December 2012

Document of the World Bank

Report No. 70772-BI

BurundiPolicy Note SeriesFiscal Challenges, Security and Growth Issues in Burundi

Poverty Reduction and Economic Management 5Africa Region

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REPUBLIC OF BURUNDI

Government Fiscal YearJanuary 1–December 31

Currency EquivalentsExchange Rate Effective as of December 31, 2012

Currency Unit Burundi FrancUS$1.00 FBu 1534.10

Weights and MeasuresMetric System

ABBREVIATION AND ACRONYMS

ADC Democratic Alliance for Change Alliance (Démocratique pour le Changement)AfDBAPI

African Development BankInvestment Promotion Agency

APR PRSP Annual Progress ReportARFIC Coffee Regulatory Authority (Autorité de Régulation de la Filière Café)BINUB United Nations Integrated Office in Burundi BOP Balance of PaymentsBRB Central Bank of Burundi (Banque de La République du Burundi)CAS Country Assistance StrategyCASA Conflict Affected States in Africa CEM Country Economic MemorandumCENI Independent National Electoral Commission (Commission Electorale Nationale Indépendante)CIP Interministerial Privatization Committee (Comité Interministériel de Privatisation)CNDD-FDD National Council for the Defense of Democracy-Forces for the Defense of Democracy CFAA Country Financial Accountability AssessmentCOMESA Common Market of Eastern and Southern AfricaCOTEBU Textile Industries (Complexe Textile de Bujumbura)CP Completion PointCWIQ Core Welfare Indicator QuestionnaireDBC Directorate of Budget and ControlDCDeMPA

Directorate of AccountingDebt Management Performance Assessment

DGP Planning DirectorateDFID Department for International Development (UK)DPO Development Policy OperationDRC Democratic Republic of the CongoDTIS Diagnostic Trade Integration StudyEAC East African CommunityEC European CommissionECF Extended Credit FacilityECOSAT Land Protection for Social Habitat (Encadrement des Constructions Sociales et Aménagements

des Terrains)EERC Emergency Economic Recovery CreditEMSP Economic Management Support ProjectERC Economic Rehabilitation CreditERSG Economic Reform Support GrantEU European Union

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EXIM Export-ImportFAO Food and Agriculture OrganizationFBuFDI

Burundi FrancForeign Direct Investment

FNL Front National pour la LibérationFPSDP Finance and Private Sector Development ProjectFIAS Foreign Investment Advisory ServiceGDP Gross Domestic ProductGER Gross Enrollment RatioGIZ German International CooperationGNP Gross National ProductGoB Government of BurundiHIPC Heavily Indebted Poor Countries (Initiative)HIV/AIDS Human Immunodeficiency Virus/Acquired Immune Deficiency SyndromeHRMIS Human Resource Management Information SystemICA Investment Climate AssessmentICAS Investment Climate Advisory ServicesICR Implementation Completion Results ReportIDA International Development AssociationIFMIS Integrated Financial Management Information SystemIFRS International Financial Reporting Standards (Normes Comptables du Secteur Privé)IGE State Inspectorate General (Inspection Générale de l’Etat)IMF International Monetary FundJSAN Joint Staff Advisory NoteLNBTP National Laboratory for Public Work and Building (Laboratoire National de Bâtiments et

Travaux publics)LDP Letter of Development PolicyMCM Monetary and Capital Markets MDG Millennium Development GoalMDRI Multilateral Debt Relief InitiativeMOCI Ministry of Commerce and Industry and TourismMFEDP Ministry of Finance and Economic Development PlanningMTEF Medium-Term Expenditure FrameworkMTFF Medium-Term Fiscal FrameworkNIF Tax Identification Number (Numéro d’Identification Fiscale)NGO Non-Governmental OrganizationNPVNTB

Net Present ValueNon-Tariff Barriers

OBR Burundi Revenue Authority (Office Burundaise des Recettes)OCIBU Burundi Coffee Board (Office de Café du Burundi)OECD/DAC Organization for Economic Cooperation and Development/Development Assistance CommitteeOHADA Organization for the Harmonization of Business Law in Africa (Organisation pour

l'Harmonisation en Afrique du Droit des Affaires)ONATEL National Office of Telecommunication (Office National des Télécommunications)OTBu Ordonnateur Trésorier du BurundiOTB Tea Board (Office du Thé du Burundi)OTRACO Public Transport Company (Office du Transport en Commun)PAGE Economic Management Support Project (Projet D’appui à la Gestion Economique)PEMFAR Public Expenditure Management and Financial Accountability ReviewPE Public EnterprisePERPETS

Public Expenditure ReviewPublic Expenditure Tracking Survey

PFM Public Finance ManagementPRGF Poverty Reduction and Growth FacilityPRSP Poverty Reduction Strategy PaperPSD Private Sector Development

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REFES Technical Committee for Monitoring of Economic Reforms. REGIDESO Régie des Eaux (National water and electricity enterprise)RTFP Regional Trade Facilitation ProjectSCEP Public Entreprises Directorate General (Service Chargé des Entreprises Publiques)SDR Special Drawing RightsSDRI Imbo Regional Development Company (Société Régionale de Développement de l’Imbo)SIGEFI Financial Management Information System (Système d’Information de Gestion Financière)SIP Public Mortgage Company (Société Immobilière Publique)SOGESTAL Coffee Washing Stations Management Corporation (Société de Gestion des Stations de Lavage de

Café)SODECO Coffee Milling and Processing Company (Société de Déparchage et Conditionnement)SOSUMOSME

Sugar processing enterprise (Société Sucrière de MOSO)Small and Medium Enterprise

SSA Sub-Saharan AfricaTF Trust FundUN United NationsUNDP United Nations Development ProgramUNOB United Nations Operation in Burundi UPRONA Union for National Progress (Union pour le Progrès National)USAID United States Agency for International DevelopmentVAT Value Added TaxWBI World Bank InstituteWFP World Food ProgrammeWHO World Health Organization

Vice President: Makhtar DiopCountry Director: Philippe DongierCountry Manager: Mercy Miyang TembonSector Director: Marcelo GiugaleSector Managers: J. Humberto Lopez/Albert G. ZeufackTask Team Leader: Jean-Pascal N. Nganou

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ACKNOWLEDGMENTS

This Policy Note (PN) series is a World Bank report. The PN is a product of well synchronized teamwork and numerous interactions, and dialogue between Bank staff and many people and institutions in Burundi: the Government of Burundi, the private sector, Non-Government Organizations (NGOs), academia, and bilateral and multilateral donors. A key event, the Cabinet Seminar of March 2011 was organized to discuss the findings of the first two notes, which led to the need for the preparation of the third note.

The team would like to thank His Excellency Mr. Tabu Abdallah Manirakiza (Minister of Finance and Economic Development Planning, Burundi) and the Government team for the excellent collaboration throughout the preparation of this Policy Note series and the valuable advice and inputs provided to complete the report. The report was completed under the overall leadership of J. Humberto Lopez (former Sector Manager, AFTP2). The team received excellent guidance from Jacques Morisset (LeadEconomist/Sector Leader, AFTP5) who provided invaluable inputs (mostly in the third Policy Note), quality control of the report, and suggestions throughout the preparation of this Policy Note series. Paolo Zacchia (Lead Economist, AFTP2) also provided excellent guidance and quality control on the first and second Policy Notes as well as on the conceptualization of this work. The team also received unwavering support and leadership from Philippe Dongier (Country Director, AFCE1), John McIntire (former Country Director, AFCE1), Mercy Tembon (former Country Manager, Burundi), and Kathie Krumm (former Sector Manager, AFTP2). The main author and task team leader of the report is Jean-Pascal N. Nganou (Senior Country Economist for Burundi, AFTP5).

This Policy Note series core team includes: Jean-Pascal N. Nganou (TTL and main author, Sr. Country Economist, AFTP5), Aurelien Beko (Poverty Economist/Consultant, AFTP5), Konan Raphael Nguessan (Consultant, AFTP5), Matthew Lowe (Oxford University, Research Assistant), Toru Nishiuchi(Consultant, AFTP2), Aurore Simbananiye (Team Assistant, AFMBI), and Senait Yifru (Program Assistant, AFTP2). Sherri Archondo (former Senior PSD Specialist, AFTFE) provided useful comments on previous versions of the two first policy notes. The team also benefitted from the overall advice and guidance of J. Humberto Lopez (Sector Manager, AFTP2), Albert G. Zeufack (Sector Manager, AFTP5), Philippe Dongier (Country Director, AFCE1), Rachidi Radji (Country Manager, AFMBI), and Mercy Tembon (former Country Manager, AFMBI), whose country knowledge and advice were extremely useful.

We would also like to thank Frederieke Quispel and Serge Rumin from the Netherlands Cooperation in Burundi for their useful input on the procurement assessment in the security sector, commissioned to Price WaterHouse and Cooper, which is summarized in this policy note.

The report also benefited immensely from discussions with the peer reviewers Bernard Harbone (Lead Social Development Specialist/Conflict Prevention, SDN), Aurelien Kruse (Economist, AFTP2), and Prof. Pierre-Richard Agénor (Hallsworth Professor of International Macroeconomics and Development Economics, University of Manchester, and co-Director, Center for Growth and Business Cycle Research, England). Additional written comments were received from Julia Lendorfer (Consultant, SDN). At the concept stage, useful comments were received from Bernard Harborne, Blanca Moreno-Dodson (Lead Economist, PRMVP), Dominic S. Haazen (Lead Health Policy Specialist, HD), Anne-Lucie Lefebvre (Sr. Public Sector Specialist, AFTPR), Pia Peeters (Sr. Social Development Specialist, AFTCS), Maximilien Queyranne (PFM specialist, AFTFM), Aurelien Serge Beko (Poverty Economist, AFTP5) and Sulaiman S. Wasty (Consultant, AFTP2). The team is particularly grateful to Professor Charles Ncho-Oguie (Emeritus Professor of Economics, University of San Francisco, California, USA) for his technical guidance on macroeconomic modeling for Burundi.

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The team would also like to extend its gratitude to Senait Yifru (Program Assistant, AFTP2), Maude Valembrun (Program Assistant, AFTP5), and Lydie Ahodehou (Program Assistant, AFTP5), who contributed in processing the document, and Aurore Simbananiye (Program Assistant, AFMBI) for logistics support and processing of earlier versions of the notes.

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Table of contents

Executive Summary........................................................................................................................ 1 Introduction..................................................................................................................................... 1 Policy Note 1................................................................................................................................. 12 Policy Note 2................................................................................................................................. 26 Policy Note 3: ............................................................................................................................... 37 ANNEX 1: A Theoretical Framework of an optimal downsizing strategy of the security........... 53 sector ............................................................................................................................................. 53 ANNEX 2: Conceptual Framework of the Burundi MACMOD Model....................................... 58 ANNEX 3: Downsizing profiles................................................................................................... 61 References..................................................................................................................................... 62

BOXESBox 1: Private investment............................................................................................................. 42 Box 2: Trade-off between fiscal gains and risks of insecurity...................................................... 44 Box 3: Why Burundi Sends Troops on International Peacekeeping Missions? ........................... 46 Box 4: Netherlands Procurement Improvement Report: Summary of Recommendations........... 51

FIGURESFigure 1: Average GDP growth: Burundi vs. EAC countries, 1970-2009 ................................... 14 Figure 2: Fiscal Balance (commitment basis before HIPC grants), 2005-10 ............................... 28 Figure 3: Strategic objectives, Budget decisions and Fiscal sustainability .................................. 28 Figure 4: Composition of Public Spending, 2001–2010............................................................... 32

TABLES Table 1: Inflation management: Burundi vs. EAC countries, 1980-2010 .................................... 14 Table 2: Productivity in Agriculture: Burundi vs. Selected Comparators, 1980-2009................. 16 Table 3: Basic Infrastructure Coverage for EAC, 2006................................................................ 18 Table 4: CPIA Transparency, Accountability, and Corruption in the public sector..................... 21 Table 5: Impact of Fiscal Space Improvement ............................................................................. 27 Table 6: Tax Revenue/GDP Ratios in EAC Countries, 2010 ....................................................... 29 Table 7: Composition of Government Revenue, 2001–2010 ....................................................... 30 Table 8: Fiscal Space Scenario—Medium-Term Expenditure Framework, 2008–15.................. 34 Table 9: Fiscal space improvement: Trends for Key Indicators, 2009–15 ................................... 34 Table 10: Comparison of the size of military personnel in selected countries, 2010 ................... 39 Table 11: Comparison of military expenditures in selected countries (in percent of GDP)........ 39 Table 12: Structure of public sector wages in Burundi, 2005-10 (percent of GDP) .................... 41 Table 13: Size and wage of security forces, 2005-2010 ............................................................... 45 Table 14: Simulation results of the impact of security issues on growth ..................................... 47 Table 15: Simulation results: Impact on PRSP-2 growth projections of proposed optimal downsizing paths........................................................................................................................... 49

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Executive Summary

Introduction

1. From 1993 to 2000, Burundi experienced 8 long years of civil war that killed more than 300,000 people, displaced 1.2 million, destroyed basic economic and social infrastructure, reduced GDP by 17.6 percent and lowered GDP per capita by 23.3 percent. Rural areas, where 90 percent of the population lives, were particularly affected by strife, human rights violations, destruction, and insecurity. The poverty rate went up from 35 percent in 1992 to 45 percent in 2000.

2. After these 8 years of civil war, Burundi went through 11 years of gradual political normalization with brief periods of recurring insecurity. In 2005, a new constitution led to democratic presidential and parliamentary elections, followed by implementation of a ceasefire agreement with the last rebel group in 2008. Another round of elections took place in 2010. Although the process was viewed as relatively fair and transparent by the international community, the results were contested by a number of political parties--thus leading to new episodes of internal strife.

3. On the economic front, the country’s performance has been moderately positive. After five years of sluggish growth, which further reduced GDP per capita and increased poverty, several years of higher growth (about 4 percent annually from 2006 to 2009) led to a slight increase in the GDP per capita. So far, however, Burundi has not yet experienced the same economic boom as other post-conflict countries such as Uganda in the early 1990s, Sierra Leone in the late 1990s, and Rwanda in the 2000s.

4. The last six years have seen the development of an intensive policy dialogue between the Government of Burundi and the World Bank, with a focus on three critical issues: (i) transparent financial management and reallocation of public resources toward priority sectors; (ii) improving the business environment to stimulate private sector development; and (iii) restructuring and privatizing the export crop sector. The dialogue has produced significant results, including: (i) the modernization of public finance management policies and the introduction of improved PFM procedures and systems (budget framework law/loi organique des finances publiques, procurement code and computerized financial management information system); (ii) the reallocation of a substantial share of available resources toward education, health, and other basic services; and (iii) the approval of comprehensive legislative reforms,which helped create a more favorable business environment and triggered a modest growth of private investment. The government also began to liberalize and privatize the coffee sector and sold 13 coffee washing stations to a reputable international investor; more recently, 28 additional coffee washing stations (out of the 104 stations remaining to be privatized) were sold mostly to local investors. Despite these achievements, additional efforts are essential to accelerate growth and, eventually, reach or exceed the objective of the first PRSP (7 percent a year in 2006-2009). With a population growth rate of nearly 3 percent, reducing poverty is an impossible task without a significant increase in the rate of economic growth.

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5. Three policy notes are outlined in this Summary. They aim to assist the government in its efforts to promote accelerated and inclusive growth. These notes are focused on: (i) the link between economic growth and poverty alleviation; (ii) the creation of fiscal space; and (iii) the promotion of growth-enhancing public investment. They also address the difficult issue of security-related expenditures and its link with private sector development.

6. The first two notes were discussed in a high-level workshop organized by the Vice-President for Economic and Social Affairs in Bujumbura in March 2011. The reactions of senior government officials attending the seminar were extremely positive. All the participants agreed on: (i) the need to accelerate growth and give priority to growth-enhancing investments and expenditures; and (ii) the high priority of improving governance and accelerating ongoing reforms in public finance management for more transparency and accountability. Reducing the civil service wage bill was one of the most debated issues during the seminar. Participants argued that civil service salaries in Burundi were particularly low and that reducing them was not politically feasible and incompatible with a poverty reduction strategy. Nevertheless, they understood the need to gradually align Burundi’s wage bill/GDP ratio on the average of other EAC and SSA countries. Questions were raised regarding the restructuring of public expenditures. The point was made that the priority for growth-oriented public spending should not be at the expense of basic social expenditures, including health and education, which will have a significant long-term impact on the growth trajectory. A number of participants felt that reducing security expenditures involved risks both in terms of political and social implications. An increase in insecurity would also have a negative impact on economic growth and on the development of new private sector activities, including tourism.

