Report No. 29847-TN Republic of Tunisia Development Policy Review Making Deeper Trade Integration Work for Growth And Jobs October 2004 Social and Economic Development Group Middle East and North Africa Region Document of the World Bank REPUBLIC OF TUNISIA DEVELOPMENT POLICYREVIEW Table of Contents Executive Summary .......................................................................................................................................... i Tunisia-Development Policy Priorities and Key Reform Options ............................................................. vii CHAPTER 1 DEVELOPMENTOUTCOMESAND MEDIUM-TERM . PROSPECTS ..................................................................................... 1 1.1. Growthperformance and developmentpolicy goals ........................................................................... 1 Strong growth has laidthe groundwork for poverty reduction.................................................................... 1 Forward-looking policies helpedpreserve external and internalbalances .................................................. 3 Achieving faster growth-the key role o fprivate investment and human resources .................................. 5 Key challenges for agncultural development .............................................................................................. 8 1.2. Medium-term outlook andpolicy priorities ahead .......................................................................... 10 The medium-term outlook i s encouraging. butraises important policy challenges................................... 10 Key development challenges and policy priorities ahead.......................................................................... 12 CHAPTER2 MEETINGTHE CHALLENGE OFJOB CREATION . .............15 2.1. Despite stronggrowth. reducing unemploymentremains the major policy challenge ..................15 2.2. Structural imbalancesin theLabor Market ................................................................................... 17 2.3 Addressing impediments to Job Creation ........................................................................................ 18 2.4. Improving targeting ofActive Labor Market Programs ................................................................. 22 CHAPTER3 FOSTERINGPRIVATEINVESTMENT. . COMPETITIVENESS. AND JOB CREATION ......................... 25 3.1. Loweringtransaction costsfor business entry. operation. and exit Starting and closing a business: mixedprogress....................................................................................... ............................................... 25 25 Improving the efficiency o f customs clearance rules and procedures ....................................................... 27 3.2. Enhancing Predictability of Rules and Regulations ....................................................................... 27 Establishing an incentive structure that reduces uncertainty and levels the playing field among Reducingregulatory uncertainty stemming from private investment restraints ........................................ investors ..................................................................................................................................................... 27 30 3.3 Enhancing market contestability by reducing restraintsto entry and strengtheningcompetition policy ........................................................................................................................................................... 31 Openingup infrastructure services to competition: a key to greater private investment andimproved competitiveness.......................................................................................................................................... 31 Openingup the Information and Communications Technologies sector: a strong promise for growth ....33 Strengthening competition policy and ensuring the coordinationand integrationo fregulatory functions across sectors ............................................................................................................................................. 35 3.4 Furthering Tunisia's international trade integration ..................................................................... 36 CHAPTER4 FINANCEFOR GROWTH: PROMOTINGAN EFFICIENT . FINANCIAL SECTOR .................................................................. 39 4.1. Managing the vulnerabilities of the banking system ...................................................................... 39 Managing non performing loans of commercial banks.............................................................................. 42 4.2. Fostering diversification of thefinancial system ............................................................................ 44 Government securities markets could become more active ....................................................................... 44 Private securities markets remain anemic .................................................................................................. Improving financial information on the quality o fborrowers and strengtheningcreditor rights...............45 50 CHAPTER 5 STRENGTHENINGMANAGEMENTOF THE PUBLIC . FINANCE SYSTEM ....................................................................... 52 5.1. Strengthening revenueperformance and tax neutrality ................................................................. 52 5.2. Tunisia'spublic expendituresystem in the international context .................................................. 55 5.3. The challenge of strengtheningbudget management ..................................................................... 60 The Budget formulation framework .......................................................................................................... 60 Budget executionand disclosure................................................................................................................ 62 Public debt management ............................................................................................................................ 62 Budgetary audits and accountability .......................................................................................................... 63 5.4. Optionsfor reform: Toward a medium-term expenditureframework andperformance budgeting ....................................................................................................................................................... 63 CHAPTER 6 LONGTERM CHALLENGES: THE KNOWLEDGE-BASED . ECONOMYAND THE EDUCATIONSYSTEM ...................................................................................... ....................... 67 6.1. Promoting the knowledge-basedeconomy 67 6.2. Priorities in education sector reform ............................................................................................... 71 Improving the quality o f education and strengthening its linksto labor market needs ............................. 71 Key challenges facing the education sector ............................................................................................... 73 CHAPTER7 ENHANCINGTHE EFFECTIVENESSOF SOCIAL . POLICIES ....................................................................................... 76 7.1. Promoting the cost-effectiveness of the health care system ............................................................ 76 Assessing health system performance........................................................................................................ 76 Key challenges facing the health sector inthe years ahead ....................................................................... 78 7.2. Challenges in socialprotection ........................................................................................................ 79 Reforming the pension system................................................................................................................... 80 Strengthening the social safety nets........................................................................................................... 82 ANNEX -STATISTICAL TABLES ....................................................................... 85 REFERENCES ........................................................................................................ 93 LISTOFFIGURES Figure I.1. Average annual real GDPgrowth.. Tunisia and comparators (in%) ........................................... 1 Figure 1.2: Headcount poverty index in Tunisia (% ofpopulation) ............................................................... 2 Figure 1.3: Tunisia.. Inflation and external balance........................................................................................ 3 Figure 1.4: Tunisia.. structural budget deficit and output gap (in % of Non Agricultural potential GDP)............................................................. ...................... ................3 Figure 1.5: Real effective exchangerates....................................................................................................... 4 Figure 1.6: Tunisia and comparators.. totalforeign debt in % of GDP .......................................................... 4 Figure 1.7: Contributions to average growth.. Tunisiavs. High.growth .................................................... Figure 1.8 a: Private investment: Tunisiaandfast-growing countries ........................................................... 6 Figure 1.8b: Private investment in infrastructure in developing countries .................................................... 6 Figure 1.9:Actual andpredictedprivate investment ratios.............................................. Figure 2.1: Non agricultural employment growth by sectors in %............................................... Figure 2.2: Real wages andproductivity in the non agricultural sector .......................... Figure 2.3. Flexibility of Hiring Index .............................................. 19 Figure 2.4. Flexibility of Firing Index ..... ..................................................................... 20 Figure 2.5. Labor Regulation and Info Figure 2.6: Allocation of spending to Figure 3.1.Number ofprocedures ..... .................................................................. 26 Figure 3.2.Actual Time (inyears) .................................................................................................................. 26 Figure 3.3. Import authorizations are on decline but they are been replaced by technical controls ........... 27 Figure 3.4. Internet hosts, servers and users(Tunisia and regional benchmarks)......................................... 33 Figure 3.5: Average MFN TariffRate.............................................................................. ...................37 Figure 4.1 :Foreign bank assets in % of total bank assets (2000)................................................................ 39 Figure 4.2 :Financial soundness indicators of commercial banks ............................................................... 40 Figure 4.3 :Netprofits of domestic banks, 1995-2000... ....................................................... 40 Figure 4.4 :Maturity structure of outstanding domestic .............................. Figure 4.5 :Stock market capitalization by sector........................................................... Figure 4.6 :Total assets of SICAVs . ................................................................................................. 46 Figure 4.7 :Newprojects approved R.............................................................................................. 46 Figure 4.8: Creditor Rights index ............................................................... ............................................. 51 Figure 5.I: Tunisia- Tax revenues in %of GDP.................................................................... Figure 5.2: Tax revenues in international comparison................................................................................. 