIKERS REMITTANCE$ 0.uO 59.09 70.45 60.255 16.550 -3. 62.13 189.68 2448.84 31.11a- EXCHANGE RATE EFFECT idi[#;FFI C0. 00 -64.43 -101. 41 -1229.05 -149.59 -1e53.42 -112.93 -86.02 -84.19 -10.152

b- 01NER EFFECT 0.00 123.53 173.86 189.30o 166.08 123.35 175.06 275.69 533Z.02 41.o5

Ill- CHANGE IN INTEREST PAYNENTS 0.00 4.17 7.98 15.80 -24.17 -1q .44 -75.11 -105.64 -157.23 -197.65I- NTEREiT RATE EFf-ECT 0. Ci0 19.48 30. 0 551.10 33.50 'Al. 45 27 .5 1 52.85 55.14 6.89

b- DEBT VOLUnE EFFECT 0.00 -15.31 -22.ol -35.1' -57.67 -4;.29 -i~,2.62 -158.49 -2121.37 -26.55

lv- RECSIDUAL 0.oa -53.48 -44.20 -3'6.44 15.68 -86.718 -104.68 -121.11 -88.72 -11.09

- 74 -

10. 1985-86: In 1985 changes in the resource balance, workers'remittances and interest payments had negative effects on the current account,although the size of each effect was rather small. In the resource balance,the pure terms of trade effect was negative and quite large, reflecting thefall in the price of oil. This was offset partially by the unbalanced terms oftrade effect. The import volume effect continued to be negative but muchsmaller than in 1984 as import restrictions were introduced during 1985 inanticipation of possible balance of payments crisis. Thus, the export volumeeffect more than compensated for the import volume effect in that year.

11. In 1985 workers' remittances fell below the 1980 level for thefirst time in US dollar terms, partly due to the decline in the number ofTunisian workers in Libya and partly due to the appreciation of the US dollarvis-a-vis European currencies. Interest payments increased beyond their 1980level with the increased debt despite declining interest rates.

12. In 1986 the most important factor in the deterioration of theresource balance was a drastic worsening of the terms of trade mainly becauseof the 1986 collapse in oil prices. This was partially offset by the positivetrade volume effect: the export volume effect was very strong as exportsrecovered greatly after the fall in 1984, and import volume effect remainedvery small, mainly as a result of import restrictions put in place in 1985 toprevent a further deterioration in the balance of payments. Interest paymentscontinued to rise. Workers' remittances recovered significantly and helped tolessen the negative resource balance and interest payment effects. This wasdue to the depreciation of the US dollar which reduced the negative exchangerate effect, and a higher inflow of workers' remittances.

1986-88 Period: Imgrovement of the Current Account Balance

13. In this period the terms of trade effect continued to besignificantly negative as Tunisia's terms of trade worsened further.Fortunately, this was more than compensated by a rapid increase in exports,whose volume effect in 1988 was double that in 1987. This reflected theinfluence of new export promotion and liberalization pclicies to reorient theeconomy towards exports. Moreover, improvement in relations with Libya led toa large influx of tourists in 1988, increasing non-factor service revenues.The import volume effect was larger than in 1985-86 as imports restrictionswere relaxed. In 1987, however, the import volume effect remained relativelysmell, thanks to an excellent agricultural year and the continuing decline ininvestments, reducing imports of capital goods. In 1988 the import volumeeffect was much larger because of increased food imports in response to thesevere drought conditions of that year. Food imports are further analyzedbelow.

- 75 -

14. Workers' remittances also increased sharply in 1987-88, mainly dueto a sizeable devaluation of the dinar against European currencies at the endof 1986. Continued weakening of the US dollar also contributed to the higherdollar value of workers' remittances. This, combined with a positive resourcebalance, improved the current account deficit beyond its 1980 level despitegrowing interest payments. In fact, the current account deficit gave a smallsurplus in 1988.

Impact of Oil Exports and Food Imports: A Closer Look

15. Oil ExRorts: Price and volume effects. The impact of oil onTunisia's exports can be more clearly seen through a breakdown of totalexports (GNFS) into oil and non-oil. Table C, shows this breakdown. In USdollar terms the total change in exports has been negative since 1980, withthe exception of 1988, when export volume increase was the greatest. Thedecomposition confirms that, since the beginning of the eighties, thecontribution of oil exports to total exports has been declining. Since theearly 1980s the depletion of oil resources is reflected in the increasinglynegative oil volume effect. The oil price effect, positive in 1981, wasnegative for the remaining years, showing the biggest dip in 1986, as might beexpected.