7. During and following the workshop, the government and its development partners agreed that more analytical work was needed on the critical issue of the demobilization of militarypersonal (reducing its size) and its impact on the budget and the overall economic performance of the country. In response, the World Bank prepared a third policy note that is also presented in this document.

8. The three policy notes are the fruit of a productive collaboration between the World Bank, the Government and other development partners. They draw from the analyses and recommendations of important analytical and policy papers and documents, including the 2011 Public Expenditure Review (PER), the 2010 Country Economic Memorandum (CEM) and the 2008 Public Expenditure Management and Financial Accountability Review (PEMFAR). Their conclusions have already been partly incorporated by the government in new strategic documents such as the second PRSP. They have also influenced budget preparation and the programmatic support donors plan to provide over the next few years.

1. The first policy note: Growth and poverty reduction

9. Growth and poverty reduction in Burundi depend mainly on seven key conditions: (i)macroeconomic stability; (ii) increased productivity and diversification of the agricultural sector; (iii) rehabilitation/development of economic infrastructure, notably hydroelectric power; (iv) improved business environment; (v) governance, including the promotion of a merit-based culture in selections for key economic management positions; (vi) development of human

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capital and lower population growth; and (vii) deeper integration of Burundi’s economy into the EAC system (convergence and regional infrastructure).

a) Macroeconomic stability

10. The country’s macroeconomic performance has been improving. Inflation has been controlled (except in 2008 following escalating international fuel and food prices) thanks to sound fiscal policies (higher domestic revenue; increased aid inflows, and improved expenditure management). The fiscal deficit declined from 4.7 percent of GDP in 2005-06 to 2.6 percent in 2007-08, but increased slightly in recent years (integration of demobilized combatants, and improved remuneration of teachers and health personnel). The external current account deficit remains high at 10 percent of GDP (narrow export base, and dependence on imports of fuel and capital goods) but has been over-financed by a surge in donor disbursements, leading to an increase in gross official reserves. For the future, the main priorities remain: (i) prudent macroeconomic policies; (ii) a flexible exchange rate, and avoiding overvaluation of currency; (iii) creation of an autonomous entity/committee that would oversee fiscal expenditures; and (iv) the adoption of EAC fiscal rules (i.e., ceilings on expenditures).

b) Increased productivity and diversification of agricultural sector

11. The main cause of Burundi’s slow economic rebound has been the poor performance of the agricultural sector, which accounts for 90 percent of the country’s employment and 35-45percent of GDP. Agricultural production per capita declined considerably during most of the 2000s; and the productivity of the sector has remained extremely low (equivalent to 36 percent of the productivity observed in other EAC countries). This is due to the modest use of modern inputs, poor rural infrastructure, lack of efficient extension services, weak farmers’ organizations, and the growing shortage of land resulting from high population density and high population growth rate. Weak marketing caused by poor connective infrastructure, has also prevented improvements in agriculture-related-value chains.

12. Lack of diversification is another major problem. Two cash crops – coffee and tea –account for the bulk of the country’s export earnings (about 70 percent). The experience of other EAC countries shows that agricultural diversification and promotion of high value primary products is feasible and would be a welcome development. Exporting new products such as bananas, vegetables, cut flowers, palm oil, and fish fillets is within the reach of Burundi, and should become a priority for the Government.

13. For the immediate future, another main priority should be to accelerate the ongoing reform of the coffee sector, which will have a demonstration effect on other crops, including the tea sector. In addition to privatizing washing stations (more than half of them remain in the public sector) and other processing facilities, the government should: (i) help organize coffee growers by strengthening the capacity of INTERCAFE; and (ii) encourage the new owners of washing stations to help finance harvests, improve input distribution, promote the rehabilitation of ageing coffee plants, and introduce modern processing techniques. Other priorities are to: (i) provide incentives for the introduction of new crops, low-cost technologies and soil fertility maintenance techniques; (ii) help organize producers and improve overall input distribution

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notably for the benefit of small farmers; and (iii) improve rural infrastructure (storage facilities, rural roads, and village and secondary markets). Finally, a discussion should start on the reorganization of the regulatory system and institutions for the export crops sector. More specifically, as the government envisages to privatize other agricultural sectors, it needs to decide on the feasibility of creating a regulatory agency for each commodity or transformingARFIC into a mega-regulatory agency for the totality of the agricultural sector.

c) Development of economic infrastructure.

14. Burundi lags behind other EAC members and SSA countries on any measure of infrastructure development (road and telephone density; other transport systems; power generation and distribution, etc.). The price of those services is also two to three times higher than in the other countries of the region. This affects the competitiveness of local businesses and discourages private investment. The coverage of rural areas is particularly deficient. High transport costs hinder internal trade and reduce opportunities of regional and international trade. Internal obstacles are compounded by high operating costs in the ports of Dar es Salaam and Mombasa. Domestic power production per capita is the lowest in the world, with only about two-four percent of households having access to electricity. The operational performance of REGIDESO, the public utilities company, is handicapped by obsolete equipment and inadequate tariff policies. The government has decided to give the highest priority to implementing a major infrastructure reconstruction and development program (with the help of the donor community) over the next few years. For the immediate future, the main measuresshould be: (i) to improve the financial viability of REGIDESO by extending the pre-payment system and revising tariffs; (ii) to prepare a business plan for the civil aviation, attract international airlines and increase availability of cargo space (for agricultural exports); (iii) to rehabilitate and upgrade the road network; and (iv) to strengthen the capacity of road transport management and regulation agencies. The government should also develop the hydroelectric potential of the country (Kagamuzi, Mpanda, and Kabu 16), and create transmission lines linking all the provincial capitals.

15. Although the telecommunications sector has been growing fast and has considerable development potential, it is still underperforming as compared to other EAC and SSA countries. The mobile market penetration rate is only 20 percent (around 30-40 percent in comparator countries) and the quality of services is inadequate. The government should promote competition, accelerate the privatization of ONATEL, make the award of licenses more transparent, and increase the independence of the regulatory authority.

d) Improve the business environment

16. The latest Investment Climate Assessment (ICA) report and the Doing Business Indicators show that Burundi’s business environment has improved but remains below international standards. Domestic private investment has only begun to pick-up (up to 10 percent of GDP) and FDI is less than 1 percent of GDP (up from 0.5 percent in the early 2000s). Political instability, corruption, inefficient bureaucracy, and insecurity are the main concerns expressed by private enterprises in the 2006 ICA Survey. Corrective measures introduced by the government include: (i) joining the EAC community; (ii) adopting a new investment code, a

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new commerce and corporations codes and a new privatization law; and (iii) creating an investment promotion agency. In addition, the government and the Parliament recently adopted a pre-cooperative law that provides the legal framework for future farmer’s organizations. Those measures have contributed to the recent improvements in the business climate ratings of the country.

17. In the short-term, the government should: (i) encourage the parliamentarians to adopt business climate-related legislation currently under consideration, and promulgate these newlaws when approved by the Parliament); (ii) adopt a mining code aimed at attracting large-scale mining investments; (iii) give a new impulse to the public-private sector policy dialogue; and (iv) prepare implementation decrees for all the business laws and codes recently approved by the Parliament. Other actions should include: (i) the reform of business regulations to reduce cost and time necessary to create a business or complete other procedures (e.g., creation of one stop shops for business creation and construction permits); (ii) improving access of rural areas to finance (through improved supervision of microfinance institutions and development of new MFI products); (iii) accelerating ongoing efforts to modernize payment systems (e.g., ATMsand electronic interbank transactions); (iv) implementing the EAC Common Market Protocol on business opportunities; (v) exploring market opportunities provided by the eastern part of the Democratic Republic of Congo (DRC); and (vi) launching the privatization of the sugar company, SOSUMO.

e) Improved governance and capacity

18. A 2008 governance and anticorruption (GAC) survey showed that corruption, an ineffective judicial system, and insecurity are the main concerns of the Burundian population. Poor governance is a major obstacle to efficient public spending. A culture of inadequate governance also derives from the traditional domination of the public and parastatal sector, and inadequate checks and balances mechanisms.

19. For the immediate future, the government should: (i) implement the recently approved National Governance Strategy (an annex of the new PRSP adopted in January 2012 by the government) and (ii) improve transparency through improved access to information on public finance (wider publication of budgets and budget execution reports, parliamentary pre-budget debates open to public, and creation of Look-Up Tables (in French and Kirundi) at the communal level, thus enabling citizens to obtain information on sectoral budget allocations (schools and health centers) in their communities. Other priorities include: (i) promoting amerit-based culture in selections for key economic management positions; (ii) revising and implementing an action plan and timetable for privatizing/restructuring state enterprises; (iii)launching a communication strategy on the merits of public enterprise reform; (iv) strengthening the capacity of the Cour des Comptes, IGE, and inspection and procuring units in ministries; and (v) improving the enforcement of decisions made by anti-corruption agencies.

f) Development of human capital and lower population growth.

20. Education has a central role to play, notably to promote skills and develop jobopportunities. Burundi’s free primary education policy has improved school enrollment rates

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but the quality remains poor. Health is a strategic priority as well as family planning. It is critical to reduce fertility rates through education, awareness campaigns, improved delivery of health services, and women empowerment.

g) Deeper integration of Burundi’s economy into the EAC system

21. The government has shown its strong commitment to the EAC, and, in particular, created a ministry in charge of EAC affairs. Regional integration is expected to yield substantial benefits to the country by: (i) helping diversify exports; (ii) attracting regional FDI; and (iii) developing the port of Bujumbura as a regional trans-shipment hub for countries bordering Lake Tanganyika. However, tariff and nontariff barriers (NTBs) must also be further reduced.

22. To reach these objectives, the government should: (i) identify, and monitor the elimination of, NTBs; (ii) strengthen institutions in charge of customs clearance and other controls at the port of Bujumbura (a one-stop window); (iii) improve layout and equipment of border posts; (iv) encourage competition for pre-shipment inspection; and (v) establish a quality control and certification infrastructure.

2. The second policy note: Fiscal space for growth-enhancing investment

23. The second policy note emphasizes that public investment can be financed through four alternative methods (or a combination thereof): (i) domestic revenue through tax reform and improved tax collection; (ii) domestic and external borrowing; (iii) donor support in the form of grants; and (iv) reallocation of available resources, including reducing the share of current expenditures (and the wage bill) and redirecting resources from defense and security to priority economic and social expenditures. The review of these alternatives is focused on their respective advantages and limitations in the Burundi context.

a) Increased domestic revenue

24. This first alternative is not feasible on a large scale. In 2010, despite the country’s low income per capita, tax revenue accounted for 14.6 percent of GDP, which seems adequate for afragile (mainly rural) economy, largely dominated by the informal sector. Although the country’s revenue performance could be further improved through broadening the tax base, better collection of the recently introduced value added tax, and improved tax administration,increasing substantially the tax/GDP ratio would be difficult and may reduce incentives for the development of more formal enterprises. Nevertheless, priorities for future action should include: (i) improving tax collection by strengthening OBR (computerization of tax and customs departments and staff training); (ii) speeding up the long-awaited revision of the tax code; and (iii) unifying local and national revenue administrations.

b) Limited use of domestic and external borrowing

25. Extensive use of the domestic financial market and external borrowing is not an appropriate alternative. The government wants to reduce borrowing from the central bank to control inflationary pressures and avoid crowding out credit to the private sector. The

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embryonic domestic financial system offers little scope for government borrowing, and Burundi has no access to international capital markets.

26. Since Burundi reached the HIPC Completion Point in 2009, the country’s external debt declined to 22 percent of GDP, but recent debt sustainability analyses (July and December 2011) show that the risk of debt distress has not been eliminated. Consequently, concessional external borrowing should not exceed 2 percent of GDP and the bulk of international financing should continue to be in the form of grants.

c) Increased donor grants

27. Foreign grants increased from 26.5 percent of total resources (domestic and external) in 2001-05 to 65.0 percent in 2006-10 and accounted for 22.7 percent of GDP in 2010. Thisincrease was the result of: (i) progress of political and socioeconomic reforms following the 2000 Arusha peace agreement; and (ii) savings in debt payments when the country reached the HIPC decision point in 2005 and the completion point in 2009. Current projections indicate that net aid inflows in the form of grants may decline to 22.4 percent of GDP in 2011 and 15.9 percent in 2012, which remains a high ratio by regional standards. The donor community, however, recognizes that a substantial increase in financial assistance is critically needed and could be justified if the government makes additional efforts to further improve governance, transparency and accountability.

28. Suggested priorities would include: (i) accelerating public finance management (PFM)reforms; (ii) decisive actions to prosecute and enforce decisions on corruption cases; and (iii) improved coordination of donor assistance (budget and sector support grants should be firmly committed before the beginning of the fiscal year; disbursement and execution plans of foreign aid should be communicated on a regular basis to the authorities in charge of preparing the budget).

d) More efficient allocation of available resources

29. This is probably the most effective way to create fiscal space for growth-enhancing public investment in the short run. Public spending increased dramatically from 22.5 percent of GDP in 2001 to a high 40 percent in 2008-10, mostly funded by foreign aid. Current expenditures account for more than 48 percent of total expenditures, increasing from 6.4 percent of GDP in 2001 to 15.7 percent in 2010. This is partly due to an increase in the wage bill from 7.3 percent of GDP in 2001 to 8.7 percent in 2011 (after the recent rebasing of national accounts). Three main policy reforms should be decided and implemented to increase productive spending: (i) reducing the share of current expenditures, notably by controlling the growth of the wage bill; (ii) redirecting resources from defense, police, and general administration toward priority economic and social sectors; and (iii) strengthening the appraisal, execution and control of investment projects and other key expenditures to improve the quality of public spending.

30. Controlling the wage bill. At 8.6 percent of GDP, the government wage bill is higher than in most other low income countries, where it typically accounts for about 6-7 percent of

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GDP. The government plans to reduce the wage bill to about 8.2 percent of GDP in 2013 by reducing the number of military and police personnel while allowing moderate staff increases in priority sectors (health and education). However, such a reform should be managed in such away that: (i) it will not have a negative impact on the quality of public service delivery; and (ii)public sector wages will remain attractive for skilled workers.

31. The most immediate requirements are: (i) to accelerate the computerization of payroll management; (ii) to activate the recruitment commission set up in 2006 and prepare an annual recruitment plan; and (iii) to create a technical support unit to provide key advice to the Ministry of Public Administration. Other priorities should be: (i) to establish fair rates of pay for different job groups reflecting skills and experience required; (ii) to increase staff in prioritysectors and downsize gradually the security sectors, while taking into consideration the capacity of the private sector to absorb demobilized/downsized armed forces and ex-combatants (see Policy Note #3).

32. Redirecting public resources from defense and security toward priority economic and social sectors. The share of defense spending in total domestically-financed expenditures declined from 31 percent in 2005 to 21 percent in 2009, while the share of other securityexpenditures increased from 9.4 percent to 14.5 percent. At the same time, the share of growth-enhancing/poverty-reducing public spending (education, health, agriculture, energy, transport, and public works) rose from 51.2 to 73.5 percent. The government should continue its policy of redirecting resources from defense and general administration to growth-enhancing expenditures. However, it must also keep in mind the need to absorb the de-militarized/downsized work force in a (hopefully) growing private sector as discussed in the third Policy Note. This, in turn, requires implementation of deep structural reforms aimed at improving the business environment in order to unleash private sector growth and job creation.

33. Improving the quality and efficiency of public investment and other public expenditures. To improve the quality and efficiency of investment and other public expenditures, the government should: (i) strengthen systems and institutions responsible for appraising, selecting, and monitoring investment projects and include in the next publicinvestment programs (PIPs) priority growth-oriented investments (energy, agriculture) with the highest return; (ii) improve transparency in PFM by introducing a legislation on access to information on public affairs, promoting parliamentary pre-budget debates open to the public, and establishing Look-Up Tables (in French and Kirundi) at the communal level for information on sectoral budget allocations (see the first Policy Note); (iii) design and introduce a feedback mechanism between the government and beneficiaries of public services; (iv) reinforce the operational independence of the Cour des Comptes and strengthen the capacity of the Court and other control agencies (IGE, Anti-Corruption Board, and procuring units in Ministries). The government should also: (i) use the MTEF instrument to identify, and reduce the share of, low efficiency expenditures; and (ii) create a central development committee within the Ministry of Finance and Economic Development Planning (MFEDP) to track project quality, improvecoherence with strategic planning objectives and improve project selection.