53 Figure 5.3: VATproductivity......................................................................................................................... 54 Figure 5.4: Public spending on wages and salaries ...................................................................................... 56 Figure 5.5: Volatility of Tunisia's public spending........................................................................................ 57 Figure 5.6: Capital spending ........................................................................................................................ 58 Figure 5.7: Social security and welfare spending.......................................................................................... 59 Figure 6.1:Fostering the Knowledge-based economy - Tunisia'sglobalpositioning................................... 68 Figure 6.2:Thefour pillars of the Knowledge-based economy...................................................................... 69 Figure 6.3.: Unemployment by age and education ........................................................................................ 74 LIST OF TABLES Table 1.1: Tunisia.. contributions to real GDP growth (averageper year in %) .......................................... 1 Table2.I: Employment andproductivity trends in Tunisia: 1989-2001....................................................... 16 Table3.1. GATSMarket Access Commitments by country and by sector...................................................... 32 Table 6.1: Education spending in Tunisia and comparator countries ........................................................... 72 Table 7.1: Health, Nutrition. and PopulationIndicators (latest availableyear)........................................... 76 Table 7.2: Health CareFinancing Indicators (1997-2000) ........................................................................... 77 Table 7.3 :Main Parameters of the Various Schemes of the TunisianPension System ............................... 81 Table 7.4: Dependency rateprojectionsfor pension funds ............................................................................ 81 LIST OF BOXES Box 1.I:The Tunisian tourism sector-signs of `tfatigue"? ............................................................................ 7 Box 1.2: The Wider Europe initiative -- what's at stake?............................................................................... 13 Box 3.I: Performance of the "Mise a Niveau''Program-mixed evidence ................................................. 30 Box 4.1 Towards enhanced transparency and reliability of Tunisian Accounting Standards ...................... 48 Box 5.1 :How appropriate is public spending level of Tunisia's current stage of development........ Box 5.2. Civil service managementpractices in Tunisia..................... ............................. 57 Box 5.3 :The budget cycle in Tunisia...................................................... ............................. 61 Box 5.4 :Developing an Medium-termExpenditure Framework-alt es.......................... 64 Box 6.I :Benchmarking countries' receptiveness to knowledge economy-the WorldBank .......................... InstituteMethodology.................... ............................................................................................... Box 6.2 :Developing the Tunisian Innovation System -policy thrusts and instruments................................. 70 Executive Summary Thanks to a steady pace of structural reforms and sound macroeconomic management, Tunisia experiencedfast and sustained growth. GDP grew by 5.2 per cent duringthe NinthDevelopment Plan (1997-2001), outpacing MENA and middle-income countries' average. In 2002 growth slowed to 1.7 percent, due to a drop in tourism and manufactured exports and severe drought for a third year in a row, but non-agncultural GDP was resilient, growing by 3.5 percent. Thanks to a strong agricultural recovery, GDP grew by 5.6 percent in2003. Forward-looking policies helpedpreserve external and internal balances, but challengesremain in the context of a volatile external environment. In2000-2003 inflation fell to 2.4 percent on average, while the external current account deficit was maintained at 3.8 percent o f GDP despite a difficult external environment. Fiscal consolidation has progressed, but a primary budget deficit still persists, preventing a rapid reduction of public debt, which hovers at around 60 percent o f GDP. Tunisia has improved its access to international financial markets, but foreign debt remains high compared to countries with a similar sovereign rating, especially inview o f Tunisia's high exposure to external shocks. High andpro-poor growth contributed to a sharp reduction in poverty in the second half of the 1990s. The core poor made up only 4 percent o fthe population in2000, down from about 8 percent in 1995, with a similar reduction in the share o f poor and economically vulnerable. 74 percent of the poor live inrural areas. Tunisia has also made important headway on non-monetary aspects o f poverty. However, a fairly highproportion o fpeople remainclusteredabove, but close to, the poverty lines, so that Tunisia's strong anti-poverty outcomes remainvulnerable to economic volatility. But despite strong growth, unemployment remains high, at around 15 percent, partly reflecting demographicpressures, andpartly the decrease in the employmentintensity of growth. Nonagncultural employment grew by 2.6 percent in 1994-2001, down from a healthy 4.4 percent in 1989-94, and agricultural employment grew more slowly. The lower employment intensity o f growth reflects faster labor productivity growth, which supports competitiveness and real incomes growth, but also the impact o f distortions inthe labor market, especially rigidemployment terminationprocedures. Reducing unemployment would callfor a significant acceleration of growth, spurred by much higher private investment. Tunisia cannot afford to increase employment at the expense of productivity growth, because improving competitiveness i s a prerequisite to meet the challenge o f intense global competition. And in the years ahead, the need to maintain a sound fiscal framework will limit the potential for job creation in the public sector, and for higher public investment to stimulate growth. Bolstering private investment and the creation of small and medium enterprises i s thus the key for stepped upjob creation. On current trends in labor force growth and participation rate, reducing unemployment by about 3 percentage points in 5 years would call for growth o f about 6.5 percent per year. All else equal, this would require a much stronger private investment effort, an increase o f about 7 percentage points o f GDP. But compared to other high-growth countries, Tunisiasuffers from a structural private investmentgap. Tunisia's growth has relied more on public investment, and less on private investment and human capital accumulation. Despite solid macroeconomic fundamentals, private investment remains compressed below potential, at around 14 percent o f GDP. One reason i s the limited openness o f services markets and network industries, in particular ICT and transport, to private investment. Still another reason i s heightened business uncertainty, reflecting the surrounding risks in Tunisia's changing economic environment-stiffer competition in the fi-ee-trade zone with the EU; removal o f MFA quotas; and structural weaknesses intourism. These factors do not perhaps explain the large private investment gap in Tunisia. Indeed, weaknesses in economic governance, in particular regarding the predictability and transparency of the regulatoryframework, and market contestability, may be an important constraint to private investment. Strong government interference in the economy and the strategy o f providing generous privileges for exporting and investing in selected economic activities has supported Tunisia's development in a context o f limited trade integration. But existing incentives systems run the risk o f loclung the country's specializations into threatened activities, which may leave Tunisia ill-positioned in the face o f stiffer international competition. Regulatory uncertainty, limited market contestability, and highdiscretionary intervention undermine the investment climate and run the risk o f discouraging risk- talung by less connected entrepreneurs. Reflecting business uncertainties, private investment has been losing momentum since the mid-l990s, with little help from the generous incentive system in place. A more open dialogue with the private sector and a deeper understanding o f factors affecting the investment climate in Tunisia would help appropriately target the policy initiatives aimed at stimulating private investment. Tunisiafaces a turning point where, unless coordinated efforts to improve the quality of economic governance and stimulateprivate investment are placed at the core of the reform agenda, the deeper engagement with the world may not fulfill its developmentpromise. Deeper integration into global markets has the potentialto stimulate growth, but will raise important challenges, due to surrounding risks and the weakness o f private investment. Over the medium term, real GDP could keep growing within a baseline range o f 4.5-5.5 percent per year, at about the same pace as during the NinthDevelopment Plan (1997-2001). But this growth would not be sufficient to reduce unemployment, which would even increase with no further employment growth in the public sector and in agnculture. Public debt would be sustainable, but would fail to decline significantly in proportion to GDP, while the debt ratio would increase incase o f shocks. Companion policies will be needed to make Tunisia's deeper trade integration work for growth and jobs. Strengtheningpolicies insome key areas would help meet Tunisia's development challenge. Strengthening the investment climate, by improving economic governance: lowering transactions costs, enhancing transparency and predictability o f the regulatory framework, and strengthening market contestability are main issues inthe reformagenda. Improving the functioning of the labor market, by reducing protection within the firm, increasing protection o f vulnerable workers outside the firm, and enhancing the efficiency o f labor market policies. Strengthening the soundness of the banking system andfostering the developmentof securities markets, to improve the diversification o f sources o f finance, ensure good access to finance for private investment, and ensure the resilience o f the economy to financial risks. Securing a robust medium-term fiscal framework, by stepping up fiscal consolidation, through better fiscal revenue mobilization and increased public expenditure efficiency-to reduce medium-term pressures on the budget and improve the capacity to deal with a potentially hostile external environment. Enhancing the efficiency of education policies, by improving the quality and links o f the education system with the labor market, while promoting an education and training system that facilitate the emergence o f the knowledge-based economy. Strengthening the effectiveness and sustainability of social sector policies, by improving the quality and containing the costs o f health care services; strengthening the cost-effectiveness o f social protection; and securing the sustainability o f the pension system. .. 