16. By contrast, the volume effect of non-oil exports have remainedpositive throughout the period. But the losses caused by the drop in the priceof Tunisia's other exports kept the total effect of non-oil exports negativeuntil 1986. After 1986, non-oil exports began to have a positive effect on thedollar value of Tunisia's exports.

17. Effect of Food Imports: In Table C, imports are also broken downas food and non-food, in order to trace the effect of fluctuations in climaticconditions on the current account. Changes in food imports show big swings inthis period, dropping below the base year level in good harvest years andjumping above it in drought years.P Food volume increases had a negativeeffect on the resource balance over the whole period. Despite the dampening ofthe volume effect in "good" years, like 1985, the food import volume remainedabove the 1980 level for the whole period. This may be indicative of apermanent upward trend in Tunisia's food imports. The food import priceeffect, on the other hand, was positive, showing a drop in world prices offood. In the years 1982, 1985, 1986 and 1987 the price effect outweighed thevolume effect for food imports. The smaller volume effects in 1982, 1985 and1987 clearly reflect favorable agricultural --nditions.

For a more accurate analysis, cereal imports should be separatelyexamined.

- 76 -

Tabir 6: TUNISIA: INPACI OF OIL EXPORTS ANh FOOD IMPORTS ON THE RESOURCE '.LANCE (1980-98)

IIN KILL. US DOLLARS)

;vao 1981 1982 1983 1984 1995 1986 1987 1988

CHANGE IN RESOURCE BALANCE *6UFS) 0.00 -244.76 -387.55 -228.81 -469.32 -38.24 -201.77 369.58 517.27

- CHANGE IN EXPORTS GNFS 0.00 -30.49 -515.50 -648.06 -796.50 -817.59 -795.62 -143.45 748.73CHANGE IN OIL EXPORTS 0.00 -39.39 -43b.79 -515.65 -550.16 -b24.10 -919.32 -842.64 -762.00OIL VOLUME EFFEC' O.00 -96.52 -359.26 -353.19 -362.72 -399.01 -289.14 -363.95 -393.83OIL FRICE EFFECT V.00 59.13 -77.53 -162.56 -187.45 -225.09 -630.19 -478.69 -568.18

6- CHANGE IN NON-OIL EXPORTS O.00 8.90 -78.71 -132.41 -246.33 -193.49 123.71 699.19 1710.73NON-OIL VOLUHE EFFECT 0.00 20U.74 229.38 254.81 356.79 509.14 588.89 1206.42 2306.67NON-OIL PRICE EFFECI 0.00 -211.e4 -308.09 -387.22 -603.12 -702.63 -465.18 -507.23 -595.93

il- CHANGE IN IMPOR'S GNFS u.00 -214.2' 127.95 419.24 327.18 779.35 593.85 513.03 -231.46e- CHANGE IN FOOD INPORr 0.06 -40.21 31.54 -46.39 -79.40 54.53 26.44 75.48 -166.31

FOOD VOLUME EFFECT .00 -109.14 -70.86 -165.93 -180.49 -51.60 -155.;1 -113.09 -363.70FOOD PRICE EFFECT :i b8.93 102.41 119.53 101.09 106.13 181.75 188.57 197.40

b- CHANBE IN NON-FOOD 1. ' .0 -174.06 96.40 463.64 406.58 724.92 567.41 437.54 -65.1bNON-FOOD VOLUME EFFECT c:.0. -409.63 -488.99 -292.10 -529.88 -45.93 141.73 327.90 -32.59NON-FOOD PRICE EFFECT 0.00 235.57 585.29 757.74 936.45 770.75 425.68 109.64 -32.5b

- 77 -

18. For non-food imports, the volume effect was negative. In 1986 thiswas due to import restrictions as mentioned above, and in 1987 was causedmainly by a fall in the imports of capital goods.

Effect of Cross-Currency Exchange Rates on Interest Payments

19. The decomposition of interest payments into debt volume andinterest rate effects as presented above does not capture the impact of cross-currency exchange rate fluctuation. Since this may be an important factor, itis analyzed here for three major currencies, other than the US dollar, whichare significant in Tunisia's external liabilities. These are French franc,deutsche mark and Japanese yen. The cross-currency exchange rate effectcreated by fluctuations in French francs, Japanese yen and deutsche markagainst the US dollar is derived and presented in Table D. Interest paymentsin these four currencies are deconposed into interest rate, debt volume andexchange rate effects. The residual term includes the changes in interestpayments for debt denominated in currencies other than the four mentionedabove.