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3. The third policy note on fiscal policy challenges: Linking security sector downsizing tofiscal space expansion for growth and private sector development

34. The third policy note was prepared at the request of the authorities, after the high-level workshop of March 2011. It is partly based on recent discussions between the government and the donor community on the merits and risks of accelerating the downsizing of security forces and reducing defense and other security-related expenditures. The recent diagnostic on the quality of procurement in the security sector, prepared by Netherlands, is also summarized in this policy note.

a) Present situation of defense and security staff and expenditures

35. In 2005-06, the size of the defense and security staff was estimated at 32,000 for the army and 19,000 for the police, and total defense and security spending accounted for 22 percent of total public expenditures and 8.1 percent of GDP. The 2000 Arusha peace agreement envisaged a significant reduction in the size of security forces to 25,000 for the army and 15,000 for the police.

36. Despite the strong political support of the donor community, the government was unable to mobilize the funds necessary to finance the demobilization program before 2005, but major efforts were made in 2006-09 to accelerate implementation of the program. In 2009, despite integration of ex-combatants of the last rebel group (FNL) in the process, the size of the defenseand security staff was reduced to about 28,000 for the army and 17,000 for the police. In 2010, defense and security expenditures went down to 13.3 percent of total public spending and 6.5 percent of GDP.

37. The objective of the government is not only to demobilize but also to professionalize its security forces. The integration of former combatants was accompanied and complemented by training programs (academic training, and development of technical standards). In addition, Burundian troops participated actively in peacekeeping operations in Somalia (about 4,000 troops).

b) What is needed to achieve the Arusha agreement objectives

38. To achieve the Arusha objectives by 2015, the government would need to reduce army staff by 3.85 percent/year and police forces by 3.77 percent/year. This does not appear as a prima facie impossible target. However, government officials and local representatives of the donor community are concerned that, in the present context, an accelerated demobilization/downsizing process could have a negative impact on the still fragile security situation of the country and might compromise progress made toward the creation of a peaceful democratic system.

39. This concern has been exacerbated by the mixed results of the demobilization/ reinsertionprocess in a number of rural and urban communities. Recent experience suggests that the reinsertion process is effective when demobilized individuals return to their rural community and find work in agriculture and other rural sector activities. The results are less positive when

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demobilized personnel settle in the capital city or other urban centers. The rate of unemployment and underemployment is high in these cities and demobilized soldiers, ex-combatants and police staff may find it easier to earn their living by using their weapons and their military/ police training for their own benefit, rather than by seeking jobs or creating their own businesses.

40. Consequently, accelerating the demobilization/reinsertion process may not be the optimal solution.

Even in rural areas, finding gainful employment in farming, cattle-raising and other rural activities may prove to be increasingly difficult. Agricultural productivity is low, the population density is one of the highest in Sub-Saharan Africa,1 and the growth rate of the population is close to 3 percent. Unless the development of rural areas is supported by the rapid success of a major agricultural diversification and development program, the absorptive capacity of the rural areas will be modest in the short-term.

The capacity of urban centers to absorb a large number of demobilized/downsizedpersonnel depends mainly on the development of the private sector and its capacity to provide employment to both skilled and unskilled workers. A major condition for the development of the private sector is the combination of political stability and continuedimprovements in the security situation of the country. This objective will be defeated if the demobilization process becomes a factor of insecurity instead of strengthening peace and stability.

c) Principal messages emerging from the third policy note

41. The first message, which is fully consistent with the conclusions of the two previous policy notes, is that: accelerating the rate of growth of GDP and reducing poverty depend on the creation of fiscal space for growth-enhancing public investments and basic social services. This objective can be achieved through policy and structural reforms that will: (i) increase foreign and domestic private investment; (ii) increase donor support and external financing on highly concessional terms; and, more importantly, (iii) increase the efficiency of public expenditures. Reducing security (military and police) expenditures is one of the possible ways of increasing the efficiency of public spending but this should be gradual (see below). This policy note also argues that a procurement reform could yield significant savings and efficiency gains that should be taken into consideration in the context of the formulation of future government policies.

42. The second message is that in the present context, rapid downsizing of security (army and police) forces to create more fiscal space for growth and poverty reduction is desirable butinvolves risks. If the government wants to comply with the Arusha objectives, it will have to demobilize about 3000 army personnel and 2000 police staff in the next three years. A more flexible approach, however, may be appropriate and downsizing should be adjusted to the capacity of the private sector to absorb additional workers. One of the alternative scenarios provides that the reduction of security personnel should not exceed an annual average of 1.3

1 The second highest after Rwanda.

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percent during the 2012-2020 period, which will de facto postpone to 2020 the full accomplishment of the Arusha objectives. Assuming that the budget allocated to these sectors remains unchanged, the model also shows that the reduction in the size of security forces would increase the average annual wage of the defense and police personnel. Thus, this would reduce the expected fiscal gains and the feasibility of major reallocations in public expenditures.

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Policy Note 1Putting Burundi on a Path of Faster Economic Growth and Poverty Reduction

1.1 Objective: This Policy Note proposes a number of priority recommendations aimed at raising economic growth rates to levels appropriate for reducing poverty and reaching the MDGobjectives. It is based on the findings and conclusions of a Country Economic Memorandum (CEM) prepared jointly by the Government authorities, and the World Bank with participation from other development partners, including AfDB and DfID.

Main Messages:

Between 2006 and 2009, Burundi’s economic growth rates averaged 4 percent annually, much lower than the 7 percent projected in the first PRSP. The experience of the last decade shows that a large group of African countries has been able to reach and sustain highergrowth rates. We believe that Burundi could also reach higher growth rates, averaging 8.5 percent, thanks to an appropriate mix of accelerated structural reforms and improved macroeconomic and public finance policies.

This Policy Note proposes six principal policy reforms that should be adopted and implemented in Burundi to stimulate economic growth:

i. Sound economic management policies aimed at promoting macroeconomic stability as the foundation for growth through sustained private and public investment.

ii. Raise productivity and promote diversification in agriculture through continued reform in the coffee sector, and through addressing key infrastructure and marketing bottlenecks, to agricultural development.

iii. Address the infrastructure gap with a focus on the development of the country’shydroelectric potential, effective competition for infrastructure services, and advocacy for improved regional infrastructure within the EAC.

iv. Improve the business environment by adopting and implementing relevant business-friendly legislation and reforming business regulation.

v. Enhance the quality of governance in key institutions, through adoption and prioritized implementation of the National Governance Strategy, and by introducing a merit-based culture in selections for key public economic management positions.

vi. Develop human capital through, inter alia, increased budget allocations to the relevant ministries, and policies aimed at reducing the exceptionally high population growth rate.

In its efforts to promote accelerated economic growth, Burundi will benefit from its participation in the EAC, by leveraging the convergence to EAC standards, higher integration in infrastructure and other services, and overall political and economic stability.

Macroeconomic Background: Recent economic growth insufficient for robust poverty alleviation

1.2 Burundi has suffered from many years of civil conflict and its consequences. The war killed some 300,000 Burundians, displaced 1.2 million, destroyed capital, repressed investment,and damaged the capacity of the public sector to provide basic health, education, water, and electricity services. A simple estimate of the cost of the war indicates that, without the conflict,

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Burundi’s GDP per capita would have been about double its current level (Burundi CEM, 2010).When peace was gradually restored in recent years, a promising economic recovery started, following continued implementation of structural economic and social reforms.

1.3 Economic growth rates, however, have not been in line with the objectives of the first PRSP: real GDP growth in 2006-09 averaged 4 percent instead of the 7 percent projected in the PRSP and the country is unlikely to meet most of its MDGs by 2015. Burundi's economic growth remains volatile due to its dependence on the widely fluctuating agricultural production,which accounts for about 46 percent of GDP and employs more than 90 percent of the country'sworkforce. The services sector, which is dominated by the public sector, accounts for 37 percent of the economy; the industrial sector is small (17 percent) but growing. Recent growth rates aremodest if compared to other EAC countries (Figure 1). A major factor behind the slow growth of Burundi’s economy is the fact that until 2008 the country was still in conflict as the FNL-Palipehutu failed to implement the peace agreement concluded with the government. Burundi's unimpressive growth performance is also explained by low productivity in agriculture due to inadequate cultivation techniques and under-investment during several years of conflict. The lack of basic infrastructure (e.g., feeder roads), poor organization of farmers, and poor governance also adversely affected the performance of the agriculture sector as well as overall economic growth in Burundi.

1.4 The economic performance of Burundi is in sharp contrast with that of a majority of African countries. Today, Africa is one of the fastest-growing regions in the world and six of the ten fastest growing economies in the world during the past decade are in Sub-Saharan Africa.Growth in Sub-Saharan Africa during that period averaged over 5 percent per year, the best performance in four decades. East and West Africa are leading the region in that area. Besidesexternal factors such as commodity prices and rapidly growing foreign demand (including trade in services), especially for resource rich African countries, several other factors explain thegrowth performance of the region. These include: (i) sustained macroeconomic stability, which boosted the confidence of domestic and foreign investors in the prospects of African economies and led to increased commitment of finance and technology to the region; (ii) strengthened governance, a critical element in improving economic and financial management; and (iii) improved institutional capacity, which helped implement sound economic policies.

1.5 On inflation management, Burundi performed as well as its EAC counterparts. Prudent monetary and exchange rate policies enabled the government to contain price increases to single digits except in 2008 when domestic inflation peaked at 24 percent following the world food and fuel crisis of 2007-08 (Table 1). As Burundi’s economy is particularly vulnerable to external shocks, another round of international food and fuel price increases in 2011-12 maypose a serious risk to the country’s macroeconomic stability. Given that these are supply shocks, the effectiveness of monetary policy responses is limited. The only scope for action is fiscal policy, possibly through temporary subsidies. But first the country must be able to build sufficient fiscal space to respond effectively without creating excessive pressures on the budget,and second, it is always politically difficult to reverse these so-called temporary price subsidies.

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1.6 The authorities implemented generally prudent fiscal policies in recent years, leading to a reduced fiscal deficit. Stronger expenditure management, accompanied by foreign aid inflows helped reduce the fiscal deficit (on a commitment basis before HIPC grants) from an average of 4.7 percent of GDP in 2005-06 to 2.6 percent in 2007-08. The deficit increased again in recent years for the following reasons: (i) implementation of the new peace agreement with the last rebel group; (ii) gradual execution of past government commitments to civil servants (notably teachers and health professionals);2 and (iii) reduction in externally-financed spending. To control arrears, the authorities recently introduced a quarterly commitment plans mechanism,which provides for commitment ceilings for each ministry, consistent with quarterly cash management plans.

In the short to medium-term, the authorities should: (i) continue to implement prudent macroeconomic policies (including structural and socio-economic reforms) as macroeconomic stability is the condition of private sector-led growth; and (ii) envisage the creation of an independent fiscal entity or council that would conduct independent evaluations of fiscal-related issues in order to improve fiscal responsibilityand sustainability; and (iii) accelerate the adoption of fiscal rules in force in the East African Community(e.g., ceilings on expenditures and debt).

1.7 The lack of diversity of Burundi’s exports, and the country’s reliance on imported oil and capital goods have led to current account deficits averaging 10 percent of GDP in the last five years. Export earnings vary from year to year depending on the size and quality of the coffee and tea harvests (coffee sales account for about two thirds of total exports) and on widely fluctuating international coffee and tea prices. Gross official reserves (in months of imports) increased from 3.4 months of imports in 2005–07 to 4.6 months in 2008-10, partly as a result of a surge in donor disbursements. To improve liquidity management by the central bank and ensure that aid-financed expenditures are absorbed through sales of foreign exchange, a number of measures were recently taken to improve collaboration between the central bank and the Ministry of Finance. A Cash Management Committee (made up of officials from both entities) wasestablished and meets regularly to discuss liquidity management issues (e.g., government’s cashoutlays, reserve money, and foreign exchange market operations).

2 This refers to the implementation of a new (2006) statute of the public service.

Figure 1: Average GDP growth: Burundi vs. EAC countries, 1970-2009

Table 1: Inflation management: Burundi vs. EAC countries, 1980-2010

1980-9* 1990-9 2000-10

Burundi 7.2 13.5 10.6

Kenya 11.8 17.4 10.3

Rwanda 4.7 -3.4 7.6

Tanzania 30.1 23.1 6.8

Uganda* 103.4 10.0 6.2

Source: World Bank, World Development Indicators Source: World Development Indicators. Note. (*) 1980 data for Uganda not available. Period average CPI.

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In the short- to medium term, the authorities should: (i) maintain a stable but flexible exchange rate and avoid over-valuation of the currency, in order to attract FDI; and (ii) accelerate ongoing reforms in the management of liquidity and foreign exchange markets, with a view to further improving exchange rate flexibility.

Removing Key Constraints to Economic Growth

1.8 Several obstacles constrain Burundi’s ability to become a modern economy: political instability and violence; poor physical infrastructure (notably inadequate supply of electricity);low productivity in agriculture; low level of integration with the world economy and, within the country, between rural and urban areas; and finally poor governance and government decision-making capacity.

A. Low performance of the agriculture sector and lack of economic diversification

1.9 Low productivity, which barely improved since independence, explains the poorperformance of the agriculture sector. Comparisons with other countries show that agricultural productivity in Burundi (i.e. the value added per worker for both food and export crops) has been the lowest of all comparators during the 1989-2007 period and led to particularly low annual growth rates of agricultural production. Agricultural productivityaveraged US$82 in 2000-07 in Burundi, US$310 in Sub-Saharan Africa and US$230 in EAC countries (Table 2). Given the high population growth rate, low productivity gains3 have led to a decline in agricultural production per capita. In addition to under-investment during several years of conflict, the main obstacles to the development of the sector are poor incentives for the farmers to introduce modern inputs, poor physical infrastructure (feeder roads), inefficientextension services a weak market organization (heavily distorted by government intervention),the low development of farmers’ associations and cooperatives, and therefore limited access to market information. Recent measures, including the privatization of coffee washing stations and the development of new entities within the new institutional framework are a positive step.4

1.10 The case of Uganda shows that the promotion of high-value primary products is a viable strategy to help diversify the economy and increase incomes. In contrast to Burundi, the other EAC members have been able to diversify their export base. Twenty years ago, Uganda was almost exclusively exporting coffee. Now, high-value primary products, such as fish fillets or cut flowers, make up more than one third of Ugandan exports. Kenya and Tanzania have also expanded their exports of high-value primary products, as well as low- and medium-tech products. In the medium-term, Burundi should focus its attention on producing and exporting high-value primary products (such as cut flowers,5 palm oil, and fish fillets).

3 In fact the growth in agricultural value added declined in recent years, with the exception of the 1980-89 period.4 The creation of the Coffee Sector Regulatory Agency (ARFIC) as well as the Coffee Inter-professional Organization (INTERCAFE) has strengthened the role of the private sector, especially in the area of coffee marketing. Coffee roasters are now focusing on direct sales and can thus negotiate prices with their customers, while plant owners are encouraged to produce specialty coffees.5 As mentioned above, flower exports suffered significantly during the crisis. Flowers were supplied to one buyer, who cancelled orders in response to low demand.

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Table 2: Productivity in Agriculture: Burundi vs. Selected Comparators, 1980-2009Agriculture Value added per worker

(constant US 2000)Agriculture Value added growth

(percent)1980-9 1990-9 2000-9 1980-9 1990-9 2000-9

Burundi 118.4 104.9 82.4 3.0 -0.4 -2.5Cambodia n.a 321.6 345.3 n.a 4.5 4.8Ethiopia n.a 168.1 176.7 1.4 2.8 6.5Kenya 399.9 347.4 352.7 3.5 2.1 1.8Mozambique 108.6 123.1 165.2 6.4 4.6 6.6Rwanda 200.8 194.2 215.8 0.7 3.3 6.5Tanzania n.a 263.7 261.5 n.a 3.1 4.4Uganda 175.1 183.3 210.2 2.3 3.7 2.6Vietnam 219.7 250.4 323.8 3.1 3.9 3.8Sub-Saharan Africa 317.9 287.7 307.9 2.6 2.6 3.1

Source: World Development Indicators. Note: Data for Burundi and Rwanda is available up to 2005 and 2003, respectively.

In the short term, the authorities should accelerate implementation of the ongoing privatization agenda, which would have demonstration effects on other cash crops.