11 Lowering transactions costs for business entry, operation, and exit. Business registration i s fast and efficient, and small commercial contracts are rapidly enforced. However, the minimum capital requirement i s still high, and delays in securing finance, land and construction permits still persist. Closing a business i s difficult due to lengthy bankruptcy process and insufficient protection o f creditors' rights in the insolvency process. Despite substantial progress on trade facilitation reforms, procedural complexities and inconsistencies in customs clearance procedures remain, substantially burdening the on- shore enterprises. Enhancing transparency and predictability of the regulatory framework. The investment incentive regime grants very generous tax advantages, especially to exporting firms. However, the impact o f the current incentive regime on job creation and private investment has been rather limited. And it has entailed sizeable fiscal costs and administrative complexity. Balancing taxation infavor o f on-shore firms would provide incentives for investment and job creation. Restrictions still apply on majority capital ownership by foreign investors in key services sectors, while the process o f prior approvals i s lengthy, uncertain, and lacks transparency, and does not contribute to strengthening the investment climate. Enhancing market contestability :by reducing barriers to entry in key infrastructure services- The scope for increased competition i s greatest in ICT and transport services. Tunisia still lags behind in key I C T sector development indicators and international communications holds highcosts. Competition inthe water, sanitation and electricity sectors could also be tested, within a regulatory system allowing to benchmark the performance o f the public operator against a private operator. Estimations suggest that mahng more room for private sector investment inservices would increase GDP by roughly 5 percent. - a n d by strengthening competitionpoZicy. Tunisia has made considerable progress on the legal front o f competition policy. But anticompetitive practices remain, while the Competition Council i s weak and lacks resources. Strengthening the role o f the Competition Council and ensuring coordination o f the regulatory functions across sectors remains a key challenge. The regulatory fragmentation and the lack o f separation between the incumbent operator and most o f the agencies in the telecommunications sector should also be tackled, because they may impede a more dynamic development o f the sector. Furthering Tunisia's international trade integration. High MFN tariff differentials to preferential tariffs on EU imports may be at the origin o f trade diversion, denying the Tunisian producers and consumers the benefit o f less expensive imports from outside the free-trade zone with the EU. Targeting tariff reductions that bring Tunisia's MFN tariffs as close as possible to the EU's external tariffs for industrialproducts would help Tunisia reap the full benefits o f trade liberalization. Enhancing theflexibility of the labor market. Although the use o f temporary help agency workers i s still not allowed, labor regulation reforms have introduced flexibility inhiring. Employment termination, however, remains rigid and too protective. Thus, Tunisian private enterprises find it difficult to restructure, and small firms often find solutions outside the legal framework. Tunisia would benefit from more effective protection outside the firm, through well-designed social safety nets, and lower employment protectionwithin the firm. The Tunisian banking sector has better room for dynamic growth, thanks to gradually reduced government ownership, but suffers from high non performing loans. Commercial banks have become increasingly exposed to sectors vulnerable to a cyclical downtum, and despite satisfactory profitability and capital adequacy ratios, non performing loans remain large, at 22 percent o f their total assets in2002. The level o f provisioning o f NPLs remains low, at 44 percent in 2002, owing to heavy reliance on real estate collateral-even though the liquidityo f real estate collateral i s limited. ... 111 Strengthening the banks' balance sheets on a sustained basis would stem financial risks, and hold major benefits for the international image of Tunisian finance. Large, under provisioned NF'Ls increase the cost o f bank intermediation, and deprive Tunisia from an even better access to intemational capital markets. Real estate guaranties also pose financial risks to the banlung system because they are illiquid and possibly overpriced-in view o f the questionable viability o f some loss-making borrowers, especially in the tourism sector. To effectively strengthen the banlung system, banks should be encouraged to increase provisioning, especially o f old delinquent loans. This would also create appropriate incentives for the banks to recover the collateral. Despite modernization and adequate regulatory framework, issuance in the primary market for government securities remains limited, while the secondary market remains fairly inactive. Dependable and easy access o f banks to liquidity, provided by the Central bank at a predictable rate, hinder the development o f an active interbank market, a prerequisite for the development of a bond market. Better transparency and predictability o f Treasury issuance would strengthen investor confidence, and help reduce the cost o f borrowing in the medium term. Improving the transparency of the "parallel" secondary market for intra-group transactions, would promote the development o f the secondary market. Partial opening o f domestic debt issuance to foreign investors could also be envisaged, but would call for careful planning to secure the liquidity o f the secondary domestic debt market. Revitalizingprivate securitiesmarkets would callfor simultaneous action on variousfronts. Reducing the highcost o f transparency faced by listed companies-by strictly enforcing the disclosure requirements o f unlisted companies that obtain large amounts o f bank finance-would lower the reluctance o f many private groups to list on the stock exchange. The supply o f suitable securities could be increased by a more ambitious privatization program. Reinforcing mandatory corporate financial disclosure and auditing procedures would strengthen investor confidence. Differentiating the tax treatment o f savings in favor o f investments with longer holding periods would help address the shortage o f long-term savings. Appropriate income tax and social security charge treatment o f group life insurance contracts; development o f distribution o f life insurance by the banlung sector; and promoting a capitalizationpillar for retirement benefits, would provide support to long-termcontractual savings. Improving SME's access tofinance. Inrecent years, the range of financial facilities available to SMEs has broadened, but the practice o f over-collateralization remains and the cost o f SME finance i s still high by international standards. Improving financial information on the quality o fborrowers, byreforming the design o f the public credit registry, and promoting appropriately regulated private credit registries, would help ease over-collateralization. Strengthening the protection o f creditors' rights in bankruptcy would contribute to improving SMEs access to credit. Efforts for reforming the tax system shouldfocus on enhancing revenue mobilization, redistributing the tax burden, and improving tax neutrality. Overall, the Tunisian tax burden i s not very high by intemational comparison, but its distribution appears to be uneven, bothbetween labor and capital income and across taxpayers. Serious non neutralities exist in the taxation o f corporate income and in indirect taxation that undermine the faimess o f the tax system; narrow the tax bases; create complexities that increase the cost o f tax administration; weaken incentives for tax compliance. Reducingthe number o f tax exemptions and preferential tax regimes-apecially for off-shore businesses and the VAT-and reforming the `Iforfaitaire" system for the self employed and small businesses would broaden the tax bases and improve the fairness and efficiency o f the tax system. Policy priorities were generally matched in the budget, but the strategy of public expenditures allocations could befurther improved, while large non discretionary spending limits budgetflexibility. Budget allocation decisions will become more complex in the future, reflecting the need for greater budget flexibility and pressures on social spending. Main issues that will require attentioninclude: iv 0 Spending on wages and salaries i s high and steadily rising, hindering the flexibility o f the budget; 0 Spending on non-wage goods and services i s low, suggesting distorted proportions between spending on wages vs. equipment; 0 Social transfers are lower than in countries at similar level o f development, but they are set to increase in the years ahead due to an ageing population and greater social risks posed by deeper international integration; 0 Capital spending i s highand rising, warranting efficiency concerns. Tunisia is well positioned to make further progress in the reform of budgetary processes. Public spending systems, control of public funds, and the accountability arrangements for their use, are already quite strong, boding well for maintaining global fiscal discipline. But implementation o f performance- based budgetingreforms, envisioned by the Government, would call for a more supporting institutional environment, interms o f the quality o f budget formulation and execution. Two, closely related directions o freform would help achieve these objectives: Greater comprehensiveness of the budget will provide a common platform to compare different policy commitments, including those existing beyond the budget; A rolling Medium-term Expenditure Framework would be a key underpinning o f performance- based budgeting; would help strengthen the overall fiscal framework; and provide the necessary foundation for active public debt management. The debt managementpractices are strong, but will benefitfrom greater centralization andfunctional focus. The debt management function i s strong but fragmented, and does not support an integrated view of public debt portfolio, a necessary condition for active risk management. Options for reform include consolidation o f the debt management function and more operational flexibility o f debt management units, within a sustainable medium-term debt strategy, relying upon clearly defined quantitative benchmarks. Facilitating the emergence of the knowledge-based economy would help create more and better jobs for Tunisia's increasingly educated labor force. Tunisia appears relatively well positioned in the emergence o f the howledge-based economy among MENA countries, but it is in a less favorable position than direct competitors in other developing regions. Particularly problematic are the insufficient development o f the ICT infrastructure, while in other key areas institutions and the regulatory framework have yet to be strengthened to support entrepreneurial capabilities. Stronger integration o f Tunisian women in the economy would help foster the emergence of the knowledge-based economy, as women increasingly make up a large proportion o f university degree holders, yet they are still disadvantaged when it comes to labor market opportunities. Education is one of theprincipal pillars of Tunisia's strategy for development, as it aims to build the kind of human capital necessary to compete in the global knowledge-based economy. Main challenges inthe years aheadinclude: 0 Improving quality and reducing selectivity, to ease geographical disparities, improve the distribution of resources, and promote good quality private secondary education. Greater participation o f the civil society in education establishments would support improved quality and help buildbetter links with the labor market. 