20. This decomposition shows that the interest rate effect due to thefranc was positive until 1984, with the exception of a small negative effectin 1983, helping to reduce interest payments. In deutsche mark, however, theinterest rate effect became negative after 1981, increasing the total interestpayments. Interest rates on yen loans also increased between 1983 and 1986.Since US dollar denominated debt mostly carried slightly concessional, fixedinterest rates, the interest rate effect has been all negative for dollarborrowings. Debt volume effect has been negative for each currency,indicating that Tunisia's external debt in all four currencies has beenaccumulating.

21. The total exchange rate effect due to francs, yen and deutschemark against the US dollar was positive between 1980-1987, indicating that thevalue of the franc, yen and deutsche mark denominated debt, as a whole,declined in US dollar terms and helped reduce interest payments.,/ Whenindividually examined, the exchange rate effect on the franc interest paymentswas positive for the whole period, and it was particularly high in 1984-85.For deutsche mark, the exchange rate effect became slightly negative after1987-88 as the sharp depreciation of the dollar wiped out the previouscumulative appreciation effect. Similarly for yen, the exchange rate effectbecame negative starting in 1986.

Of course, it should be remembered that the dinar depreciatedagainst the US dollar and in fact, Tunisia's interest payments indinar increased because of that exchange rate effect. Thisanalysis on the other hand is confined to a discussion of thecurrent account in US dollar terms.

.78 -

22. The residual term is negative and growing, indicating thatinterest payments due to debt in other currencies are also increasing rapidly.

Table 0: TUNISIA: DECOMPOSITION OF CROSS-CURRENCY EFFECTS ON INTEREST PAiMENTS 1I

(IN HILL. US DOLLARS)

1980 1991 1982 1983 1984 1985 1986 1987 1988

CHANGE IN INTEREST PAYMENTS 1i 0.00 4.17 7.98 15.80 -24.17 -19.44 -75.11 -tv1.o4 -157.23

1- CHANGE IN INTER. PAY. ON DEBT ;N FF 0.00 9.vo 10.33 7.32 11.24 10.73 -1.04 -10.36 -15.93d- CHANGE DUE TO INTEREST RATE EFFECT 0.00 7.86 3.27 -1.55 1.04 -2.41 -6.87 -9.88 -8.80b- CHANGE DUE TO DEBT VOL.UME EFFECT 0.00 -8.68 -8.86 -12.72 -17.09 -12.30 -13.28 -15.78 -24.70c- CHAN6E DUE TO EXCNAN6E RATE EFFECT 0.00 9.88 15.9J 21.59 27.29 25.45 19.11 15.30 17.57

11- CHANGE IN INTER. PAY. ON DEBT IN DM 0.00 1.72 0.07 -1.54 -1.77 -4.63 -11.03 -13.35 -16.90a- 6HAH5E 24f TO 19TERECT RATE EFFECT O.; I. t142 -O.p -.3 -n.59 =3.. A - - .77 -6.67 --.G5b- CHA1NGE DUE TO OEBT VOLUNE EFFECT 0.00 -2.13 -2.85 -5.48 -6.93 -5.75 -5.90 -6.49 -9.56c- CNANGE DUE TO EXCHANGE RATE EFFECT 0.00 2.43 3.29 4.54 6.21 6.13 2.63 -0.19 -0.69

11I- rHANSE IN INTER.PAY. ON DEBT IN YEN 0.0OC -1.14 -3.98 -7.48 -14.78 -14.58 -25.36 -22.45 -34.52- CHAn DUE TO INTEREST RATE EFFECT 0.00 0.00 1.01 -0.57 -5.60 -1.84 -2.21 7.68 5.40b- CHANGE DUE DO DEBT VOLUIE EFFECT 0.00 -1.04 -5.72 -7.35 -9.52 -13.53 -16.57 -18.32 -21.49c- CHAN6E DUE TO EICHANGE RATE EFFECT 0.00 -0.10 0.74 0.45 0.54 0.79 -6.58 -11.81 -18.44

IV- CHA11E IN INTER.PAY. ON DEBT IN Us. 0.00 3.81 4.9 30.84 5.85 15.64 14.01 24.b4 14.67a- CHANGE DUE TO INTEREST RATE EFFECT 0.00 10.92 21.90 50.91 50.75 6b.36 71.60 89.22 70.13b- CHANGE DUE To OEBT VOLUME EFFECT 0.00 -7.11 -16.91 -20.07 -44.91 -44.72 -57.58 -64.58 -55.46

V- RESIDUAL 0.00 -9.27 -3.43 -13.34 -24.71 -26.60 -51.70 -a4.12 -104.54

1/ INTEREST PAYMENTS ON PUBLIC AND PUBLICLY BUARANTEED DEBT, EXCLUDINS IMF. FROM DEBT REPORTING SYSTEM (DRS); OLD BANK.