In the short- to medium-term, the authorities should: (i) strengthen the capacity of INTERCAFE to help Burundian coffee growers organize into competent producer associations and to improve the marketing of Burundian coffee on international markets; (ii) encourage the new owners of washing stations to improve access of coffee growers to finance (for coffee harvests), introduce modern processing practices and improve input distribution and training; (iii) provide basic infrastructure (irrigation, rural roads for market access) and modern inputs, and support agricultural research; (iv) design and adopt a reform strategy for the tea sector (liberalization, creation of appropriate institutions and revitalization of thesector) inspired by the reforms initiated for the coffee sector; and (v) discuss the feasibility of creating aregulatory agency for agricultural commodities following the eventual privatization of state assets in tea and sugar sectors.

Diversification toward non-subsistence farming is possible. Possible champions include horticulture (banana, cut flowers and vegetables) and fishing. In the short-term, the authorities should strengthen input distribution systems and supply more inputs to small farmers.

In the short- to medium-term, the authorities should: (i) provide incentives for the introduction of new crops, appropriate low-cost technologies and soil-fertility maintenance techniques; (ii) organize, structure, and professionalize producers; and (iii) improve rural infrastructure (storage facilities, rural roads, markets).

1.11 Demographic trends (the rate of growth of the population reached 2.6 percent in 2005) impose another heavy burden to the agricultural sector, as cultivable land is becoming scarce.Burundi experiences extreme population pressure, as the population is confined to a very limited land base. The fact that the rate of urbanization is extremely low (it rose from 8.3 percent in 1999 to 10 percent in 2008), also shows that the expected economic transition from an agrarian to an urban economy based on industry and services is very slow. With a population growth rate of about 2.6 percent, more primary rainforest will be converted and more land will be cultivated in the coming few years or decades. However, farming of degraded lands will not be sustainable in the long term without innovations.

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B. Poor Infrastructure raises the costs of Burundi’s landlockedness

1.12 Burundi’s economic development is handicapped by major infrastructure gaps in terms of roads, power generation, communications and access to water and sanitation. On just about any measure of infrastructure development—road density, telephone density, power generation capacity, or service coverage—Burundi and the other EAC countries lag behind most of the countries in other regional groupings, but Burundi also lags behind other EAC member-countries in terms of access to basic infrastructure services (Table 3). The country lacks roads, bridges, ships, rails, power, communications, water, and sanitation. Despite abundant hydroelectric potential, Burundi has a severe generation and transmission capacity deficit caused by years of under-investment and deterioration/damage during the conflict years.

1.13 Limited access to infrastructure services and the poor state of existing infrastructure leads to substantially higher production costs. Prices for services can be two to three times higher than prices in other countries, thus undermining the competitiveness of Burundi’sbusinesses in regional and global markets. The cost and adequacy of these services affect the availability of business opportunities for small farmers and enterprises (small and large). The limited coverage and the poor condition of infrastructure creates costs in time and money that lower returns, discourage domestic and foreign investment, and constrain economic growth. Business surveys consistently identify the cost of power and the poor reliability of the service as the single-most important obstacle to increased private investment. High transport costs, caused by the lack of adequate infrastructure, hinder internal trade and reduce Burundi’s trade opportunities with East Africa and other countries. For instance, the cost of diesel fuel is about US$1.22 per liter compared to an average of US$0.99 for non-landlocked EAC countries. Internal costs and obstacles are compounded by high handling costs in the ports of Dar es Salaam (Tanzania) and Mombasa (Kenya), through which Burundi trades.

1.14 Modern electricity is expensive and available only to 2 percent of households, compared with 16 percent for Sub-Saharan Africa and 41 percent for other low-income developing countries. Bujumbura accounts for two thirds of all connections. As of 2008, the power utility, REGIDESO, had about 31 megawatts of installed electrical generation capacity, but only about 26 megawatts were in use. Domestic electrical production capacity per capita is the lowest in the world. Limited access to electricity is a major barrier to development. The shortage of electricity generation is partly met through imports from the Democratic Republic of Congo, but these imports are not sufficient to satisfy demand at current prices. A strategy to tackle this issue is critically needed.

In the short term, the authorities should improve the financial viability of REGIDESO (the electricity and water supply company), by: (i) improving cost recovery through extension of the existing pre-payment system; and (ii) undertaking a tariff revision on the basis of the conclusions of a recent tariff study for water and electricity.

In the short- to medium-term, the authorities should improve electricity supply with the development of Burundi’s hydroelectric potential (Kaganuzi, Mpanda, Kabu 16) and the provision of 110-kV lines with necessary substations to link all the provincial capitals.

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Table 3: Basic Infrastructure Coverage for EAC, 2006East African Community Other Country Groupings

Indicator Burundi Kenya Rwanda Tanzania Uganda Average Sub-Saharan

Other low-income

Africa countries Roads Percent of roads paved 10 14 19 9 23 15 - - Paved road density - - - - - - 31 134 Road density for arable land 13 12 12 9 14 12 137 211 Total road density 48 11 57 9 36 12 - - Electric power Generation capacity 6 - - - - - 37 326 Electricity coverage 2 13 5 11 8 10 16 41 Electric power consumption 14 138 - 61 - - - - Communications Mainline density 4 8 2 4 4 5 16 78 Mobile density 25 201 33 146 67 126 175 76 Internet density 7 76 11 10 50 39 34 30 Water and sanitation Access to improved water 71 57 65 55 64 60 58 72 Access to improved sanitation 41 42 23 33 33 35 31 51

Source: As cited in AfDB (2009): World Bank 2008c; Africa Development Indicators, 2008/09; and www.infrastructureafrica.org. Note: — = not available. Road density is in kilometers of road per square kilometer of arable land; telephone density is in lines per 1,000 people; generation capacity is in megawatts per 1 million people; electricity, water, and sanitation coverage are in percentage of population.

1.15 Rural areas are poorly served by roads, telecommunications and market facilities.Improvement in rural infrastructure is essential to improve access to market for producers and traders and reduce transportation costs. About 90 percent of the population lives in rural areas. Despite the critical role of the agricultural sector, only a small proportion of the rural population has access to all-season roads. Road density in arable land areas is substantially lower in Burundi than elsewhere in Africa and in other low-income countries. The availability of cargo space to export fresh produce would also facilitate agricultural diversification and would contribute to the development of other sectors, such as horticulture and fishing. Burundi is also lagging in mainline and mobile telephone densities (see below), as well as Internet access. Teledensity remains poor at 3 percent of the population, with more than 90 percent of the subscribers concentrated in urban areas.

In the short term, the authorities should prepare a master plan for civil aviation with the aim to expand the role of civil aviation, attract international airlines and increase the availability of cargo space, which is critical for the development of specialty agriculture.

In the short- to medium-term, the authorities should: (i) rehabilitate, upgrade, and maintain national highways as well as provincial and community road networks; and (ii) build human and institutional capacity in the government agencies responsible for regulating and managing road transport activities.

1.16 The telecommunications sector in Burundi is underperforming. The mobile penetration rate is approximately 20 percent, but this includes many people who have more than one SIM card; consequently, the proportion of the population that has a phone is significantly lower(penetration rates in comparator countries are around 30-40 percent). Available networks are relatively poor in terms of quality and coverage. Of the 5 operators,6 only one, Leo, has anextensive network and its coverage is almost national. The others are focused on Bujumbura and other urban centers. In Malawi and Rwanda, around 90 percent of the population is living within range of a mobile networks. Burundi’s networks in Burundi are congested with occasional outages and frequent call-blocking or dropping at peak time. Data services such as 3G remain almost non-existent and the country does not have access to regional and global fiber-optic telecommunications networks.

6 In fact the number of operators may be excessive for such a small market as Burundi; this may discourage investors to enter the market and invest resources in network development.

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1.17 Despite significant measures recently taken by the government to improve the performance of telecommunications systems, the sector continues to underperform with low levels of investment and poor services. The sector has been liberalized; 6 mobile operators have been licensed (five are operating) and several ISPs are operational. The government has set up a regulatory authority and has prepared a new draft legislation for the sector. It has also decided to privatize Onatel, and has begun to build a national fiber-optic network through a partnership with five of the current operators. A positive development is that prices for basic voice services have fallen significantly although they remain higher than in many other countries in the region.

In the short term, the authorities should promote effective competition within the sector by accelerating the privatization of Onatel. In the short- to medium-term, they should: (i) increase the transparency of license awards and spectrum management7and make the process more attractive for large international operators; and (ii) increase the independence and strengthen the capacity of the regulatory authority and encourage it to carry out its mandate of effective and balanced regulation.

1.18 Burundi should also use its EAC membership to advocate for better infrastructure management in regional ports, rails, and roads. Regional infrastructure is vital for Burundi but the country has little influence on its development. Burundi depends on Dar es Salaam and Mombasa for most of its external trade. Efficient port management is critical to improvecompetitiveness of regional products, as is also the network of roads, railroads, and bridges that connects these final destinations to Burundi.8 In addition to promoting market access and reducing production costs, infrastructure development also has indirect effects on health and education and helps promote human capital accumulation and growth.

C. Unfavorable Business Environment and slow growth of the private sector

1.19 The development of the private sector is hampered by several constraints, which can be broadly grouped into four categories: (1) structural constraints, (2) supply-side constraints, (3) poor regulatory environment, and (4) poor governance. The Government has recognized the situation and started the reform process, but much remains to be done.

1.20 The contribution of the private sector9 to growth is weak and the share of the public sector in total investment is high (averaging 74 percent of total investment between 2001 and 2004, and in more recent years). The main factors are the lack of adequate infrastructure (see above subsection) and an unfavorable business environment that discourages investment, diversification of activity, and job creation. A Financial Sector Assessment Program (2009), an Investment Climate Assessment and the Doing Business Indicators show that Burundi's business climate discourages investment. Recently, domestic private investment started to pick up but remains low, averaging about 8 percent of GDP between 2005 and 2008 and almost half of total

7 It should treat all licensees in a transparent and equal manner and should focus on ensuring that radio-spectrum is utilized effectively to deliver services to customers.8 For public investment in infrastructure to make a significant difference, a relatively ambitious, front-loaded program must be implemented, and this raises the financing issue which is discussed in the Policy Note 2.9 The Burundian private sector includes a large number of small enterprises, most of which operate in the informal sector. The formal private sector includes about 3,000 registered enterprises, employs some 37,000 workers, and produces mainly for the local market. Construction, agricultural processing, brewing, energy, and communications are the main activities of the very small industrial sector. The service sector is more important, but it is dominated by growing public services, accounting for about two thirds of the sector.

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investment. Foreign direct investment represents less than 1 percent of GDP, but has improved from below 0.5 percent of GDP prior to 2006. Private investment, both domestic and foreign, is unlikely to increase unless access to core infrastructure services is significantly improved, thanks to the appropriate combination of public and private capital formation. Finally, poor governanceimpedes the development of the private sector. Implementing fundamental structural reforms is essential to promote a private sector-led growth. Reforms have begun but much more is necessary.

1.21 Despite recent efforts to improve the regulatory framework, Burundi has one of the most unfavorable business environments in the world. According to the 2012 Doing Business report, Burundi has become one of the top 10 investment climate reformers in recent years and this signals the commitment of the government to address the many constraints faced by the private sector. The rank of Burundi in the Doing Business report improved from 177th in 2011 report to 169th in the 2012 report, but additional progress is clearly needed. Another cross-country assessment of business conditions (the Global Competitiveness Index) ranked Burundi 133th out of the 133 countries surveyed. Survey respondents highlighted corruption, political instability, inefficient government bureaucracy, and crime and theft among their top concerns. While many of the key laws governing private sector activity have been recently updated, appropriateregulations have not been adopted and this leads to limited and arbitrary implementation of the laws. Weak legislative capacity and, in the past, the low priority accorded to reforming the business environment have created a sense of distrust notably with respect to the capacity of the judicial system to enforce contracts.

1.22 Nevertheless, prospects for improvements are good and some of the ongoing efforts to better the business climate have started to bear fruit. According to the Heritage Foundation’s Index of Economic Opportunity, Burundi’s rating improved in recent years, as a result of: (i) Burundi’s EAC membership; and (ii) implementation of a modern Investment Code (September 2008) that provides new incentives for investors. In effect, the code not only provides substantial tax incentives but also introduces some of the best practices in investment legislation, including investor protection, freedom to transfer capital and dividends, and a streamlined approval process. The new investment promotion agency (API), established in July 2010, has already licensed more than 61 new operations following the reduction of the processing time for new investments. The new Privatization Law recently adopted introduces a legislative framework ensuring that the withdrawal of the state from productive sectors will not result in uncompetitive market outcomes (creation of private monopolies). A pre-cooperative law, consistent with the liberalization strategy of the coffee sector, was recently enacted (December 30, 2011). It is expected to provide the legal framework for the creation of producer associations. Efforts are currently underway to improve financial systems through financial integration, automatic teller machines (ATMs), and mobile banking. Three structures have recently been set up by the authorities with the urgent tasks of proposing all the necessary reforms to address the major PSD-related difficulties identified in Doing Business reports.

In the short term, the authorities should: (i) promulgate the business climate related legislations under review by the Parliament (e.g., the tax code) as soon as they have been approved; (ii) adopt a draft mining code, aimed at preparing the country for large-scale mining investments and clarifying the role ofartisanal and small-scale mining operations; (iii) stimulate the public-private policy dialogue byorganizing regular meetings with a specific agenda; and (iv) prepare implementation regulations for all the business climate related laws and codes already enacted.

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In the short- to medium-term, the authorities should: (i) adopt an action plan aimed at reforming business regulation and simplifying the creation and operations of private businesses through a substantial reduction (minimum 10 percent) of the time and costs associated with these procedures; (ii) improve access to finance in rural areas through the development of new MFI products (and new MFI regulations) and through strengthening the capacity of the central bank to supervise MFIs; (iii) accelerate efforts to improve the payment system with the introduction of ATMs, mobile banking, etc.; (iv) accelerate implementation of business practices included in the EAC Common Market Protocol while exploring business opportunities provided by eastern DRC; and (v) initiate/accelerate the privatization of the sugar company (SOSUMO).

D. Poor Governance and limited institutional capacity

1.23 After a prolonged period of conflict and ethnic tension, it is critical to improvegovernance, including the decision making and taxation capacity of the government. In 2011, the Ibrahim Index improved Burundi’s ranking to 37th among 53 African countries (Mo Ibrahim Foundation 2011). However, the recently released Corruption Perception Index of Transparency International ranks Burundi 170th among 178 countries in 2010, against 131th in 2007 and 158th

in 2008. According to the World Bank’s CPIA on transparency, accountability, and corruption in the public sector, Burundi’s score averaged 2.0 in 2008-11, below the EAC average of 2.8 during the same period. Burundi’s governance performance is also lower than the performance of Rwanda and Sierra Leone, two comparable post-conflict countries (Table 4).

Table 4: CPIA Transparency, Accountability, and Corruption in the public sector2005 2006 2007 2008 2009 2010 2011

Burundi 3.0 2.5 2.0 2.0 2.0 2.0 2.0

Congo, Dem. Rep. 2.0 2.0 2.0 2.0 2.0 2.0 2.0

Kenya 3.0 3.0 3.0 3.0 3.0 3.0 3.0

Rwanda 3.0 3.0 3.5 3.5 3.5 3.5 3.5

Sierra Leone 2.5 2.5 2.5 2.5 3.0 3.0 3.0

Tanzania 3.5 3.5 3.5 3.0 3.0 2.5 3.0

Uganda 3.0 3.0 3.0 3.0 2.5 2.5 2.5

EAC 3.1 3.0 3.0 2.9 2.8 2.7 2.8Source: World Development Indicators, World Bank. Note. Rating 1=low to 6=high. This indicator is based on state capture by narrow vested interests, access of civil society to information on public affairs, and the accountability of the executive.

1.24 Corruption and poor governance are major obstacles to private sector development and therefore to investment (domestic and foreign). Poor governance is difficult to measure;however, the main problem areas can be identified on the basis of survey-based assessments of perceptions among citizens and businesses. A Governance and Anti-corruption (GAC) survey, commissioned by the Government of Burundi through the World Bank in November 2007, found that the main concerns of respondents were corruption, access to, and abuse of, the judicial system, security and criminality. Poor governance and limited institutional capacity mean lower productivity in all sectors and inhibit investment in physical and human capital. Given the role of government spending (as a share of GDP) in a post-conflict economy, increasing the efficiency of public spending is vital. Poor governance, however, is an obstacle to more efficient public

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spending.10 In addition, the government’s capacity to adopt and implement quick and effective policy decisions is weak. This also delays private sector initiatives.