0 Improving internal efficiency, by reducing the number o f non-teaching staff and personnel in primary and lower basic education, where student population i s set to decline, and using the savings to increase spending on pedagogical inputs and expand staff insecondary school. V e Defining the new roles of secondary and higher education, to diversify the post-basic education curriculum and strengthen links to pre-employment vocational training, while reinforcing short and technical tracks inhigher education. e Diversijjing specialtiesfields and increasingjlexibilities, to adapt education to the needs o f the market-by establishing structural links between education establishments and the labor market; improving flexibility in qualification o f teachers; encouraging diversity in the orientation o f girls inthe secondary andhigher educationsystem. e Introducing partial cost recovery in higher education and promoting private sector involvement, to release scarce public resources that now subsidize the better-off and that could be reallocated to benefit the poor. While the health sector shows superior performance, challenges remain to ensure sustainability and cost effectiveness of service delivery. e Improvingfinancial risk protection. In spite o f virtually universal coverage o f the population, the private out-of-pocket health expenditures have approached 50 percent o f all health expenditures, while the economic burdeno f health expenditures on the poor i s substantial. e Containing costs. Health care costs have increased rapidly during the past decade. Due to the strong pressures created by an ageing population, systems reforms are neededto contain costs. e Implementing major organizational reforms. Organizational and provider payment reforms would encourage greater efficiency and improved quality o f care. Regulation o f private providers, the. development o f accreditation procedures, and the development of a capacity to regulate private health insurance markets, will be essential if the private sector i s to perform in a socially desirable way inthe future. During the last two decades the government has developed a vast number of active labor market programs, but targeting could be improved. ALMP expenditures o f about 1.5 percent o f GDP are high by international comparison. Micro-credits and youth interventions represent the majority o f total expenditures, but public work programs and labor market training for unemployed adults are limited. ALMPs would need to be streamlined and better targeted, while a comprehensive social protection scheme needs to be developed to protect those who will lose their jobs. Impediments for enterprises to undertake training for their workforce needto be addressed. With risingproportion of oldpeople in thepopulation, bothfinancial sustainability and coverageof the pension system would need to be improved. Parametric reforms within the existing framework are essential to improve the financial sustainability o f the pension system, reduce fragmentation, and gradually increase coverage. To cope with the ageing pressures, more radical reforms would need to be considered : (i) alternative designs and transition mechanisms for the main pillars o f the system; (ii)better governance o f public pension funds and voluntary plans; (iii) eliminating constraints to the expansion o f pension and long-term-savings products within life insurance companies; (iv) considering coverage expansion o f current non-contributory schemes for the elderly poor (zero pillar). vi . e e . . e . . . e e . e e * e * e e e . e * I . e * . e e . . . e e . e . . . e . e . . . . . . e . . e. e .. . e X .i e e . . . . Chapter 1. Development Outcomes and Medium-TermProspects 1.1.Growthperformance and developmentpolicy goals Strong growth has laid thegroundworkfor poverty reduction 1. Thanks to a steady pace of structural reforms and sound macroeconomic management, Tunisia experiencedfast and sustained growth. GDP grew on average by 4.3 percent in the decade since the initiation o f structural adjustment in the mid 1980s, and growthaccelerated 5.2 per cent to Figure 1.1 : Average annualreal GDP growth-Tunisia and comparators (in%) during the Ninth Development Plan (1997-2001). Growth outpaced MENA and middle-income countries' average since 1987, even though it was slower than in other fast growing countries (Chile, Korea, Malaysia, Mauritius, Thailand-see Figure 1.1). GDP per capita increasedby one third over the 1990s in real terms. The country's sound economic management helped overcome several shocks, such as the Gulf war in the early 1990s, the 1997 East Asia crisis, and the droughts which regularly afflict 1982-1986 1987-1991 1992-1996 1997-2001 2002-2003 Tunisia's agriculture. 2. Over the 1990s, growth was increasingly driven by domestic demand, and relied more on services. Exports, mostly to the EU, continued to be an important dnver o f economic activity, reaching 47.5 percent o f GDP in2001-02, up from 42 percent in 1990-91. Growing export markets have supported investment, employment, real incomes, and thus growth o f private consurr ition. But Tunisian exnorts are also intensive in imports o f intermediate goods Table 1.1 : Tunisia-conkibutions I real GDP growth (average per year in %) (especially exports - o f textiles and clothing), Demandside 1992-1996 1997-2001 2002-2003 while imports of consumer goods are becoming 0.5 0.7 0.7 more sensitive to domestic demand owing to trade public consumption PrivateConsumption 2.5 3.2 2.6 liberalization. Thus, net foreign demand Gross 0.8 1.6 -0.3 stocks Fixed Investment accounted for a smaller fraction o f growth over 0.2 -0.1 0.5 Foreigndemand 0.5 -0.2 0.3 the 1990s (Table 1.1). The contribution o f net foreign demand turned even negative during Supply side Agriculture 0.3 0.6 1997-2001 owing; to the strong; growth o f imports. - - 0.1 Industry 1.0 1.3 0.7 I On the supply side, services have made up ;bout ::;::tion 0.3 0.3 0.2 3.1 3.3 2.3 two-thirds o f GDP growth, reflecting the healthy importance o f tourism-which accounts for about 30 percent o f total export receipts. The contribution o f agriculture was mute, because o f its continuing vulnerability to droughts. 3. Despite a slowdown since 2002, the Tunisian economy remained broadly resilient. In 2002 growth slowed to 1.7 percent, from 4.9 percent in 2001, due to a drop in tourism and manufactured exports and severe drought for a third year in a row. Sluggish growth in the EU and the prolonged effect of September 11on tourism and transport, have hampered export growth. But non-agricultural GDP was resilient, growing by 3.5 percent, supported by construction and other services, especially telecommunications. Thanks to favorable rainfall in the 2002/2003 season, agricultural production recovered strongly, by about 25 percent, in 2003. This has boosted GDP growth to about 5.6 percent. 1 Exports to the EU have also rebounded since the fall o f 2002, through the first half o f 2003. However, reflecting weak domestic demand, non apcultural GDP i s grew at the same pace as in 2002, below the goals set inTunisia's Tenth Economic DevelopmentPlan (2002-2006). 4. But, despite strong growth, unemployment remains high, at around 15 percent, partly reflecting demographic pressures, and partly the decrease in the employment intensity of growth. Nonagricultural employment grew by 2.6 percent in 1994-2001, down from a healthy 4.4 percent in 1989- 94, and agricultural employment grew more slowly. As further explained in chapter 2, the lower employment intensity o f growth reflects faster labor productivity growth, which supports competitiveness and real incomes growth, but also the impact o f distortions in the labor market. In addition, in recent years, job creation for slulled workers has slowed, so that unemployment o f people with formal education has increased. Jobs for educated workers are mainly created in administration and public services, which have limited absorption capacity (see chapter 2). 1990s' The `Ore poor (those living a lower poverty line, reflecting a minimum consumption Figure 1 2 : Headcountpovertyindex inTunisia (% of population) 18 expenditure level) made up only 4 percent o f the 16 population in 2000, equivalent to some 400,000 14 people, down from about 8 percent in 1990 and in 12 1995 (World Bank, 2003~).Similarly, the share o f IO poor and economically vulnerable (those living 8 below the upper poverty line), fell from 17 percent in 6 1995, to 10 percent in 2000 (Figure 1.2). The trends 4 of falling poverty over the second half o f the 1990s 2 hold for both urban and rural areas and are visible in o all administrative regions. Poverty reduction reflects - 1990 1995 2000 strong per capita consumption growth o f 3.4 percent between 1995 and 2000, up fromjust 0.7 percent in 1990-95. Moreover, in 1990-95: and contrary to the early 1990s, growth was pro-poor, as the consumption expenditures o f the poorest decile grew above average. 6. Core poverty remains entrenched in rural areas but, economic vulnerability is important, especially in urban areas. The distribution of the core poor remained stable over time, with, in2000, 74 percent living inrural areas, about the same as in 1990. The core poor made up 8.3 o f rural population, a rate twice as highas the national average. Economic vulnerability remains, however, an important issue in urban areas, as 50 percent o f the economically vulnerable lived inurban areas in2000, up from 43 percent in 1990. Moreover, a fairly highproportion o f people remain clustered above, but close to, the poverty lines. If poverty lines were set at twice the level for the lower poverty line, 40 percent o f the rural population and 15 percent o f people in Metropolitan areas would fell in extreme poverty. Tunisia's high exposure to volatility (droughts) and external shocks (tourism, exports) may thus affect poverty outcomes inunpredictable ways. 7. Tunisia has also made important headway on non-monetary aspects of poverty. Health levels improved, as indicated by increasing life expectancy and falling infant, child and maternal mortality rates. Primary education became nearly universal and illiteracy i s close to becoming eradicated among younger generations. Disparities still remain in female and male literacy rates, and urban and rural infkashcture. Overall, however, these achievements have put Tunisia ahead o f countries at similar income levels. The strong progress on social indicators i s an important factor behind the reduction in the poverty headcount index over the 1990s. 2 Forward-looking policies helpedpreserve external and internal balances 8. I n 2000-2003 inflation fell to 2.4percent on average, while the external current account defxit was maintained at 3.8percent of GDP. Despite strong and accelerating GDP growth over the 1990s, prudent Figure 1.3 : Tunisia--Inflationand extemalbaiance (1990-2003) I 15 demand management helped bring inflation down, to -.... CPI Inflation, 5 fast-growing levels below those seen in the five fast-growing comparators (Figure 1.3). At the same time, the number of administered prices has steadily decreased.' Tunisia's current account deficit-reflecting the sizeable trade -5 I I < Current account balance (in % of GDP) i i deficit, at over 10 percent o f GDP-was also kept under control, at around 3 percent of GDP for most o f the late . _ Trade balance (in % of GDP) 1990s. However, due to domestic demand pressures, the 1990 1992 1994 1996 1998 2000 2002 1 current account deficit surpassed 4 percent o f GDP in 2000 and 2001. In early 2002, the extemal shocks were further exacerbating the pressures on the current account. To prevent a potentially steep widening o f the deficit, the authorities tightened fiscal and monetary policies, thus containing domestic demand pressures. With slowing domestic activity imports of equipment declined sharply, while imports o f intermediate products fell as well, owing to sluggish exports. The current account deficit was thus reduced and foreign exchange reserves have stabilized at the equivalent o f three months o f imports since early 2003. 