-79 -

THE FORMULATION OF DECOMPOSITION OF THE CURRENTACCOUNT BALANCE

1. The Decomposition of the Resource Balance:

(PX, * ( - PM, * MN) - (PX0 * X. - PM. * M.) -

- 1 (PX, - PX0) - (PM, - PM) * + (PMt - PMo) * (X, - M,)"pure" terms of "unbalanced"trade effect terms effect

+ (X, - Y.) * PX. - (M, - M.) * PM.Export volume Import volume

effect effect

where,X. & M, are the base year export and import volumes

X, & M, are export and import volumes in year t

PXg. PM- are the base year prices for exports and imports

PX,, PM, are import and export prices in year t

2. The Decomposition of the Workers' Remittances:

WR, - WR0 - (e, e WRo - e. * WR0 ) + residual - (e, - e.) * WR. + ResidualUS$/FF exchangerate effect

where,WR0 is the base year Workers' Remittances.

WR, is the Workers' Remittances in year t

E, ~~~~~Eoe, - and e0 - - 1

E. Eo

where E, is the US$/FF index for year t andL. is the base year US$/FF index (-100)

- 80 -

3. The Decomposition of Interest Payments:

(a) INT, - INT- - D,1 (i, - i.) + (Dt, - D.1) i.interest rate debt volume

effect effect

where,INT, is the interest payments in year t

INT0 is the interest payments in the base year

i- is the average (implicit) interest rate in year t

io is the average (implicit) interest rate in the base line

Dt - is the $ debt stock (DOD-PPG) in the year t-l

D.- is the $ debt stock (DOD)-PPG) in the year before thebase year (i.e., 1979)

or Alternatively,

INT, - INTt - Dt, *Et (it io) + Dt * (E

interest rate effect exchange rateeffect

+ (DM, - D.1) E, * io + residualdebt volume effect

where,j - is F, DM, Y or US$

Dt - debt stock denominated in currency "j" in year t-l

.- debt stock denominated in currency "j" in the base year

(currency j units)

Et the exchange rate of the currency "J" vis-a-vis the US$,i.e., S , S, 8

DM F Y

- 81 -

E. - the $/currency j exchange rate in the base year

it - the average (implicit) interest rate on the debt denominiatedin currency "j" in year t

io - the average base year interest rate for debt in currency "J"

C: \HJT\TU1N\CEM\APPEND.

IIIU

U

MAP SECTION

-~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

S e < - tw ~~~~~~~~~~~~~~~~~Dieb l

-37P \trtq TLNS ,',EtAouorio 37_

& ( 8EJA & >Nelo -/ Ei o lremm

.~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Mce Te ; l obim.Krb

R ULNDOU$A

TO ot

Ali'a' / GtordirnsoouHmoe

36 3e-

t ,< /Ecktor J /~~~~~~~~~~~~<. ~SOUSSEg dfoloot ft t lXuss lilo-\9- i n vtA a~~MONASTtR

\~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~s EsSti nowse \atY 3? Dbioa b' - MHDIA

.35e ! W /SIDI bOUZID .DIabennno 35R

TUNISA 2 /S Al h \lGoveenarate Capitals Th/ s 8ir bus been nreared by '. -SFAX

~~~~~~~~~~~Te Wol beR /stoP po Dn

| PiLdew71 <, Gueorts Skhi

I usedUR,/ - od te bndssonth-i.5 NOn tOw dtGASES o hek

.~ ~~~~~~~o jusno o the o roo s0te or -{'

\ ' - s] KEblLI | Moret\ t < KEWIL

\n , nternotionoJ B/oudrwies tn:rsyoot

> ~ ~ ~ ~ ~ ~ ~ ~ ~~~aa bondris "'N ODu ' -/,

i ,, ' ~ ~~ ~ ~~~~~~~~~~~~~~~MEEDNI

_33'1_

T U N I S I A /TTAOUINE Xtao 2gi so 75/ * >

69 National Capital KILOMiETERS ll ;4 Governorate Copitols Th-h - bO.- Xryw-rd by

Paved Roads f6fhCnYth P. -w-- f ,Roilwaoys -d- d6raxsc i. V lb /h ORemd ,] t11&> v-

Ports -dPO Th k r,fWlrou ) F-

Air*ports sdaore n ssv a Sol t LakesrJdorh ddFtn e( |m-- Gove rnofa te Bou nda ries rnasrn4fnneCozprt-e 32- AL GE R IA .| LI SY A j

em -- ~~~~International Boundaries fmv, tadmenoteeeeas -WL