1.25 The culture of poor governance is also the result of the economic domination of public enterprises, most of which are in poor shape. According to a 2007 study on public enterprises, the government had shares in 48 entities (40 enterprises and 8 financial institutions), 16 of which were fully publicly owned. Public enterprises also dominate the export sector (coffee, tea, cotton, sugar, cigarettes). Several public enterprises are handicapped by governance problems similar to those encountered in many other countries, including political interference. Their debt (about 14 percent of GDP in 2006) increases faster than their turnover, and debt obligations often exceed cash flow. The Service Chargé des Entreprises Publiques (SCEP), a special entity created in the 1990s to oversee public enterprises, does not have the resources and capacity necessary to improve the performance of the sector and to plan/monitor the privatization program envisaged by the government. The government recognizes, however, that it needs to reduce its involvement in the productive sectors.

1.26 Nevertheless, more effective anticorruption units have taken up the fight against embezzlement of public funds. The State General Inspectorate (IGE) has increased the frequency of its inspections of public sector institutions. The anti-corruption Board has also intensified its public awareness, dissuasion, and prosecution campaigns. More attention is being paid to enforcing anticorruption decisions. Recently two managers of public enterprises - Société Sucrière de Moso (SOSUMO) and Office des Transports du Burundi (OTRACO) – and the President of a Court of Justice in Kayanza (north Burundi) were prosecuted and jailed for corruption charges. Finally, the government has adopted the National Good Governance Strategy which is expected to help implement the “zero tolerance” principle (in the management of public funds) advocated by President Pierre Nkurunziza.

In the short term, the authorities should increase transparency in public finance management by improving access to information through: (i) wider publication of budgets and budget execution reports, (ii) parliamentary pre-budget debates open to the public, and (iii) introduction of Look-Up Tables (in French and Kirundi) at the communal level, thus enabling citizens to obtain information on sectoral budget allocations (schools and health centers) in their communities.11

In the short- to medium-term, the authorities should: (i) prioritize implementation of the National Governance Strategy and strengthen enforcement of decisions made by anti-corruption entities; (ii) introduce a merit-based culture in the selection for key public economic management positions; (iii) adopt and implement a draft action plan and timetable for the liberalization (privatization or restructuring) of State owned enterprises (on the basis of recently completed technical and financial audits); (iv) launch a communication strategy on the merits of effective restructuring of public enterprises; and (v) strengthen the capacity of the Cour des Comptes, the IGE, the Anti-corruption Board,the Inspection and Procuring units within ministries, SCEP, OBR, API, and other regulatory agencies and improve governance within these institutions.

10 Dabla-Norris et al. (2011) find that the efficiency of public investment in Burundi is only 0.23 out of scale of 0 to 1 based on average estimates for developing countries. It indicates that there is significant scope for increasing stocks of public infrastructure not accompanied with increase in flow of public spending.11 The importance of economic governance for growth should not be underestimated. A separate Policy Note addresses issues such as fiscal space and aid effectiveness in a context of fragile peace and security.

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E. Developing the human capital and slowing down population growth

1.27 Education, health and gender have a major role to play in a growth strategy. Education is critical to improve rural productivity and livelihoods, and promote sustainable development.Improving the knowledge and skills of the people concerned is essential to implement the government agricultural policy and begin to diversify agricultural production and other rural sector activities. There is no doubt that the free primary school policy yielded significant results in terms of improved school enrollment and reduced gender disparities. Nevertheless, the quality of education remains unimpressive. Completion rates in primary education were only 56 percent in 2010 and the country is unlikely to reach this MDG in 2015.12 For the future, the authorities should focus their attention on the quality of the services and the real needs of the labor market.Health also is a strategic priority and the health sector should receive a higher share of planned and executed government budgets. The provision of free health services to pregnant women and children under five has been effective. Special attention should also be given to the close links of the health sector with overall production and productivity, the development of the labor market and the long-term success of appropriate population planning policies.

1.28 Gender can also play a vital role in non-farm rural activity. Studies have shown that non-farm activities in rural areas are usually dominated by women while agriculture is the main occupation of men.13 It is also critical to contain fertility rates through education, awareness campaigns, improved delivery of health services, and women empowerment programs. Reducedfertility rates would have a positive impact on most economic and social sectors. It would facilitate the formation of human capital, help reduce poverty and land shortage (caused by high population density), relieve pressure on the environment, and improve the health of women and children. Improved access to infrastructure, especially water and electricity, would allow women to reallocate time from household chores to more productive economic and social activities including marketing and also child rearing that will improve children’s health and therefore human capital and labor productivity.

F. Leveraging Integration in the EAC as an Engine of Growth

129 Burundi’s membership in the East African Community is likely to generate substantialgains from trade, regional FDI, increased access to regional infrastructure and, finally, political stability and improved security. Because of its geo-strategic location, the port of Bujumbura has the potential to return to its traditional role as a regional gateway for the supply of goods and transport services to countries bordering the Lake Tanganyika (especially the eastern portion of the Democratic Republic of Congo). The port is adequately equipped but, according to statistics of the port authority, operates at less than 50 percent of its capacity. With the progress of regional integration, the port of Bujumbura would benefit from the development of mining and other economic activities in Burundi, the Eastern part of the Democratic Republic of Congo and Rwanda. The future role of the port, however, will largely depend on developments regarding the Tanzanian railways. Until recently, the bulk of the cargo movements between Burundi and Dar es Salaam was carried by rail to and from Kigoma (Tanzania) or

12 Poor quality of education may be related to poor access to infrastructure in some rural areas, i.e., lack of roadsmakes it difficult to attract competent teachers, who may prefer to commute from urban areas. Household income levels and child labor are also mentioned as other root causes of low completion rates.13Berdegué, J.A.; Reardon, R.; Escobar, G. Echeverri, R. (June 2000). Policies to Promote Non-farm Rural Employment in Latin America. In: ODI Natural Resource Perspectives.

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Mpulungu (Zambia), and by vessel from these ports to and from the port of Bujumbura. In recent years, the lack of suitable cargo-handling equipment at the port of Kigoma, and the poor performance of the Tanzania Railways Corporation seriously affected the traffic handled by the port of Bujumbura (now only one third of what it was in 2000).14

1.30 Because of the structure of its exports, Burundi is likely to reap more benefits from the Economic Partnership Agreement with the EU than from its trade with EAC countries. However, trade with the EAC has already enabled Burundi to expand into new goods, which it does not export to Europe. Regional trade agreements among natural trading partners are likely to facilitate deeper integration involving differentiation and diversification, which further expands welfare gains. However, while the EAC offers a good opportunity for Burundi to export new products, the country needs to implement a number of reforms to be able to expand and maintain its new exports.

1.31 Attracting FDI is crucial for export diversification. Opening up to foreign direct investment is an effective mechanism to increase competition and efficiency in the domestic economy. Regional partnerships aimed at attracting regional FDI could help Burundian firms increase profitability thanks to economies of scale generated by a bigger market and better supporting services. In addition, low wages and the availability of (unskilled) labor is a potentialincentive for relocating in Burundi part of the activities of regional production centers. Regional partnerships could take the form of joint ventures with local small and medium enterprises, equity participations, or creation of subsidiaries with maximum benefits for the domestic and regional economy. The main benefits of FDI for the domestic market would include large-scale production with lower prices, higher standards of quality, technology and know-how transfer in the industry, expansion of the tax base and more investment flows and job creation with a multiplier effect on the national income.

1.32 International trade in services could play an important role in the development of Burundi’s services sector. A key challenge for the development of trade in services is the coordination of regulatory reforms with the removal of trade barriers. Opening up to services’ imports and FDI would increase competition and efficiency in the provision of services in the domestic economy. Liberalization of services trade could also have a positive impact on production and export of goods and services throughout the economy. In addition, services may offer dynamic export opportunities. Exports of services (e.g., tourism and financial services) are of particular importance for landlocked countries which have limited opportunities to diversify into exports of manufactures because of high transportation costs.

1.33 Burundi may be capable of positioning itself and its port as a trans-shipment hub for the region. However, one of the lessons from successful regional integration experiences elsewhere in the world is that tackling tariff barriers is not enough to stimulate trade. Burundi must also facilitate regional trade by addressing non-tariff barriers (NTBs), such as restrictive product standards or complex rules of origin. NTBs in Burundi remain a serious obstacle tointraregional trade—especially customs and administrative procedures, the length of clearance formalities and the large number of institutions involved in control operations at the port of Bujumbura.

14 Possible scenarios range from a disappearance of the need for transshipment from rail to vessels at Kigoma if a proposed rail extension into Burundi is constructed to carry freight and passenger traffic direct to Bujumbura, to an improvement in Tanzania Railways Corporation’s performance and a move back to rail transport for bulk cargo.

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Proposed measures to reduce and eventually remove Burundi’s NTBs within the EAC are:(i) Establish a mechanism for identifying and monitoring the elimination of NTBs. Ideally, this

mechanism should include representatives of public and private sector entities interested in trade facilitation.

(ii) Consolidate institutions in charge of customs clearance and administrative control at the port of Bujumbura and create a one-stop window to streamline transit and customs formalities.

(iii) Improve the layout and equipment of border posts.(iv) Introduce competition in the selection of pre-shipment inspection companies.(v) Gradually establish a quality control and certification infrastructure.

Institutional reforms

1.34 The Government of Burundi has shown its strong commitment to EAC integration.Since Burundi officially became a member of the EAC on July 1, 2007, significant efforts have been made by the authorities to align the country’s practices and regulations with EAC requirements, especially in the political, institutional and economic areas. Burundi signed the treaty, ratified the protocols and the conventions, and developed (belatedly) a communication campaign aimed at sensitizing the population on the likely benefits of the integration process. In line with the practice of other EAC members, the government created a full ministry responsible for EAC affairs. Following the establishment of the new institutional structure, the government should develop a strategy aimed at ensuring the success of its participation in the EAC.

1.35 The Ministry of the East African Community Affairs (MEACA) should be staffed with competent personnel; an extensive capacity building program should be implemented and all the necessary institutional arrangements should be completed. An important initiative would be the creation of a coordination, monitoring and evaluation committee for all EAC-related issues,that would include representatives of the government, the donor community, the private sector and the civil society. The role of the committee would be to clarify the roles and responsibilities of all the potential actors and maximize their contribution. In addition, the communication campaign designed to create national support for integration should be continued and completed.

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Policy Note 2Reaping the Fiscal Dividends of Peace: Creating Fiscal Space for Growth-enhancing

Investment in Physical and Human Capital

2.1 Objective: This Policy Note examines the economic policies and budget strategies that would enable Burundi to create the fiscal space necessary to meet the dual objective of: (i)consolidating peace and security; and (ii) accelerating growth and reducing poverty to meet the MDG targets over the next five years.15 This Note draws from the analyses and recommendations of several important analytical and policy reviews, including the 2011 Public Expenditure Review (PER), the 2010 Country Economic Memorandum (CEM), and the 2008 Public Expenditure Management and Financial Accountability Review (PEMFAR), prepared jointly by the GoB and the World Bank, with participation from other development partners. Italso takes into account the important work on the MTEF jointly carried out by the GoB and the World Bank.

Main Messages:

The scope for financing growth-enhancing investments by raising additional domestic revenue or increasing the budget deficit is extremely limited. The ratio of domestic revenue to GDP in Burundi (14 percent of GDP in 2010) is already among the highest amongcomparable countries (and the highest among EAC countries). Increasing the fiscal pressure in arural economy dominated by the informal sector would be unsustainable as it would reduce incentives, and hamper private investment, diversification, and growth. In addition, given Burundi’s shallow domestic financial markets, increased domestic borrowing to finance larger deficits would be difficult to implement, would crowd out private credit and investment and would increase the risk of excessive and unsustainable indebtedness.

Therefore, the fiscal space necessary to meet Burundi’s considerable needs for growth-enhancing public investment and basic social services can come only from policies and structural reforms that would: (i) increase foreign and private sector investment; (ii) increase donor support and concessional foreign aid; and most of all (iii) increase expenditure efficiency.

i. Increased foreign and private investment, especially in the production and infrastructure sectors, would lead to higher growth without burdening the government budget; this, in turn, would increase the resources available for productive public expenditures without raising the revenue share of GDP. As the experience of other countries has demonstrated, especially in a post-conflict context (e.g., Rwanda, Sierra Leone, Mozambique), Burundi could achieve GDP growth in the range of 8-9 percent, if the government remains committed to its overall reform program, and is resolute and effective in its implementation.

ii. Increased donor support and concessional foreign aid would alleviate budget constraintsand free-up space for productive investment. However, this would require considerable progress in political, administrative and economic governance. Measures aimed at increasing transparency, accountability and trust and ensuring an effective use of available resources would be a strong incentive for donors to increase their assistance. In this regard, Burundi is

15 Time horizon for the MDG target is originally set for 2015. As was discussed in PN #1, Burundi is unlikely to reach most of the MDG targets by 2015 but they will try to reach these goals as soon as possible.

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at a crossroad since official grants linked to the post-conflict status of the country may soon decline. The government’s ability to offset this negative trend will depend on how rapidly and convincingly governance improves. Incidentally, the government should also urge its development partners to adopt aid practices that improve the predictability of foreign aid. For instance, for effective planning of public resources, the government should insist that current grants, particularly budget or sector support, be firmly committed well ahead of the beginning of the fiscal year.

iii. Efficient resource allocation, expenditure targeting (through MTEF), and effective execution of planned actions are critical for achieving growth and poverty reduction objectives at a sustainable budget cost. It allows the government to establish priorities, rekindle resources to growth-enhancing expenditure, and sustain execution of planned intervention, thus increasing the growth-impact of spending and public interventions. For post-conflict Burundi, this will also mean continuing with phased expenditure-switching strategies from defense and security to the productive and social sectors, as well as enhancing capacity to select, plan, and effectively execute investment projects.

2.2 Medium-term macroeconomic simulations confirm that a resolute implementation of a government reform program along the above lines would indeed expand fiscal space and yield encouraging results in terms of sustained growth and poverty reduction. GDP growth rates(Table 5) could double from an average of 4.0 percent in 2008-2009 to 8.8 percent in 2010-15.This would be supported by increased investment spending (from 14.5 percent of GDP in 2007-09 to 18.6 percent in 2010-15, compared to 16.6 percent under the baseline scenario), and by switching resources from non-productive sectors (their share would decline from 47.5 percent of total expenditure to 32.8 percent in 2010-15, instead of 39.5 percent in the baseline scenario) in favor of productive infrastructure (from 14.3 percent to 22.5 percent) and social sectors (from 32 percent to 37 percent).16

Table 5: Impact of Fiscal Space Improvement

Indicator 2008-09average

2010-15 averageFiscal Space Scenario

GDP growth (%) 4.0 8.8

Share of productive infrastructure spending in budget (%) 14.3 22.5

Social sectors spending in budget (%) 32 37

Non-productive sectors (%) 47.5 32.8Source: Burundi Country Economic Memorandum (2010).

16 The MacMod-Bi model used here does not adequately capture many of the externalities associated withinvestment in infrastructure (e.g., indirect effects of infrastructure on health and education), as result growth effects are probably underestimated to a significant extent.

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Increased donor support and savings from the HIPC Initiative: Two major factors that transformed the Structure of Public Finance in Burundi

2.3 Burundi’s fiscal position has improved in recent years, thanks to increased external financing. The fiscal deficit (on a commitment basis and before HIPC grants) decreased from 3.7 percent of GDP in 2001-05 to an average of 3.2 percent of GDP in 2006–10, mainly because of increased grant disbursements.

2.4 Nevertheless, although the authorities made significant efforts to improve the country’s fiscal stance, increased spending and limited revenue mobilization may create large, unsustainable fiscal deficits. There is a real risk that a larger deficit will lead to increased borrowing from the domestic financial market. This would raise the cost of funds and may crowd out private investment and stifle growth. Consequently, this Policy Note explores other options for creating fiscal space to meet Burundi’s daunting needs in terms of public investment and basic social services.

Figure 2: Fiscal Balance (commitment basis before HIPC grants), 2005-10

Source: IMF.

Figure 3: Strategic objectives, Budget decisions and Fiscal sustainability

Source: Adapted by authors

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2.5 The analysis of the fiscal space looks at the sources for additional fiscal resources along the four axes of the fiscal diamond:

Domestic revenue Foreign and domestic borrowingForeign aid Reallocations (reduction of unproductive /low-priority expenditures) and gains in efficiency.