9. Fiscal consolidation has progressed, but a primary structural budget deficit still persists. A sizeable primary budget deficit o f 2.1 percent of GDP in 1990-91was turned into a 1.3 percent surplus by 1994, thanks to an important fiscal consolidation effort, and the primary budget deficit hovered around zero since then. But in 2000-2001 fiscal policy turned expansionary, despite strong domestic demand growth, and the primary budget deficit broadened to 0.7 Figure 1.4 :Stnrcturalbudget deficit and oulpul gap (in% of NonAgricultural percent of GDP. The fiscal stance was tightened in the potenealGDP) 2002 and 2003 budgets, but the primary budget deficit still remains and prevents a rapid reduction of public debt. Overall, however, as suggested by the positive correlation between the estimated primary structural budget deficit and the output gap, fiscal policy has generally maintained a counter-cyclical stance. (Figure 1.4).2 But because o f existing rigidities in the budget reviewed in chapter 4, when adjustment i s needed, as in 2002-03, creating more fiscal space typically leads to 10 1 ~ cuts in the public investment budget, with a detrimental 1980 1982 19e4 1986 1988 1990 1992 1994 1996 1998 zoo0 2002 impact on growth potential. 10. Monetary policy has supportedmacroeconomicstability and has respondedswiftly to changing conditions. The monetarypolicy fi-amework aims to preserve the internal and external value o fthe dinar, by maintaining low inflation and preserving the external balance. To achieve its goals, the Central Bank of Tunisia targets a rate o f credit growth consistent with the growth o f domestic demand, while following a constant real effective exchange rate rule. Controls on capital movements provide some autonomy to The CPI inflation accelerated in the second half o f 2003, reaching 4.7 percent in early 2004 on a year-on-year basis, partly reflecting in part the increase in the prices o f some subsidized foods and partly the depreciation o f the dinar versus the Euro, as most o f Tunisia's imports are denominated inEuros. 'Theprimary structural budget deficit was estimated after removing the cyclical component from the actual deficit, related to automatic fiscal stabilizers (direct and indirect taxes). It excludes interest payments andprivatization receipts and grants. Because the tax base o f direct taxes i s narrow, the cyclical component of the budget i s relatively small. The cyclical component varies around k0.5 percent of GDP, so that the estimated structural budget deficit comes very close to the actual deficit. 3 monetary policy and allow simultaneous targeting o f domestic credit and the exchange rate. To rein inthe growth o f domestic demand, monetary policy was swiftly tightened in 2001, with the Central Bank drastically cutting its refinancing to commercial banks. The tighteningo f monetary policy was eventually reflected into a better alignment o f credit expansion with the growthindomestic demand, and allowed an easing o f monetary conditions in2003. 11. Targeting a constant real effective exchange rate provided a valuable anchor in Tunisia's economic management and is being implemented more flexibly in the run up to thefree-trade zone with the EU. Targeting a constant real effective exchange rate has contributed to maintaining a good level o f competitiveness and the prudent budget management has provided an necessary anchor for this exchange rate policy. Inparticular, exchange rate depreciation was not substituted to fiscal and monetary adjustment to absorb the pressures from the current account. However, the real exchange rule was implementedina more flexible manner in2002 and 2003, as the government allowed some real exchange rate depreciation (Figure 1.5). Real exchange rate depreciation i s supporting Tunisia's ongoing trade liberalization inthe final stages o f the implementation o f the free trade zone with the EU, and it responds to increased competitive pressures from countries with exchange rates tied to a weaker dollar. Moreover, real exchange rate depreciation supports the preparation for a more flexible exchange regime and a more open capital account inthe future. Figure 1.5 : Realeffective exchange rates-Tunisia and corrparators (1995=100; increase indicatesappreciation) Figure 1.6 : Foreigndebt in% of GDP (2001) 80I 130 - 60 120 - 40 110 - 20 100 - 90 - 0 80 - 70 Y 60 , 1990 1992 1994 1996 1998 2000 2002 12. Over the past two decades, Tunisia successfully controlled the public debt burden, while pursuing a prudent debt managementpolicy. Because of the structural current account deficit and the persistent primary budget deficit, public debt hoveredat around 60 percent duringthe 1990s (of which, 39 percent foreign and 22 percent domestic debt in 2002). With foreign private debt representing an additional 13 percent o f GDP, Tunisia's total foreign debt amounted to 52 percent o f GDP in 2002. The debt service ratio was brought down to around 15 percent o f exports inrecent years. Tunisia i s among the few emerging market borrowers that have investment grade rating. Prudent macroeconomic policies have helped Tunisia improve its access to international financial markets, allowing borrowing at long maturities and under relatively favorable conditions. Strengthened creditworthiness helped Tunisia to extend the maturities o f its long-term debt from 9.3 to 12.1 years over the 1990s. However, Tunisia's foreign debt remains high in intemational comparison, especially in view o f the country's exposure to extemal shocks. Importantly, Tunisia's foreign debt ratio i s about 12 percentage points o f GDP higher than in the average o f 10 other countries with a similar sovereign rating (BBB-, BBB, and BBB+), suggesting that a faster reduction o f public debt could yield substantial benefits in terms o f access to intemationalcapital markets (Figure 1.6). 4 Achievingfaster growth-the key role of private investmentand human resources 13. Tunisia has performed better, or at least as well as other developing countries, across all determinants of long-term growth. Evidence from 38 developing countries reveals that Tunisia's strong growth over time reflects above-average performance mainly on three fronts (Figure 1.7; also see Anos Casero and Varoudalus, 2003):3 (i) progress in structural reform in foreign trade openness and the financial sector; (ii) above-average investment inthe public sector (administration and public enterprises); (iii)strong human capital assets (education andhealth). Macroeconomic stability (accounted for by inflation, the foreign debt ratio, the extemal current account deficit, and the budget deficit) contributed to growth as much as in other developing countries. On average, private investment had a contribution to growth as in other developing countries, but seems to have lost steam since the mid-1990s. -igure 1.7 : Contributionsto average growth--Tunisiavs. High-growth(in O h per year) ~ 2 3 1 ~ andother 14. But compared to other high-growth countries, Tunisia's growth relied more on public investment, and less on private investment and human capital. The contribution of trade and financial reform (interms o f trade openness and credit supply) to growth was as strong as in the five high-growth comparators (Chile, Korea, Malaysia, Mauritius, and Thailand). However, the high-growth countries took advantage of much stronger private investment. By contrast, public investment was not a significant factor in these countries (Figure 1.7). In addition, human capital assets had a stronger contribution to growth over time in the fast-growing countries than inTunisia. Growth in the five comparators was also bolstered by better macroeconomic stability than in Tunisia, because these countries had, on average, smaller current account andbudget deficits, and a lower foreign debt ratio. 15. Despite solid macroeconomic fundamentals, Tunisia suffers from `a structural private investment gap. Over 1997-2001, average private gross fixed investment remained compressed at 13.5 per cent o f GDP, moderately up from 13 per cent over 1990-1996. By contrast, over the 1990s, the private investment ratio in the five fast-growing comparators was 25 percent. Tunisia's structural gap inprivate investment further broadened over the 1990s (Figure 1.8a). And the private investment ratio remained Using the coefficients o f a panel growth regression, the difference o f Tunisia's growth to the average growth o f 32 other developing countries was broken down into 6 components: macroeconomic stability; structural reform in trade and finance; private investment; public investment; human capital (education and health); other exogenous factors (convergence effect, reflecting the initial conditions in terms o f income level, fixed effects, and the growth residual). The same decomposition was carried out for the difference o f growth of 5 other fast-growing countries (Chile, Korea, Malaysia, Mauritius, and Thailand) to the average o f the 32 developing countries. The results are summarized inFigure 1.7. 5 stagnant in 2002-03, amid a difficult economic environment. What are the reasons for Tunisia's private investment gap? Intemational experience suggests that the limited openness o f the Tunisian services markets and network industries to private investment, in particular telecommunications and transport, deprives Tunisia from significant opportunities for private investment, and probably also foreign direct investment. Telecommunications i s a case inpoint because, despite recent moves, Tunisia still ranks low compared to other developing countries-including in MENA-in liberalization o f the sector. Throughout the 1990stelecommunications have received the lion's share o f private investment-US$330 billion out o f US$ 755 billion in total private investment in network industries in developing countries (World Bank 2003d' and Figure 1.8b). At the same time, limitedcompetition innetwork industries keeps the cost o f backbone services high and hinders competitiveness, as consistently suggested by the results o f business surveys inTunisia (IEQ2002b). This limitsTunisia's attractiveness to private investment. Private investment in % of "- 5 high- , Roads Water $76bn. $40bn - - - $29 bn Ports Electricity- $213 bn' Total Privatelnvcstment= US$754 biilior 1970-74 1975-79 1980-84 1985-89 1990-94 1995-92 (in 2001 US$billion) billion Figure 1.8a Figure 1.8b Private investment: Tunisia and fast-growing countries Private investment ininfrastructure indeveloping countries (source: Harris, 2003) 16. Heightened uncertainty in Tunisia's economic environment may have deterred private investment. Businesses face uncertainty reflecting the surrounding risks inTunisia's changing economic environment. Commercial risks stem partly from Tunisia's commitment to deeper international integration since the signing o f the Association Agreement with the EU in 1997, and partly from the expected removal of MFA quotas for textiles and clothing exports, which will deprive Tunisia from preferential access to EU markets for these products. Structural weaknesses in the tourism industry, a main pillar to Tunisia's growth over the pas decades (see Box 1.l), and the increased exposure o f the sector to volatility, due to intemational security concems, also amplify business uncertainties. 6 17. The quality of economicgovernance is key to attenuate business uncertainty andfosterprivate investment. International experience suggests that uncertainty stemming from weaknesses in the regulatory framework for doing business may hinder private investment (World Bank 2003g). The Tunisian authorities have traditionally kept a high degree o f discretion inregulating economic activity- including by providing generous privileges for exporting and investing in selected economic activities. This strategy has supported the country's development in a context o f limited trade integration. But Tunisia faces a tuming point on the eve o f a much deeper engagement with the world. Existingincentives systems run the risk o f locking the country's specializations into threatened activities, which may leave Tunisia ill-positioned inthe face o f stiffer intemational competition. Moreover, regulatory uncertaintyand high discretionary intervention by the government weaken the investment climate, especially when competitive forces are weak. Discretionary intervention then runs the risk o f strengthening the hand o f "insiders", thus reducing market contestability and discouraging risk-tahng by less connected 7 entrepreneur^.^ As further elaborated in chapter 2, to strengthen the investment climate, it i s important that transparency and competitive market conditions prevail. Intheir absence, privatization, deregulation, and other supportingreforms may not produce the expectedresults, owing to mute investment response. 18. Reflecting business uncertainties, private :igure 1.9 :Actual and predicted pnvate investment ratios (in % of GDP) investment has been losingmomentum since the mid- 18 ....__.. - ~ _ , -.--73 1990s, with little help from the generous incentive system in place. Tunisia's structural private investment gap has been exacerbated by a weak responsiveness o f private investment to healthy macroeconomic conditions since the mid-1990s. Based on past experience, private investment has been lower than expected by an estimated 0.5 percentage points o f GDP per year on average-or a cumulative 3.5 percentage points o f GDP from 1995 to 2001 (Figure -2 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 1.9; also see Anos Casero and Varoudakis, 2003). This may have deprived Tunisia o f an estimated 5 percent o f GDP over the same period, with a resulting "deficit o f jobs" o f 2.5 percent o f total employment. It i s worth noting that the "missing investment" occurs despite the generous investment incentives in place, and the subsidies granted through the enterprise "Mise 2 niveau program. This calls into question the effectiveness o f the existing incentives " system as a means o f stimulatingprivate investment, and underscores the importance o f a sound business environment to help Tunisian firms meet the challenges o f the future. 19. I n summary: Ensuring sustainedfast growth in the years ahead would call for a business environment conducive to greater private investment, consolidation of human capital assets, and further strengthening the macroeconomic fundamentals. It is unrealistic to assume that public investment will continue to be a main driver o f growth inTunisia inthe years ahead. This would strain the budget, at a juncture where Tunisia needs to improve budget flexibility and create enough room for adjustment to respond to external shocks. Moreover, investment by public enterprises has been declining over the last decade, and this trend i s likely to continue with the gradual retrenchment o f the state from commercial activities and a number o f network industries. Stronger private investment i s the key to stepped up growth andjob creation, as well as to improved productivity and competitiveness. Sustaining and further improving Tunisia's human capital achievements i s an additional precondition for faster growth-but has to go along with investment inhigh-shll activities, to meet the structural challenges in the labor market outlined above. Further strengthening the macroeconomic fundamentals i s a third precondition for faster growth, as this will further bolster investor confidence and help mobilize more finance for investment. Key challengesfor agricultural development 20. Sustained agricultural growth would help consolidate recent progress in poverty reduction. Agriculture generates about 14 percent o f GDP and employs about 22 percent o f the labor force. Overall Examples o f lack o f transparency and predictability o f the regulatory framework include : Prior approvals for investment in sectors where private investment is restricted; prior approvals for foreign majority participation in Tunisian companies; lack of transparency o f the decisions o f the "Commission supirieure d'investissement "; VAT refunds subject to tax controls for sales on the domestic market and companies non eligible for the "Mise ri niveau " program; lack o f systematic application o f auditing requirements for companies that have significant access to bank credit; the absence o f a Concession law that would clarify the "rules o f the game" for private sector participation in the provision o f infrastructure services. These issues are further examined inthe following chapters. 8 food exports are about 10% of merchandise exports and food imports are around the same level. The traditional strengths o f Tunisian agnculture are olive oil, and most fixits and vegetables. Fisheryproducts are also highly competitive exports. Cereals production i s generally competitive in high potential humidsubhumidzones on medium and large size farms, butnot inarid and semi-arid areas on small and medium-sized farms. Ovine and bovine production are also competitive, but milk production i s not competitive. A high degree o f variability characterizes agricultural production, mainly because o f the dependence o f cereals on rainfall. Even though recent poverty trends reveal a balanced decline in rural and urbanpoverty, rural poor remain vulnerable due to agnculture's volatile conditions. 21. Due to the small size of the domestic market, it is important to improve access to export marketsfor products in which Tunisian agriculture is competitive. Like other agncultural producers in the Mediterranean basin, Tunisia faces producer subsidies and restrictions on exports o f products which are also producedinthe EUand other export markets, including olive oil, citrus and fruits and vegetables. Despite significant progress in sectoral adjustment, some products including cereals are still protected domestically through high tariffs and producer subsidies, managed through public enterprises. Domestic protection further discourages production for export by diverting resources out o f potentially more competitive products (World Bank, 2000). However, unless there i s greater access to export markets, mainly inthe EU, for agncultural products inwhich Tunisia i s competitive, the scope for farmers to shift into these products would remain limited, and resources would be transferred out o f the agncultural sector. The cereals sector, especially small to medium size producers in arid and semi-arid zones, would be the worse affected. Consequences couldbe destabilizing socially and politically. 22. But in the absence of more efficient management of water resources in the years ahead, projected water shortages may create bottlenecks and deprive Tunisia of potentially better export opportunities in high-income markets. If current trends persist, water shortages will be inevitable by 2015 as Tunisia would have developed by then its full water resource potential while demand for water would continue to increase. Though doing better than most other countries in the Region, Tunisia still only recovers about 90 percent o f the operation and maintenance costs o f irrigation water, and recovery rates vary from 50 to 125 percent, depending on the region and/or type o f perimeter, creating disincentives for more efficient use o f what i s the country's scarcest natural resource. 23. Despite decades of Government efforts toprotect natural resources, climaticfactors, combined with over-exploitation and inadequate management practices, have led to significant resource degradation. It is currently estimated that about 47 percent o f agricultural land i s eroded, that 20 percent o f rangelands have disappeared since 1972, that 24 percent o f shall aquifers are over-exploited and that the irrigation efficiency rate in some small perimeters i s only 40 percent. Tunisia's fragile natural resources -water, soils and forests -needbetter management to prevent them from becoming a constraint to rural income growth. Improvement i s needed both to introduce participatory management and strengthen administrative capacity to deal with the social, cross-disciplinary, decentralized and information-intensive nature o f improved naturalresource management. 24. The Governmenthas adopted a long-term strategy to address water management issues. A first round o f reforms i s being implemented, with support by the World Bank, including: (i) delegating progressively overall responsibility for the management o f irrigation perimeters, including those of the State, to water user associations; (ii) extending modern commercial cost and income accounting practices to all regional agricultural departments, with a view to introducing transparent billing and contracting procedures and reduce the cost o f water delivery inthe irrigation sector; (iii) introductiono f a water tariff structure based on fixed and variable terms (tarzjkation bindme) as part o f current price increases. Implementation o f second-round reforms to promote integrated management and conservation o f water 9 resources, efficiency o f irrigation water use and institutional restructuring and capacity buildingwill help address the challenges ahead. 1.2.Medium-term outlook and policy prioritiesahead Themedium-term outlook is encouraging, but raises importantpolicy challenges 25. Tunisia has made thefirm choice of integrating more closely the world economy+ strategic move that has the potential to stimulate growth. Tunisia has already seen the benefits o f greater trade openness and o f removing cumbersome regulations on the business sector. The best example i s when it significantly deregulated offshore enterprises from the constraints imposedon the rest o fthe economy and the resulting robust growth o f the offshore sector greatly contributedto employment, growth, and extemal sustainability. With the right regulatory framework in place, as explained in chapter 2, the completion o f the Association Agreement with the EU, has the potential to facilitate integration o f Tunisian firms into EU production networks, thus improving Tunisia's attractiveness as a hub for export-oriented foreign direct investment. The free-trade zone will also expose firms supplying the still protected domestic market to greater competition, thus forcing restructuring, which eventually will result in improved efficiency and better prospects for growth. 26. But greater integration into global markets will raise challenges, first, for the import- competing manufacturing industries- The first challenge that faces Tunisia i s to "extend" the offshore sector performance in the rest o f the economy, which will be exposed to increased competitive pressures with the completion o f the Association Agreement with the EU.As explainedinchapter 2, the regulatory framework o f investment incentives and trade facilitation, which currently discriminates in favor o f the offshore sector, will have to become more even and supportive to the onshore sector. Without proper changes in the regulatory framework for investment and a more predictable business environment, the onshore sector faces the risk o f a serious setback as a result o f exposure to stiffer competition. The realizations o f existing enterprise support programs, such as the "Mise ci niveau do not seem to provide " the needed support to the import-competing sector (chapter 2). 27. - a n d , second, for the traditional exporting sectors. The second challenge i s to help exporting f i r m s strengthen their competitiveness, upgrade their market niches, and position into new, higher value added exports, while improving the quality andreducing the cost o f services that facilitate trade. This will help exporting firms reap more benefits from the free-trade zone with a 25-member EU, and deal with upcoming threats. With the gradual phasing-out o f the MFA quota system by 2005, Tunisia's textile exporters will face stiffer competition fiom low-cost producers intraditional Europeanmarkets. They will need to upgrade their market niches and their ability to respondto rapidly changing market demand, with more support from a much better transport and ICT infrastructure. This would call for bold steps in the liberalization o f trade related services that still burden Tunisian exporters with high costs. As already, discussed, the tourism sector would also need to undergone significant restructuring to improve the quality o f services and better position inthe global market, while improving the financial sustainability o f large units. And, in the absence o f reform, agnculture will continue to face significant challenges due to the looming water shortages and the degradation o f natural resources. 