Government Revenue

2.6 Domestic sources account for 32 percent of total government revenue. More than 91 percent of domestic revenue is derived from taxes: about 73 percent from taxes on domestic activity (goods and services and income) and 18 percent from taxes on international trade during the period 2001–10 (Table 7). Despite the narrow tax base (due to the very small size of the formal private sector), the government was able to stabilize domestic revenue around the 2006 level of about 14.0 percent of GDP during most of the 2007–10 period. Additional (but modest) increases in domestic revenue will depend on improved revenue administration and elimination of a large number of excessive tax exemptions. In this context, the government plans to revise the general tax code and unify the local and national revenue administrations, in line with current tax policies in the East African Community.

2.7 There are three potential sources of growth in domestic revenue (as a share of GDP): (i) the income elasticity of some taxes; (ii) changes in tax policy (tax rates, thresholds, exemptions etc.); and (iii) increased “buoyancy” of the tax system thanks to improved administration. Table 6 compares the tax revenue collected in Burundi with that of other East African countries. Despite its low income per capita, Burundi has a high tax revenue to GDP ratio (it was the highest among EAC countries before the recent rebasing of national accounts).

Table 6: Tax Revenue/GDP Ratios in EAC Countries, 2010

GDP per capita ($US)

Tax revenue (% of GDP)

Burundi 192.1 13.7

Kenya 775.3 19.0

Rwanda 529.7 12.1

Tanzania 527.0 14.6

Uganda 508.9 11.8

Sub-Saharan Africa 1301.7 n.a

Source: World Bank World Development Indicators Database, 2010; various IMF staff reports.

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2.8 Although Burundi’s tax revenue relies mainly on a narrow tax base, there are possibilities of efficiency gains in revenue mobilization through the recent introduction and improved collection of the value added tax (VAT), expansion of the tax base and better enforcement with the creation of the OBR (Burundi Revenue Office). However, there is little room for further expanding fiscal space significantly by raising domestic revenue, as this would create disincentives and smother private sector-led growth (Table 7).

In the short to medium run, possible increases in domestic revenue could come from measures aimed at expanding the tax base, including: (i) strengthening the capacity of the new OBR to improve tax collections and enforcement (computerization of the tax administration – tax and customs departments –and staff training are critical in this area); and (ii) accelerating the revision of the general tax code and unifying the local and national revenue administrations, in line with tax policy in the East African Community.

Domestic and Foreign borrowing

2.9 Domestic Borrowing: During the period 2008-10, domestic borrowing averaged 1.9 percent of GDP. Domestic borrowing was limited by the government’s desire to reduceborrowing from the central bank to control inflationary pressures and avoid crowding out credit to the private sector.17 The embryonic domestic financial system offers very little scope for the government to borrow from commercial banks or non-bank financial institutions. Therefore, low domestic financing of government operations is essential to maintain macroeconomic stability(net domestic borrowing should be kept below 1 percent of GDP).

2.10 External Borrowing: Net external borrowing averaged 22 percent of GDP (mostly due to savings gained from reaching the Completion Point of the HIPC initiative in 2009). So far, the bulk of external financing has been in the form of grants. The grant element of external finance increased in recent years, reaching about 90 percent in 2008. The high share of grants is in line with the conclusions of the debt sustainability analysis of the HIPC Completion Point, which stressed that the provision of external financial assistance needs to be heavily weighted toward grants, due to the country’s vulnerability to external shocks and its low and volatile export performance. Concessional external borrowing is therefore expected to remain limited to below 2 percent of GDP.

17 The crowding-out effect may last only short run if the extra domestic borrowing serves to finance public investment in infrastructure. In the long run, the crowding-out effect may be offset by the complementarity effect because lack of access to basic infrastructure services may be a key constraint on private capital formation.

Table 7: Composition of Government Revenue, 2001–2010(percent of GDP)

Revenue source Average 2001-05

Average 2006-08

2009 2010 Average 2006-10

Total revenue 21.7 36.0 80.0 37.3 45.1Domestic revenue 15.6 13.7 13.6 14.6 13.9

Tax revenue 14.2 12.5 12.5 13.7 12.8Income tax 3.8 3.6 3.8 4.4 3.8Taxes on goods & services

6.9 6.5 6.6 7.8 6.8

Taxes on international trade

3.2 2.3 2.0 1.6 2.1

Other tax revenue

0.2 0.2 0.1 0.0 0.1

Nontax revenue 1.4 1.2 1.2 0.9 1.1Grants 6.1 22.3 66.4 22.7 31.2

Source: International Monetary Fund.

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Foreign Aid

2.11 Grants: Grants represent an increasing source of revenue, rising from 26.5 percent of total resources in 2001-05 to 65.0 percent in 2006-10. This is due to two main factors: (i) increased donor support to reconstruction efforts as the government was able to implement a program of political and socio-economic reforms following the 2000 Arusha Accord; and (ii) savings derived from the HIPC process (2005 and 2009). Foreign grants included in the government budget reached about 22.7 percent of GDP. Project support accounts for the largest share of external grants, with an estimated 7.3 percent of GDP in 2010, followed by program grants (5.0 percent of GDP) and technical assistance (5.1 percent of GDP), special programs (DDR, elections, 2.5 percent of GDP) and MDRI (1.2 percent of GDP).18

2.12 Aid inflows in the form of grants have been projected to decline considerably in the short term: from 22.7 percent of GDP in 2010, to 22.4 percent of GDP in 2011 and 15.9 percent in 2012. However, the government may be able to slow down the decline if it tackles the issue of governance with a sense of renewed urgency and makes it a top priority. Indeed, the donor community has recognized that a substantial increase in financial assistance is critically needed in post-conflict Burundi, and donors have noted Burundi’s steady progress toward political and economic stability in the face of major medium and long-term economic reconstruction, rehabilitation and development challenges. Nevertheless a sizable increase in aid flows would require even stronger commitment and more resolute efforts to enhance governance, transparency and accountability.

In the short- to medium-term, the authorities should: (i) accelerate PFM reforms (fiduciary controls) to improve transparency in the management of public expenditure and avoid the misappropriation of resources; (ii) take decisive actions in line with the Head of State’s “zero tolerance” for corruption by stepping up the prosecution of corruption cases and enforcing decisions made by anticorruption agencies; and (iii) encourage a more coordinated action of donors.

Burundi’s heavy reliance on grants makes it vulnerable to the lack of predictability of aid flows. The government should therefore insist that current grants, particularly budget and sector support, be firmly committed by donors ahead of the beginning of the fiscal year.

The lack of predictability of aid flows may have strong negative consequences as a number of planned investment projects may require sustained commitments from donors. The lack of predictability maydeter governments from engaging into ambitious, multi-year public investment programs (PIP) and may act as a disincentive to implementing domestic reforms. This could be particularly costly (in terms of growth) if the network effects (e.g., infrastructure on human development sectors and therefore on long term growth) are important. The country also needs predictability from multilateral donors, who may need to step up their assistance to finance critical investment projects if bilateral aid falls below projected levels.

Privatization proceeds

2.13 Privatization proceeds are a welcomed source of financing. So far, privatization receipts have been very modest (0.1 percent of GDP in 2010), because the privatization program concerned comparatively small public enterprises. The privatization of state assets in the

18 The 2010 grant figures reflect delayed budget support initially planned for 2009 but effectively disbursed in 2010.

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financial and coffee sectors is likely to create more revenue and may help reduce domestic borrowing requirements. Although several large enterprises still remain in the public sector,including the Office National des Telecommunications (ONATEL), the Burundi Coffee Company (BCC), the Office du Thé du Burundi (OTB), the Sugar Company (SOSUMO), the Société Immobilière Publique (SIP), and a number of assets in the tourism sector (Hotel Source du Nil), it is difficult to estimate the additional resources that could be generated by the ongoing and future privatization process. What is certain however is that accelerating the privatization process will not only reduce current expenditure (subsidies for cash-strapped public enterprises) and contingent liabilities, but may also create investment opportunities for the private sector and entry points for foreign investors.

The authorities should accelerate their privatization program: first the sale of the coffee washing stations, then the tea processing plants, SOSUMO, public assets in the tourism sector and ONATEL.

Reducing/switching government spending and efficiency gains

2.14 Cutting nonproductive expenditure can free-up fiscal space for growth enhancing investment. Overall, government spending has been rising rapidly in recent years, reaching an average of 40 percent of GDP over the last three years (from 22.5 percent of GDP in 2001). This share is considerably higher than those in other Sub-Saharan Africa countries and this level of public spending is not sustainable (Figure 4). Current expenditures (excluding externally financed special programs) account for more than 35 percent of total expenditures and net lending. The wage bill increased from 5.9 percent of GDP in 2001 to 8.6 percent in 2011 budget. Capital expenditures more than doubled (from 5.1 percent of GDP in 2001 to 12.0 percent in 2010) thanks to a steep rise in foreign grants.

2.15 Allocative efficiency: The government has improved its allocation of public expenditure for the benefit of priority sectors over the last six years. The combination of HIPC funding (since 2005) and increased donor support enabled the government to increase funding for priority economic and social expenditures (from 4.8 percent of GDP in 2001 to about 16.9 percent on average during the period 2008–10). Increased allocations to social sector expenditures reflect the government’s commitment to pro-poor spending, notably education and health.

2.16 There is room for further improvements in public resource allocation in Burundi. In 2010, whilst defense spending accounted for around 19 percent of total expenditure, spending on priority sectors, excluding education, amounted to only 15 percent. High defense and policespending and the high wage bill remain key obstacles to the reallocation of public resourcestoward priority economic and social sectors. In the past five years, however, the governmentmade substantial progress towards reducing defense spending for the benefit of growth-

Figure 4: Composition of Public Spending, 2001–2010

Source: International Monetary Fund. Note: Exceptional expenditure includes spending on DDR and elections.

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enhancing and poverty-reducing sectors. Defense spending as a share of domestically-financed expenditure decreased from 29 percent in 2005 to about 14 percent in 2009. A declining trend was also observed for Police-related (security) expenditure (from 12.1 percent to 10.5 percent).Meanwhile, the share of growth-enhancing and poverty-reducing sectors (including education, health, agriculture, energy, transport, and public works) rose from 50 percent to 54.4 percent during the same period.

2.17 In the medium term, as the government is able to consolidate peace and improve security, it should continue to redirect resources from defense and general administration to growth-enhancing and poverty-reducing expenditure. It should avoid a policy of “saupoudrage” and give clear priority to agriculture, infrastructure, education and health. While reducing defense spending, the government must also keep in mind the need to absorb the demilitarized work force in a growing private sector (see Policy Note 1). This in turn requires accelerated implementation of deep structural reform programs that can unleash the private sector development potential and boost private sector growth and job creation. The MTEF provides an instrument which the government can use to organize implementation of these priorities and to improve consistency and complementarities in government interventions, thus improving the overall effectiveness of Burundi’s growth and poverty reduction agenda.

2.18 To assess the growth and poverty impacts of various strategies for increasing fiscal space,simulations were made using the government and World Bank macro modeling tools (MacMod-BI). Key assumptions included: (i) improved efficiency of public expenditure management that would translate into acceleration of structural reforms and improvements in MTEF allocations(Table 8) toward growth-enhancing and poverty-reducing sectors (e.g. infrastructure and agriculture); (ii) reduced growth of defense and police spending with a tighter control of the wage bill; (iii) constant domestic revenue ratio to GDP, averaging 19.5 percent of GDP over the projection period (2010-15).19

2.19 The simulation results indicate that higher GDP growth and increased poverty alleviation are within reach. Table 4 summarizes the trends of key economic indicators: GDP growth would average 8.8 percent over the projection period, a 4 points increase over the 5.1 percent expected to be achieved under the baseline (“business as usual”) scenario.

19 The effects of a slow pace of security expenditure downsizing are analyzed in the third Policy Note. It concludes that donors may need to be remained engaged in the country for a long haul, as savings from security expenditures may be limited and risky for private sector development.

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Table 8: Fiscal Space Scenario—Medium-Term Expenditure Framework, 2008–15

Actuals EstimateAverage

2008 2009 2010 2011 2012 2013 2014 2015 2010-15

Percent of total expenditure

Recurrent expenditure (excl. debt service) 60.6 60.4 59.9 57.5 54.3 51.8 51.2 50.8 54.3

Capital expenditure 39.4 39.6 40.1 42.5 45.7 48.2 48.8 49.2 45.7

Sectoral allocation (% total expenditure, excl. debt service)

Social sector 28.8 33.7 33.1 38.0 37.2 37.2 37.9 38.3 36.9

Education 20.3 23.8 23.1 26.6 25.8 25.6 25.8 26.0 25.5

Health and social development 8.5 9.9 10.0 11.3 11.4 11.6 12.0 12.4 11.5

Productive Infrastructure 15.8 12.8 21.9 19.9 22.5 23.7 23.4 23.6 22.5

Mining and energy 2.2 2.2 4.8 1.9 1.9 2.0 2.1 2.1 2.5

Transports and telecom. 0.4 2.9 0.8 2.5 2.6 2.8 2.8 2.8 2.4

Water, environment, and urbanism 0.5 0.6 4.0 0.6 0.6 0.6 0.6 0.6 1.2

Public work and equipment 12.7 7.0 12.3 14.9 17.4 18.3 17.9 18.1 16.5

Productive sectors 5.3 8.8 9.6 10.1 10.5 11.1 11.6 12.1 10.8

Agriculture 4.1 8.3 9.0 9.5 10.0 10.6 11.1 11.6 10.3

Industry and Commerce 1.2 0.5 0.6 0.6 0.5 0.6 0.6 0.6 0.6

Other sectors 50.1 44.7 35.5 32.0 29.7 28.0 27.1 25.9 29.7

Projections

Source: World Bank staff and Burundi authorities.

2.20 Indeed, improved efficiency and targeted productive investments would have a strong impact on growth. As noted in the 2010 CEM, the government’s top priorities for accelerating growth and reducing poverty are energy, public works, and agriculture, three sectors that would need to invest around US$860 million over the 2010-15 period. GDP growth would accelerate and the incidence of poverty would decline if three specific reforms are implemented: (i) improving execution of public capital expenditures; (ii) improving efficiency in agriculture (food and export crops and livestock development); and (iii) increasing public capital spending in infrastructure (road maintenance, small hydro-plants around Bujumbura; construction) and in the productive sectors.

Table 9: Fiscal space improvement: Trends for Key Indicators, 2009–15Actuals Est. Average Average

2008 2009 2010 2011 2012 2013 2014 2015 2006-09 2010-15

Real GDP growth 4.5% 3.5% 4.0% 4.2% 8.4% 11.1% 12.5% 12.9% 4.2% 8.8%

Consumer prices (period average) 24.5% 8.8% 6.9% 8.7% 9.0% 9.6% 9.9% 9.9% 7.6% 9.0%

GDP defator 24.5% 8.5% 8.4% 9.0% 8.9% 9.4% 9.5% 9.5% 11.4% 9.1%Exports of goods and non factor services (USD)

34.6% -15.9% 20.9% 10.2% 13.0% 14.7% 15.1% 14.9% 14.8% 14.8%

Imports of goods and non factor services (USD)

26.2% -8.4% 5.0% 5.8% 8.9% 10.8% 11.9% 12.4% 20.1% 9.1%

Current account deficit (incl. official transfers)

-12.3% -13.0% -14.1% -15.2% -11.0% -9.7% -11.4% -12.2% -13.9% -12.3%

Revenue (excl. grants) 18.6% 19.0% 19.1% 19.2% 19.4% 19.6% 19.8% 20.1% 18.8% 19.5%Total expenditure and net lending 44.1% 50.4% 50.2% 46.7% 47.1% 45.3% 40.1% 36.6% 42.8% 44.3%Overall balance (excl. grants)a -0.8% 58.5% -8.4% -6.9% -5.0% -4.2% -2.1% -1.7% 14.1% -4.7%

Poverty Incidence (% population) 58.3% 56.8% 53.3% 51.1% 45.8% 39.6% 33.5% 27.0% 61.8% 41.7%

Primary Enrolment rate (Net) 89.4% 96.4% 97.5% 105.9% 108.5% 111.8% 114.3% 120.1% 88.8% 109.7%

Juvenile-infantile mortality rate (p.1000 n.b.)

101.0 93.6 90.1 83.2 79.1 75.1 71.6 66.6 123.4 77.6

Projections

(annual percent change)

(percent of GDP)

Source: International Monetary Fund, World Bank, and Burundi authorities. a. Commitment basis. b. Includes grants received under the HIPC Initiative.

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To further improve the allocative efficiency of public expenditure, the authorities should: (i) use the MTEF tool to identify expenditures with low efficiency that can be cut; (ii) establish a Central Development Committee (CDC) within the Ministry in charge of Planning to improve selection, track project quality and evaluate coherence with strategic plans, including medium-term expenditure frameworks (MTEFs).