28. Surrounding macroeconomicandfinancial risks, both external and homegrown, should not be ignored. The tariff reductions scheduled in the Association Agreement with the EU, combined with the need for large imports o f equipment and intermediate goods to support fast growth, will make it more difficult to reduce current account deficits. The loss o f tax revenues on extemal trade will enlarge the financing needs in the budget and make it harder to reduce the public debt. Deeper integration into EU markets will heighten Tunisia's dependency on economic swings inthe EU, where growth has proven less 10 resilient to global downturns, as seen in the 2001-2002 slowdown. Anemic growth in the EU, which absorbs more than 75 percent o f Tunisia's exports and i s home to more than 70 percent o f the country's foreign visitors, i s swiftly felt in Tunisia, as in the sharp slowdown seen in 2002. In the emergng international environment with heightened security concerns, growth and the external balance may also suffer setbacks from the increased volatility o f tourism receipts. Risks also arise from "homegrown" vulnerabilities, such as the highlevel o f under provisioned non performing loans (NPLs) o f commercial and development banks-especially to the tourism sector. As further explained in chapter 3, the heavy reliance on overpriced and illiquid real estate guaranties for the provisioning o f NPLs leaves the banlung system, and thus credit to the private sector, vulnerable to the financial health o f the tourism sector and a possible downturn inthe real estate market. 29. Over the medium term, relatively healthy growth, based on continuing reform efforts, couldgo in tandem with current accountpressures and some loss offiscal revenues. Reflecting the momentum provided by the completion o f the AAEU and ongoing reform efforts, but also the uncertainties and structural weaknesses mentioned above, real GDP could grow within a range o f 4.5-5.5 percent on average, at about the same pace as during the Ninth Development Plan (1997-2001). Achieving continuing fast growth despite the competitive threats and surrounding risks, would call for coordinated efforts to strengthen the investment climate, by steadily improving the quality and predictability o f the regulatory framework, while keeping up the pace of liberalization in sectors still under the government's umbrella.' At the same time, due to the tariff reductions scheduled inthe Association Agreement with the EU, the current account deficit may increase by an estimated 0.8 percentage point o f GDP. Moreover, reflecting the loss o f tax revenues on external trade, the primary budget deficit may worsen by 0.6 percentagepoints o f GDP. 30. Despite tensions on the external and internal balances, debt would be sustainable- With growth close to the high end o f the baseline range, total public debt would decline to about 54 percent o f GDP by 2012, from 61 percent in 2002-although at a slower pace after 2006 due to the widening primary current account and budget deficits (World Bank, 2003b). Foreignprivate debt would increase to 20 percent o f GDP, from 12 percent in 2002, reflecting the persistent current account deficit and the improved access o f the private sector to international capital market financing. However, total foreign debt would decline to about 44 percent o f GDP, from 51percent in2002. The debt service ratio would be stabilized at around 11percent o f total exports, down from 14percent in2002. However, these favorable outcomes depend critically on maintaining a high rate o f growth. With growth at the middle o f the projected range, public debt would remain virtually unchanged inproportion to GDP, while with slower growth, close to the low end o f the range, the public debt ratio would increase. 31. -but unemployment would remain stagnant. With the relatively low elasticity o f employment to output observed in recent years (see chapter 2), growth even at the high end o f the projected range would fail to reduce unemployment. Assuming no employment growth in the public sector and agnculture, the unemployment rate would actually increase, to a projected 16.4 percent by 2006 (World Bank, 2003a). In view o f the projected trends in the labor force and the participation rate, reducing the unemployment rate by about 3 percentage points in 5 years would call for a higher growth rate, o f about 6.5 percent per year. All else equal, this would require a much stronger private investment effort, o f about 7 percentage points o f GDP-compared to 2 percentage points in the high end o f the baseline range Assumingthe incremental capital output ratio remains unchanged at its 1998-2001level (5.06), achieving growth at the high end of the baseline scenario would call for an increase in the fixed domestic investment ratio by 2 percentage points o f GDP (from 25.7 to 27.8 percent). With a large part of the budget absorbedby non discretionarypublic expenditures (see chapter 4), andgiventhe needto achieve faster fiscal consolidation,there is practicallyno room for maneuverto increasepublic investment. The neededextra investmenteffort would thus have to come from privateinvestment. 11 projection.6To achieve such an increase ininvestment, mutual reinforcing, broad-based reforms would be necessary, to considerably strengthen the business environment and secure adequate financing for investment, as further explained inchapters 2 and 3. 32. Further strengthening the fiscal framework would hedge against vulnerabilities and risks. Takmg early steps to achieve an ambitious medium-term fiscal consolidation would provide the needed fiscal room for maneuver to deal with surrounding risks. This should be underpinned by both better revenue mobilization and enhanced public expenditure efficiency. Main benefits from fiscal consolidation would include: 0 Securing domestic finance for greater investment, by mobilizing more public savings, so as to minimize pressures on the external balance over the medium term. 0 Keeping inflation in check, and avoid a sharp tightening o f monetary policy that may hold back private investment and growth inthe years ahead. 0 Reducing the level of public debt. This would further bolster the confidence o f domestic and foreign investors. As seen above, at 60 percent o f GDP, public debt remains highby international comparison and possibly denies Tunisia a more favorable access to international capital markets. 0 Creating enough room in the budget to (i) adjust to severe shocks, and (ii) possibly conduct counter-cyclical action, to offset part o f the impact o f adverse external shocks. 0 Creating room for expanding the social safety nets, to offset the social impact o f structural changes due to deeper trade integration. 0 Promoting a policy mix that would sustain an easier monetary policy stance, and thus facilitate the move toward a new monetary policy framework, underpinned by greater interest rate flexibility. 33. Taking early steps infiscal consolidationwould also hedgepublic debtfrom future calls on the budget that may arisefrom the contingent and implicit liabilities of thepublic sector. Contingent and implicit liabilities may arise from a variety o f sources: (i) The under provisioned, non-performing loans accumulated by the banlung system, and by public banks in particular (see chapter 4). Non performing loans would be likely to spike in a low-case scenario, owing to the growing exposure o f banks to the tourism industry and to exporting sectors. (ii) unfunded liabilities o f the pay-as-you-go pension The system (chapter 7); (iii) guarantees on the foreign-currency debt issued by public enterprises; (iv) performance guarantees to private providers o f infrastructure services, through BOT or BLT agreements, may also give rise to contingent liabilities in the future; (v) in a low-case scenario, foreign exchange guarantees may generate fresh debt if the adjustment to persistent external shocks were to partly rely on exchange rate depreciation. This would be the case with the unfunded foreign exchange guarantees provided by the government to external borrowing by public non financial enterprises. Funded guarantee schemes-such as the "Fonds depirrdquation des changes", which issues foreign exchange guaranties for loans by local or foreign banks operating inTunisia-may also generate losses. Key developmentchallengesandpolicypriorities ahead 34. With the right business environment in place, Tunisia's integration into global markets will create opportunitiesfor faster growth, but will also raise a multi-faceted development challenge during the Tenth DevelopmentPlan and beyond. Tunisia's strengths and weaknesses over the recent years, and the outlook and risks reviewed above, point to four key medium-term challenges: Improvements in total factor productivity could reduce the needed incremental investment effort to achieve faster growth. But such improvements would also call for continuing structural reforms, spurringdiffusion o f ICT in production and distribution, and ensuring better quality of production inputs and services, more efficient organization o f enterprises, and better skills in the labor force. 12 0 Step up investment in theprivate sector, to achieve the much faster growth required to reduce unemployment, while mobilizing enough public and private savings to finance investment so as to minimize pressures on the external balance; 0 Maintain fast productivity growth, to improve competitiveness and meet the challenge o f the free-trade zone with the EUand stiffer international competition; 0 Promote high-skill sector growth, and the emergence o f a knowledge-based economy, to match the rapidly changing skillmix inthe labor force; 0 Reinforce the efficiency and sustainability of social services, to consolidate Tunisia's valuable human assets, nurture the knowledge-based economy, and shield vulnerable groups in the emerging more competitive environment. 35. Companionpolicies will be needed to make Tunisia's deeper trade integration workfor growth and jobs. As shown by intemational experience (EU accession countries, Mexico, East Asia), most countries that have created more open markets have been able to stimulate domestic investment and attract significant flows o f FDI along with their integration into broader economic areas. But in all success stories the reduction o f trade barriers had to go in tandem with complementary policies: broader regulatory reform that improved the attractiveness to investment; strengthening o f human resources; and a solid macroeconomic fi-amework (World Bank, 2003d). This will be all the more important to reap the benefits o f the "Wider Europe" initiative, which may create new dynamics and opportunities for growth for the Southern Mediterranean countries (Box 1.2). The challenge i s even greater inTunisia because, as noted earlier, business risks stemming from the external environment are amplified by weak competitive forces, high discretionary interventionby the govemment, and regulatory uncertainty, which weaken the investment climate. Tunisia thus faces a turning point where, unless coordinated efforts to improve the quality o f the regulatory framework for private sector activity are placed at the core o f the Government's reform agenda, the deeper engagement with the world may not fulfill its development promise. 0 Strengthening policies in some key complementary areas would help meet Tunisia's development challenge. 0 Improving the investment climate, by lowering transactions costs, enhancing transparency and predictability, and strengthening market contestability. This Will help unleash Tunisia's business 13 potential, particularly for the creation o f new enterprises. Continuing liberalization efforts will boost competitiveness by improving the quality and reducing the cost o f backbone services and production inputs--especially o f ICT services, the foundation o f a knowledge-based economy. Improving the functioning o f the labor market, by reducing protection within the firm, increasing protection o f vulnerable workers outside the firm, and enhancing the efficiency o f labor market policies. Strengthening the soundness o f the banlung system and fostering the development o f government and private securities markets, to improve the diversification o f sources o f finance, ensure good access to finance for private investment, and ensure the resilience o fthe economy to financial risks. Securing a robust medium-term fiscal framework, by stepping up fiscal consolidation, through better fiscal revenue mobilization and increased public expenditure efficiency. This will help improve efficiency o f public service delivery, while reducing medium-term pressures on the budget and improving the capacity o f fiscal policy to deal with a potentially hostile external environment. Enhancing the efficiency o f education policies, by improving the quality and links o f the education system with the labor market and promoting an education and training system that facilitate the emergence o f the knowledge-based economy. Strengthening the effectiveness and sustainability o f social sector policies, by improving the quality and containing the costs o f health care services; strengthening the cost-effectiveness o f social protection; and securing the sustainability o f the pension system. The status o f reform initiatives and policy options in these key areas of the reform agenda are reviewed inthe following chapters. 36. Improving the quality of governance deserves particular attention because it underlies the development reform agenda. Progress on the four priority fronts will call for mutually reinforcing initiatives to improve the quality o f governance, so as to establish an environment in which fair and predictable rules form the basis for economic and social interactions. As discussed in chapter 3, establishing an enabling environment for a competitive private sector would call for initiatives to promote competition, transparency, and predictability o f regulations. The challenge o f improved governance i s also at the core o f the financial sector reform agenda-for example to improve provisioning o f non performing loans; upgrade risk management and credit allocation mechanisms by improving information flows in the credit market; improve corporate transparency; strengthen the protection o f creditor rights (chapter 4). Tunisia has a strong track record in public sector management and internal accountability. However, rising up to the growth challenges would call for further strengthening public sector governance in a number of areas. As explained inchapter 5, initiatives should focus on improving the fairness and efficiency o f the tax system, and strengthening efficiency o f public service delivery, by creating new spaces for accountability and talung appropriate steps to sharpen incentives and reduce the cost o f the civil service. Underlyingthe objective o f better public service delivery i s a structure o f government that promotes checks and balances, transparency, and accountability, in particular through the participation and voice o f civil society. For example, as further explained in chapter 7, greater accountability and autonomy in the management o f public hospitals would help improve the quality o f health care services, while better participationo fthe civil society ineducation establishments would support improved quality and help build better links with the labor market. And greater autonomy o f higher education establishments would help produce the kmd o f excellence in research needed to move toward the knowledge-based economy. 14 Chapter 2. Meetingthe Challengeof Job Creation 37. Promoting employment i s at the heart o f Tunisia's Tenth Development Plan-called le pari de l'emploi. According to the Plan, 400,000 new jobs are expected to be created between 2002 and 2006 (about 80,000 jobs a year compared to about 67,000 during the NinthPlan). To achieve the job-creation objectives o f the Tenth Plan and beyond, in view o f the structural challenges ahead, the government i s well aware that the overall employment strategy needs to be based on the fundamentals o f sound economic and employment policy. As analyzed in the next chapter, most important i s a commitment to economic policies that promote competitive product markets, productivity, and private-sector investment. This i s the most promising path to raising aggregate demand for labor and increasing labor productivity and incomes. But to maximize the employment gains o f Tunisia's international economic integration, labor market regulations and institutions need to be flexible so that employers and workers can adjust to changes in business conditions. As analyzed in this chapter, this approach requires less protective measures inside the firm and a more effective social protection system outside the firm through efficient active labor market programs and, perhaps, through income support for laid-off workers. The final ingredient in a job strategy for Tunisia i s a human resource development framework that generates a skilled and employable workforce for a liberalizing and increasingly sophisticated economy. This will require continued reforms in the education and vocational training systems, as further highlighted in chapter 6. 2.1.Despitestronggrowth, reducing unemploymentremains the majorpolicy challenge 38. The number of jobs created was just enough to match the increase in labor supply. Nonapcultural employment (78 percent of total em] o-went in 2001) grew by about 2.6 percent in 1994-2001, down from a healthy 4.4 percent in igure 2.1 : Nonagriculturalemploymentgrowth by sectors (in%) 6 1 1989-94 (Table 2.1). Agricultural employment grew 7 , more slowly, by 1.5 percent per year on average over 1989-2001. Tunisia's non agricultural employment 5 growth was at par with regional comparators, such as Morocco, and much above the OECD average, but behind countries such as Ireland (4.5 percent) and Mexico (5.6 percent) with a strong job creation record. Employment growth slowed markedly in manufacturing and private services, where 60 percent o f non apcultural workers hold a job (Figure 2.1). The slowdown was particularly sharp in the textiles industry-which provides jobs to 10 ' I percent o f workers-where employment grew by 1.9 percent in 1994-2000, down from 4.6 percent in 1989-94. By contrast, the pace o f employment growth was stepped up in administration and public services. - 15 Table 2.1: Employment and productivity trends in Tunisia: 1989-2001 1989-1994 1994-1997 1997-2001 Non agricultural employment growth (Tunisia) 4.4 2.5 2.6 Elasticity of employment to output (Tunisia) Non agricultural employment 1 0.5 0.5 olw manufacturing 0.6 0.7 0.5 olw services 1.I 0.5 0.5 Productivity growth (Tunisia) Non agricultural sectors 0.1 2.4 3.4 olw manufacturing 2.4 1.4 4.7 olw services -1.7 3.1 5.8 Source: World Bank staff 39. Unemployment has persisted, partly reflecting continuing demographicpressures, and partkj the decrease in the employment intensity of growth. With the labor force growing rapidly, by an estimated 2.5 percent per year, unemployment remained sizeable, at about 15-16 percent. Despite slower projected demographic growth, strong labor force growth i s expected in the years ahead, because, educational attainment i s improving, while, at 26 percent in2001, labor force participationby women still remains low. Inthe coming years, tensions inthe labor market will also be intensified by the shedding o f labor out o f agriculture, which still ensured 22 percent o f total employment in 2001, down from 26 percent in 1989. The non agncultural employment elasticity to output was halved, reflecting mainly a decline inthe employment elasticity o f services (Table 2.1). The overall employment elasticity in Tunisia i s not out o f line with international experience, but i s close to the more capital intensive OECD countries, and lower than inTurkey, Mexico, or Ireland(World Bank, 2003a). 40. The lower employment elasticity of growth reflects faster labor productivity growth, but may alsopartly reflect the impact of distortions in the labor market. Inmanufacturing, a trend o f declining productivity growth was reversed in 1997-2001 (Table 2.1), and productivity growth in private services continued to increase. The faster labor productivity growth largely reflects the ongoing modernization in private sector manufacturing, with the aim o f improving efficiency in the context o f Tunisia's increased exposure to internationalcompetition. Labor shedding associated with public-enterprise restructuring also boosted productivity in the nonagricultural sector. However, remaining rigidities in the labor market, especially in employment termination procedures, may have contributed to the lower employment elasticity of growth. Changes inthe relative costs o f capital and labor, linked to the hgh non-wage costs o f labor and the systemo f investment incentives inplace, may have reinforcedt h s trend (see below). 41. Faster labor productivity growth supports competitiveness and real incomes growth, but calls for a significant acceleration of growth to step upjob creation. This i s confirmed by the experience o f the East-Asian countries with rapidly growing productivity, which succeeded to reduce unemployment thanks to exceptionally high GDP growth, and that o f OECD countries with rapid productivity growth, such as Ireland. By contrast, in slow-growing EUcountries, strong productivity gains have been reflected indeclining employment. Not counting on administration, public services, and agriculture, growth would have to increase significantly to create enough jobs to absorb the fast growing labor force. Growth o f about 7.5 percent per year inmanufacturingand 11.5 percent inprivate services would be needed. This i s beyondpatterns seen inthe past inTunisia, butnot out o f line with international experience. 42. Accelerating growth, to meet Tunisia's employment challenge, would call for much higher private investment- Inthe years ahead, keepingpublic expenditures under control to maintain a sound macroeconomic framework will limit the potential for job creation in the public sector, while traditional export and growth drivers are likely to lose steam. As explained in the previous chapter, private investment remains low by international comparison, depriving Tunisia from stronger growth and faster 16 job creation. Bolstering private investment should be the focal point o f the development strategy, with ambitious steps to strengthen the investment climate, and create more opportunities for private sector entry inprotected services sectors and network industries. 43. -along with continuing progress in productivity growth. Tunisia cannot afford to increase employment atthe expense o f productivity gro&k Sustained highproductivlty growth would be neede I to further improve competitiveness in the face o f Figure 2 2 Real wages and productivity in the non agricultural sector intense global competition. With the right (1989:lOO) - - - business environment and adequate opportunities 130 7 1 for private investment, the relatively benign 125 - +Productivity -I-- Real wages 120 - wage setting environment in the labor market would support competitiveness and employment growth. Over the 199Os, real wages have kept /-=- 105 pace with labor productivity growth-reflecting 100 - -