2.21 At around 8.6 percent of GDP in 2010, the government wage bill is large compared to other LICs where the wage bill typically accounts for 6 to 7 percent of GDP. Containing the growth of the wage bill is a crucial part of the government strategy to create fiscal space. But limiting the size of the wage bill is extremely difficult, not only for political reasons but also because many public servants are front line service providers (e.g. 54 percent of the wage bill is for teachers, 11 percent for the police and 23 percent for the military). The current government plan is to bring down the wage bill to around 8.2 percent of GDP by 2013 by reducing the number of police and military personnel while allowing moderate staff increases in priority sectors (e.g. health and education). Additional reforms of the wage bill involve delicate trade-offs. First, the wage bill should be reined in without impacting public service delivery (in capacity and quality); and second public sector wages should remain attractive in order to attract and retain skilled workers and quality staff for improving service delivery. Policies that increase productivity of public servants will be needed to help resolve this difficult trade-off.

In the short term, to control the growth of the wage bill, the authorities should: (i) accelerate the computerization of payroll management; (ii) activate the Recruitment Commission set up in 2006 and prepare a national recruitment plan to improve the management of the public wage bill; and (iii) re-establish the Ministry of Public Administration as an effective human resources management agency through the creation of a technical support unit (cellule d’appui) that would provide key advice to the Minister on HR management issues.

In the short to medium term, the authorities should: (i) establish fair rates of pay for different job groups, reflecting the skills and experience required; and (ii) continue to reduce the wage bill while increasing staff in priority sectors by downsizing the security sector. This should be based on a realistic evaluation of the growth of private sector development necessary to absorb “demobilized” armed forces and ex-combatants (see Policy Note 3).

2.22 Technical efficiency: In the new IMF’s PIMI (Public Investment Management Index), Burundi is ranked 63 out of 71 LICs and MICs.20 The government’s poor performance in public expenditure and investment management is due to a number of factors. First, there is a lack of coordination among national institutions, and between those institutions and the donor community, and this weakens project selection, implementation and the procurement process.Second, monitoring is constrained by the lack of information about execution and by inadequate audit and reporting mechanisms. Third, project performance is affected by considerable delays in disbursements and the volatility of external aid. The combination of these problems may induce the government to scale back its investment program. It may also be unrealistic to assume that donors (in an environment of fiscal consolidation in their own countries) will be ready to pre-commit to multi-year investment and support program. Finally, the recent increase in development spending went mostly to the social sectors, thus limiting public investment in such

20 Dabla-Norris et al. (2011) find that the efficiency of public investment in Burundi is only 0.23 out of scale of 0 to 1 based on average estimates for developing countries.

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economic sectors as infrastructure, which, by the way, have an indirect social impact through improvement in health and education.

The government should implement its plan to strengthen the system of appraisal, selection and monitoring of investment projects and should include in the next Public Investment Program (PIP) high-priority growth-oriented investments (in infrastructure and energy and in agriculture support services) with the highest return. In this context, it is important to accelerate the gradual introduction of Medium Term Expenditure Framework (MTEF) into the budget preparation process.

Other key PFM measures aimed at improving the efficiency of public expenditures include: (i) strengthening transparency in PFM by introducing and implementing a legislation on access to information on public affairs management; (ii) designing and piloting a feedback mechanism enabling beneficiaries to comment on the performance of public sector services (especially in the health sector); (iii) reinforcing systems for transparent public financing through automatic blocking of the attribution ofpublic contracts to suppliers who do not have a tax registration number and/or are not up-to-date on tax payments; (iv) introducing a bill aimed at reinforcing the operational independence of the Cour des Comptes and strengthening its internal procedures; and (v) strengthening the capacity of government entities including the Cour des Comptes, IGE, Anti-corruption Board, Procuring units within ministries, and OBR, and improving the quality of governance within these institutions.

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Policy Note 3:Fiscal Policy Challenges: Security Sector Downsizing, Private Sector Development,

and Fiscal Space Expansion for Growth

3.1 Introduction and Objectives: This policy note examines major fiscal policy challenges that Burundi will be facing over the medium term, with particular reference to the need for creating fiscal space and downsizing the security sector as a result of continuing internal reforms,improved spending efficiency, and policies supporting the development of the private sector. This note draws on previous policy notes21 in addition to other analytical work carried out by the World Bank in partnership with other development institutions. The note ends with core policy recommendations on how the Government of Burundi could effectively respond to these fiscal challenges.

Main Messages:

The main difference between Burundi and other post-conflict economies is the lack of a strong economic recovery following the cessation of hostilities. Burundi, however, is at a point in time where good policies may bring about a long overdue economic turnaround.Policies to create fiscal space for growth and to promote PSD are intrinsically linked. Success in one area is more likely if Burundi succeeds in the other area. A sound, well-executed strategy is necessary for achieving both objectives.The reallocation of expenditures from unproductive/low-priority sectors to priority and growth-enhancing sectors offers great potential for fiscal space. A key component of this strategy is the downsizing of the security sector as part of ongoing internal reforms and improvements in spending efficiency.It has been argued that the optimal pace of demobilization should be adjusted to the capacity of the private sector to absorb ex-combatants. If PSD is slow, the risk is that downsizing will lead to unemployment of demobilized personnel and will trigger instability.Burundi must continue to attract aid by strengthening its commitment to good governance. Otherwise the country should prepare for a substantial decrease in foreign aid (due to the decline of grants related to its post-conflict status). Increased foreign aid is crucial to accommodate a slower (and more prudent) demobilization process which would not compromise prospects for growth and poverty reduction. Currently, Burundi’s private sector is not a driver of growth. With the right policies (tackling constraints due to low agricultural productivity, poor physical infrastructure and an inadequate business environment), the private sector will be ripe for development.Burundi may also achieve additional PSD-led growth through better use of its EAC membership.

What Makes Burundi Different - The Political and Security context

3.2 Since the Arusha Agreement of August 2000, Burundi made great strides but also experienced major setbacks on the road to lasting peace. Following the adoption of a new constitution in February 2005, and presidential and parliamentary elections in August 2005, a

21 Putting Burundi on a High Growth Path for Poverty Reduction; Reaping Fiscal Dividends of Peace: Creating Fiscal Space for Growth-enhancing Investment in Physical and Human Capital.

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ceasefire accord was reached in 2006 with the last hold-out rebel movement, the Front National pour la Libération (FNL). However, sporadic fighting continued until 2008-2009 when the FNL renewed its commitment to negotiated peace, and was reintegrated into the political system. Disarmament, demobilization, and reintegration continued over the recent years. Burundi's second series of democratic elections in 2010 represented a milestone in its political transition despite the boycott decided by a coalition of opposition parties alleging fraud and vote-rigging.22

3.3 The security situation is relatively calm but remains fragile as controversies over the election results sparked violence that sometimes led to loss of life. The self-exile of the FNL president and former rebel leader Rwasa Agathon along with other opposition leaders grouped in a consortium of opposition parties, known as the Democratic Alliance for Change (ADC), has also created an atmosphere of uncertainty. Sporadic and targeted attacks on the population have continued, including a recent incident involving gunmen killing 41 people in a town near the capital city.

3.4 In this divisive environment, the ruling party tries to appease the socio-political atmosphere. The ruling party gained the majority in parliamentary elections, but two opposition parties which did not boycott the polls also gained representation. In order to consolidate peace and promote reconciliation, the government gave a new impulse to the Ombudsman Office and accelerated the creation of two other institutions: the National Committee for Reconciliation and the National Council for Human Rights. In addition, Burundi recently launched a campaign for the promotion of transitional justice through the formation of a Truth and Reconciliation Commission and the creation of a Tribunal as stipulated in the 2000 Arusha peace accord. Finally, a reform of the police is underway which is expected to make police forces more professional.

Macroeconomic and social context

3.5 The civil war led to an 18 percent reduction of Burundi’s GNI (from US$170 in 1993 to US$140 in 2008). The proportion of the population living below the poverty line (US$2.15 a day) rose from 58.4 percent in 1993 to 89.2 in 2002. The rate of poverty subsequently declined to about 67 percent in 2006, according to more recent poverty data. The civil war destroyed capital resources, repressed investment and seriously damaged the capacity of the public sector to provide basic public services.

3.6 The most notable difference between Burundi and other post-conflict economies has been the absence of a strong economic turnaround following the cessation of hostilities.During the demobilization period (2005-09), the growth of GDP per capita averaged less than ½ percent. This is in stark contrast with developments in Uganda in the early 1990s and Sierra Leone in the late 1990s, two countries where per capita growth averaged 4 percent during and after demobilization. Rwanda also experienced a strong rebound in the aftermath of the cessation of hostilities and the growth of GDP per capita reached 9.5 percent in 1994-99.23 Against this background, two issues need to be discussed: (i) why Burundi was unable to experience the same

22 According to international observers, the elections conformed to international standards despite minor irregularities during the local council elections. However, thirteen opposition parties formed a coalition to boycott the presidential election, leaving President Nkurunziza to stand unopposed who was re-elected for a second term, with 92 percent of the votes, in June 2010. 23 Of course, this masks quite large volatility in the growth rate over that five-year period.

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economic turnaround as other post-conflict countries? and (ii) which reforms are now necessary to kick-start a stronger economic recovery?

3.7 The main explanation for Burundi’s sluggish growth is the continued insecurity,which decreased following the first round of democratic elections in 2005 and the peace agreement with the FNL in 2006, but remains high by international and regional standards as shown by the number of military personnel and the size of military expenditures (Tables 10 and 11). Insecurity is responsible for the lack of private sector development (as measured by private investment), which, in turn, may have heightened insecurity because of slow economic growthand high unemployment, notably for demobilized soldiers and ex-combatants.

Table 10: Comparison of the size of military personnel in selected countries, 2010Country Active

MilitaryReserve Military

Para-military

Total Total per 1000 capita

Active per 1000 capita

Burundi 20,000 0 31,050 51,050 5.4 2.1

Mozambique 11,200 0 0 11,200 0.5 0.5

Rwanda 33,000 0 2,000 35,000 3.3 3.1

Sierra Leone 10,500 0 0 10,500 2.0 2.0

Uganda 45,000 0 1,800 46,800 1.4 1.4Source: International Institute for Strategic Studies; Hackett, James (ed.) (3 February 2010). The Military Balance 2010. London: Routledge.

Table 11: Comparison of military expenditures in selected countries (in percent of GDP)2000 2005 2006 2007 2008 2009 2010

Burundi 6.0 6.2 4.9 4.7 3.8 .. ..

Mozambique 1.3 0.9 0.8 0.9 0.8 0.9 ..

Rwanda 3.5 1.7 1.8 1.5 1.4 1.4 1.4

Sierra Leone 3.7 1.9 2.0 1.8 2.3 .. ..

Uganda 2.5 2.4 2.2 2.3 2.5 2.1 1.7Source: World Bank DDP.

3.8 Despite the persistent insecurity, the government has taken a number of measures aimed at improving the country’s business environment. According to the 2012 Doing Business report, Burundi is one of the top 10 investment climate reformers of the year, with its ranking improving from 177th (in the 2011 report) to 169th thanks to major improvements in sub-indicators concerning the protection of investors and, to some extent, improvements in tax administration. More attention was also given to the agricultural sector, which employs close to 90 percent of the working population. As shown by Nganou and Kebede (2010), increased agricultural productivity would contribute more to overall economic growth than accelerated growth in any other sector.

3.9 With a very small private sector, the Burundian economy would continue to languish and the country would not reach any of its MDGs by 2015. In this context, the new priority given to the promotion of private sector activities is a most welcomed development. This Note emphasizes the importance of private sector development (notably in rural areas) and its critical role in helping to absorb demobilized army forces and ex-combatants.

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A. Main Challenges: Fiscal space for growth, Security sector downsizing and Private sector development

3.10 Following the end of the civil war, a major task of the government has been to redirect public spending toward priority sectors with a view to promoting growth and reducing poverty.Creating fiscal space and promoting private sector development are two closely linked objectives. The best example of this mutual dependence is the link between downsizing the security sector, creating fiscal space and stimulating private sector activity. Rapid downsizing (tocreate fiscal space) is desirable only if the private sector is able to ‘absorb’ demobilized soldiersand if the demobilization does not have a negative impact on security. At the same time. PSD helps create fiscal space by increasing tax revenue and replacing government spending by private sector activities. Clearly fiscal policy challenges and PSD cannot be treated in isolation. This is why the reform program supported through Bank-financed development policy operations wasalways focused on both public finance management and PSD promotion.

B. Challenges to the Creation of Fiscal Space

3.11 Burundi’s fiscal position improved in recent years thanks to a major increase in donor grants, and its fiscal deficit decreased from 3.7 percent of GDP in 2001-05 to 3.2 percent of GDP in 2006-10. However, the government now needs to make special efforts to create the fiscal space necessary to finance productive public investments and expand the provision of public services in order to meet the MDGs. In addition, fiscal reforms must be consistent with the promotion of private sector development. There are broadly four possible sources for the creation of additional fiscal space: (i) domestic revenue, (ii) efficiency gains and reallocation of expenditure from unproductive/low-priority uses (e.g., through security sector downsizing), (iii) foreign aid, and (iv) domestic and foreign borrowing.

3.12 As discussed in more details in the second policy note, most of the additional fiscal space needs to be created though improving the allocation and the management of existing expenditures and the potential of the other options appear extremely limited for the near future. The government has already made some progress in reallocating expenditures to priority sectors,and the share of priority economic and social spending rose from 4.8 percent of GDP in 2001 to around 17 percent in 2008-10. Yet, in 2010, defense spending still accounted for about 19percent of total expenditures and only 15 percent of total spending was for priority sectors (excluding education). Clearly there is room for further improvement in public resource allocations.

3.13 The government wage bill is a significant component of total expenditure – rising from 5.9 percent of GDP in 2001 to 8.7 percent in the 2011 budget. This is more than the 6-7 percent in comparable low income countries (LICs). Both the IMF and World Bank have argued that reducing the wage bill depends on reducing the size of security forces. The dilemma, however, is this: on the one hand rapid downsizing of defense and security spending would reduce the wagebill and create fiscal space; but, on the other hand, it may also threaten security if ex-combatants fail to find jobs and turn to crime, and the downsized security sector does not have the capacityto perform its role of protecting the population.

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Table 12: Structure of public sector wages in Burundi, 2005-10 (percent of GDP)2005 2006 2007 2008 2009 2010

Total public sector salaries 6.0 6.0 8.0 8.2 8.6 8.6

of which: priority sectors 2.5 3.3 3.5 4.4 5.1 5.5

of which: security sectors 2.5 3.0 3.2 2.6 2.5 2.1

of which: others 1.0 1.1 1.3 1.3 0.9 1.0

Source: IMF.

3.14 Consequently, the objective is to implement a pace of demobilization, which is consistent with opposite constraints. This issue has been analyzed through a simple theoretical framework that reflects interactions between the public and private sectors in a dynamic way. The main features of this model are illustrated in Box 1 and 2 and a more detailed presentation is provided in Annex 1.

C. Downsizing armed forces – A Basic Theoretical Framework

3.15 The largest scope for creating fiscal space in Burundi is through reallocation of expenditures from non-priority to priority sectors as well as through improvement in spending efficiency. The demobilization/downsizing of ex-combatants is the main element of this strategy. To explore what might be an “optimal demobilization/downsizing process”, the government should choose a pace of demobilization/downsizing, which offsets the marginal benefits of increased pro-poor and growth enhancing expenditures with the marginal cost of the greater threat to security. In other words, the pace of demobilization/downsizing needs to be adjusted to the capacity for the private sector to absorb demobilized personnel in productive activities.24

3.16 The model developed here, which is presented in detail in Annex 1, reveals the endogenous link between private sector investment (and therefore private-sector-led growth)and insecurity. Because of this link, downsizing defense and security forces may ipso factodampen private sector investment and economic growth as it heightens insecurity. If former army officers and soldiers cannot find jobs in the private sector, they may be recruited by rebel factions or decide to turn to criminal activities.

3.17 In the long run, the development of the private sector is also influenced by fiscal policy. A faster demobilization process will increase productive government spending and therefore stimulate private sector development (incidentally, the efficiency of public spending can also improve through reforms of procurement practices in defense-related expenditures). While the government would retain a level of security forces sufficient to maintain security, it could alsocreate more fiscal space by getting “more value for its money”. Similarly, integration of security forces could stabilize macro security by switching some of the defense and security spending to more growth-enhancing investment in infrastructure (including “génie militaire”), agricultural mechanization and irrigation activities.

24 A general model of this kind should capture the trade-off inherent with a program of demobilization/downsizing -the fiscal gains (or 'peace dividend') of a reduced wage bill against the potential threat to security of ex-combatants/security forces returning to civil society. On the security issue, Collier (1994) considers two main forms - micro-insecurity as the increase in crime and as a result of demobilization and macro-insecurity as the increase in the probability of insurrection. The model here incorporates both types of insecurity.

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3.18 Private investment depends on (i) government spending on pro-poor and growth-enhancing programs including access to public infrastructure services, and (ii) the risk of insecurity, which itself is a function of several factors, including unemployment of civilians and former soldiers, efficiency of public spending in the security sector, and integration of security forces (no isolated but powerful elite security units), and (iii) regional demand. These relationships are described in Box 1.

Box 1: Private investment

3.19 The key problem for the government (or donors) is to choose the optimal pace of demobilization/downsizing of security sector through maximizing its utility function subject to its budget constraint.25 This problem is described in Box 2. The government’s utility depends on the total GDP net of the total cost of insecurity to the government as it internalizes the cost of insecurity for the private sector. In fact, insecurity creates output and investment losses in both the public and the private sectors, which constitute the total cost of insecurity to the government.Total GDP is composed of government GDP (including pro-poor and security expenditure) and private investment, which itself depends on government GDP. The budget constraint stipulates that government spending (security wage bill and other public expenditure, including pro-poor and growth-enhancing spending) is financed through domestic revenue and foreign aid.

3.20 The key result of this optimization process indicates that the marginal benefit of demobilizing/downsizing should be equal to its marginal cost in terms of greater insecurity. It follows that the optimal rate of demobilization/downsizing is lower when downsizing has a greater impact on unemployment (since the subsequent unemployment increases the risk of a return to civil war). The impact of demobilization/downsizing on unemployment is attenuated when private sector investment is strong. More generally, the resolution of this model will suggest that the rate of demobilization/downsizing is not constant, but rather reflects the evolution of the private sector.

25 The model was extended to introduce a cost function to the demobilization/downsizing process. The extended model, which is presented in detail in Annex 1, indicates that a preference for a smooth or accelerated path of downsizing depends on the curvature of this cost function.

Government spending –mostly on pro-poor, growth-enhancing

programs

Probability/likelihood of insecurity: macro and micro

Regional demand

Private investmentexpenditure

Efficiency index in security sector spending; degree of integration of

security forces; and unemployment rates of

former soldiers and civilians

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3.21 The model also suggests that if aid flows (or tax revenues) decrease (as is expected in the case of Burundi), the optimal response of the government will be to increase the rate of demobilization/downsizing, since, ceteris paribus, the marginal return on pro-poor expendituresand growth-enhancing programs will increase. In other words, there will be an even greater need to demobilize/downsize quickly to free up resources toward pro-poor activities if external aid declines. Alternatively, there is a greater need to improve efficiency of spending.

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Box 2: Trade-off between fiscal gains and risks of insecurity

Marginal change of unemployment of former security sector employees

relative to change in downsizing pace

(-)

Pro-Poor Expenditure and

growth-enhancing

Security sector wage bill

Other non-pro-poor expenditure (incl. non-

wage security) Private investment

Government GDP

Cost of insecurity

Total GDP

Marginal probability of insecurity with respect to unemployment of former security sector workers

(-)

Maximize government utility

Budget constraint

Optimal level of downsizing

Security sector wage bill

(+)

Marginal impact of insecurity on private

investment(-)

Marginal probability of insecurity relative to

security sector labor force (-)

(Investmentloss)

(Output loss)

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D. The Application of the Model to Burundi

3.22 In Burundi, the actual size of the military and police stands at around 28,000 and 17,000 respectively.26 These numbers are higher than the Arusha targets of 2000 (respectively 25,000and 15,000). During the period 2005-2010, the annual demobilization rate averaged 3 percent

the army and 5 percent for the police. To meet the Arusha targets by 2015, the Government will need to achieve a constant rate of demobilization of 3.7 percent for the army and 3.8 percent for the police. The model could be used to determine by how much private investment and growth should increase with these demobilization rates, to keep unemployment constant. Thus, it will provide useful information on the realism of the solved value for private investment.

Table 13: Size and wage of security forces, 2005-2010

3.23 A general question for Burundi is whether the rate of demobilization should be constant, or whether it should respond to private sector conditions. To the extent that Burundi’s security context remains fragile, many observers have argued that downward flexibility in the demobilization/downsizing rate is desirable. Similarly, if economic recovery finally kicks-in and growth rates reach the PRSP projections of seven percent, upward flexibility in the demobilization/downsizing rate would be welcomed, as greater fiscal gains would be possible without a significant downside risk of a return to civil war (or an increase in micro-insecurity).Although the issue of the pace of the demobilization process is at the center of the political and fiscal debate in Burundi, few analyses have been made that provide guidance to policymakers. One of the exceptions is the evidence recently presented by Gilligan et al. (2010). Their work is based on a quasi-experiment in the form of an exogenous bureaucratic failure in implementingthe Disarmament, Demobilization, and Reintegration (DDR) program This bureaucratic failure resulted in the withholding of benefits for about 1/3 of ex-combatants for reasons unrelated to the reintegration prospects. This exogenous variation in the provision of benefit enables Gilligan et al. to argue more forcefully on the causal impact of the reintegration program in Burundi. They conclude that the program provided a significant boost to income, resulting in a 20-35 percentage point reduction in poverty incidence among ex-combatants. They also find evidence of a moderate improvement in the livelihood prospects of ex-combatants. On the other hand, they find no evidence that the program contributed to more satisfaction with the peace process or a more positive disposition toward current government institutions – which indicates that the reintegration has not succeeded in increasing the willingness of ex-combatants to respect the rule

26 We are aware that intelligence services reportedly play non-negligible role in Burundian security. However, they are not included in the security sector as they are directly reporting to the President and not accounted for in security sector expenditure.

Size Wage (% of GDP)Army Police Army Police

2005 31839 n/a 2.0 0.62006 29346 19573 1.8 1.22007 28064 18991 2.0 1.32008 26322 17751 1.5 1.02009 27919 17382 1.5 1.02010 27236 16183 1.3 0.9Source: Burundi authorities and IMF.

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of law.27 This finding seems to confirm the concern that rapid (uncontrolled) demobilization may have costs in the form of a possible return to civil war or an upturn in crime. Meanwhile, Collier (1994) argued that the short-term effect of a well managed demobilization in Uganda was actually a reduction in crime.

3.24 Another important consideration is the varying degree of professionalism and capacity observed in the security sector in Burundi. The army seems to be one of the main sources of stability in the country at the moment. Following the Arusha Accord, the army, has undergone an effective internal reform and seems to be trusted by the population. In the case of the policewhich is new (it was created in 2004) and composed mainly of former rebels, intensive training is needed to transform it into a body capable of protecting the population. Development partners including Netherlands are providing training to professionalize police forces.

Box 3: Why Burundi Sends Troops on International Peacekeeping Missions?

E. Simulations design and results of the model

3.25 The starting point was to modify Burundi’s MTEF macroeconomic model (MacMod-Bi) to accommodate the treatment of security and growth nexus. Then, three simulations were conducted to examine the effects of security issues on growth. In the first simulation total public

27 It should be mentioned that parallel to the demobilization process, the government also pledged to professionalize its security forces. The integration of former combatants was accompanied and complemented by training programs (academic training, and technical standards).

Burundi sent 4,000 troops to Somalia, and the Somali Islamist insurgent group, Al Shabab, slaughtered 70 Burundian soldiers in December 2011. Burundi sends its troops to participate in UN or African Union peacekeeping operations not only Somalia but also in Sudan, Chad and Central Africa. The national police is also present in several countries (Côte d'Ivoire, Darfur, Central African Republic, Chad, and Haiti) as part of the United Nations Police.

UN peacekeeping missions for civil war left Burundi only five years ago. The reason why one of the poorest, post-conflict countries, such as Burundi, is sending troops abroad are as follows: (i) peacekeeping operations are a significant source of revenue for the government and reduce the cost for the wage bill; (ii) they reduce the number of soldiers operating inside the country and, therefore, relieve internal tensions; (iii) they provide training and capacity building for the troops abroad, and (iv) they are an important source of income for the troops - wages are significantly higher for peacekeeping operations than for nationally based troops.

Burundi earns about $20 million annually (in the form of budget support) for its participation in UN peacekeeping missions. The US State Department – Africa Contingency Operations Training and Assistance (ACOTA) – offers training in return for participation in peacekeeping operations in Somalia. Burundi asks the US to train not only troops participating in these operations but also the entire military personnel. The missions also represent an important source of revenue for soldiers. The African Union pays $750 monthly to the troops, and the government collects $100 in taxes.

This, however, does not mean that the government should reduce the pace of demobilization by sending troops abroad. Peacekeeping operations are temporary and national troops will ultimately return to Burundi where they will be demobilized. While military staff and military spending per capita is low in the neighboring post-conflict country, Uganda (Tables 10 and 11 in the text), which also sends troops on international peacekeeping missions, Burundi must continue ongoing efforts to reduce the size of the security sector.

47

spending is reduced (for fiscal considerations), while the share of security spending remains unchanged at its 2011 level. The second simulation also assumes that total public spending is reduced (for fiscal reasons) but the share of security expenditures is reduced for the benefit ofproductive sectors. The third simulation envisages no restraint on the growth of total expenditures (which increase slowly) but security expenditures are reduced in favor of productive sectors. The results of these three alternative simulations are discussed below (see Table 14).28

Table 14: Simulation results of the impact of security issues on growth

Weak sensitivity of investment to

security

Strong sensitivity of investment to

security

Weak sensitivity of investment to

security

Strong sensitivity of investment to

security

Weak sensitivity of investment to

security

Strong sensitivity of investment to

security

Average2012-2016

Average2012-2016

Average2012-2016

Average2012-2016

Average2012-2016

Average2012-2016

Share of public spendingSecurity sector spending 16.8% 16.8% 12.8% 12.8% 12.5% 12.5%Production sector spending 26.6% 26.6% 31.0% 31.0% 31.5% 31.5%

Annual real growth rate of public spendingSecurity sector spending -2.9% -2.8% -13.2% -13.1% -5.9% -5.8%Production sector spending 8.2% 8.3% 13.5% 13.6% 25.4% 25.4%

Sentitivity parameters

Sensitivity of private investment to macro security 0.00 0.90 0.00 0.90 0.00 0.90

Sensitivity of private investment to micro security 0.00 1.20 0.00 1.20 0.00 1.20

Economic activity

Private investment growth 7.2% 2.1% 7.6% -18.7% 12.7% 2.0%Public sector real GDP growth -0.1% -0.1% -0.2% -0.1% 8.6% 8.6%Real GDP growth 4.9% 4.6% 5.4% 4.8% 9.8% 9.5%Ke

y Re

sults

Scenario 1 : Contracting total public expenditures while maintaining the current rate of security spending at their 2011 level

Scenario 2 : Contracting total public expenditures

while controlling security spending to the benefit of production sectors

Scenario 3 :Increasing total public expenditures

while controlling security expenditures to the benefit of

production sectors

Key

Varia

bles

Para

met

ers

Source: MacMod-BI Model, simulation and macroeconomic framework.

Simulation 1: Contracting the level of total spending while maintaining the share of security expenditures at the 2011 level:

3.26 The contraction of overall spending reduces the capacity of the government to undertake ambitious programs (e.g. structural projects) required to lay the foundation of a strong economy. With reduced fiscal space (through constrained total spending), the government can neither meet the basic needs of the civilian population nor provide the basic security required to ensure a sustainable peace. As a result, GDP growth is slow and persisting insecurity negatively impacts the growth of an embryonic private sector, whose development is constrained by the quasi-inexistence of a growing structural demand. Although such a contractionary fiscal policy reducesthe fiscal deficit, it also slows down economic growth and thus maintains the economy in a state of sluggish growth. In this context, the demobilization process should also be slow. Simulation 2: Reduction of total expenditures but switching of security expenditures toward productive sectors.

3.27 Although switching expenditures from security related sectors (army, police and justice) to productive sectors (including agriculture and infrastructure) seems to provide some impetus to economic activity, contracting total spending will reduce aggregate demand and impact

28 For future work, it would be useful to conduct a budget-neutral experiment involving a shift in spending from security toward productive sectors. This would avoid mixing “level” effects of public expenditure and “reallocation” effects.

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negatively economic growth in the short run. The focus on productive sectors will encourage the development of these sectors and will lead to an increase in overall GDP growth in the long run as the reallocation of spending toward productive sectors has a significant spill-over effect on the private sector. The constraint faced by the government in terms of limited fiscal space to finance development combined with the assumption of a strong sensitivity of private investment to the security situation will translate into weaker economic growth rates. The demobilization process should be faster than in simulation 1 but would be constrained by the limited expansion of the private sector.

Simulation 3: Fixing a target consistent with overall spending growth while switching security expenditures in favor of productive sectors.

3.28 Reducing security spending (military, police and justice) in favor of the productive sectors is expected to (a) impulse economic activity, and (b) create a strong and sustainable rate of economic growth sufficient to reduce poverty. Meanwhile, the growth in government spending will impulse demand opportunities for the private sector, resulting in ripple effects in the entire economy despite low levels of resources devoted to security. Agriculture remains the mainstay of Burundi's economy, with seasonal incomes. In this context, the public sector remains a key player. Increased public spending (excluding debt service) constitutes an important structural demand for the private sector and therefore for its development, and the pace of demobilization could be accelerated.

3.29 The results of the simulations presented above were complemented with additional simulations using the downsizing paths and the macroeconomic framework of the second PRSP. These simulations are intended to provide further insights into the findings and conclusions of this policy note by using Burundi budget statistics. They are based on the reference scenario of the PRSP-2, recently transmitted to the Bank. They are intended to show the effect of the pace of downsizing in the security sector on increasing the fiscal space devoted to growth-related sectors (production sectors). In this context, savings from any downsizing path are reallocated to productive sectors.

3.30 The results of these additional simulations (presented in Table 15) show that Scenario 3 (moderate/slow pace of downsizing in the security sector)29 is more favorable to economic growth. Indeed, the moderate pace of demobilization of former combatants (scenario 3) allows the Burundian economy to take advantage of both an improved security situation and the positive effects of increased switching efforts toward productive sectors. Moreover, this implies greater access to foreign aid than in other scenarios. This has implications for its feasibility as the authorities will have to improve their performance in terms of good governance to be able to mobilize additional assistance. To the contrary, although an accelerated downsizing path (reducing the size of security forces by 3.77 percent for the army and 3.85 percent for the police) provides important budgetary savings it would rely less on foreign aid to close the budget gap. Moreover, expenditure switching efforts to productive sectors are inhibited by the risk of increased insecurity. In other words, rapid downsizing of the security sector downsizing might very negatively affect the level of security in the country, and consequently

29 The moderate path of downsizing consists in reducing the size of army personnel by 1.3 percent per annum and that for the police by 1.27 percent. The final objective here is to reach the targets of the Arusha Accords by 2020. Further details are presented in Annex 3.

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slow private sector momentum (reduced effect on private sector growth). (See results of Scenario 2).30

Table 15: Simulation results: Impact on PRSP-2 growth projections of proposed optimal downsizing paths Scenario 1. No change in the size of Army and Police. (Business as usual)

Scenario 2. Downsizing is accelerated to reach the Arusha Accords

Scénario 3. Downsizing is gradual and slow to reach the Arusha Accords

Amount (million of FBu)

Amount (million of FBu)

Amount (million of FBu)

Strengthening security 963.30 933.13 957.37 Security expenditures for the Army 561.81 543.38 557.29

Current expenditures 539.37 520.83 534.83 o/w Wage bill in the Army 314.78 296.23 310.23

Capital expenditures 22.44 22.56 22.47 Security expenditures for the Police 401.48 389.75 400.07

Current expenditures 384.07 372.24 382.64 o/w Wage bill in the Police 205.08 193.25 203.65

Capital expenditures 17.41 17.51 17.43

Average2012-2016

Average2012-2016

Average2012-2016

Expenditure sharesSecurity expenditures 12.9% 12.6% 12.9%Expenditures in production sectors 28.7% 28.9% 28.7%

Annual growth of nominal expendituresSecurity expenditures 3.1% 1.8% 2.7%Expenditures in production sectors 23.7% 23.9% 23.8%

Economic developmentGrowth of private investments 7.33% 6.39% 7.95%Real growth of Public sector GDP 4.19% 4.44% 4.50%Real growth of total GDP 7.39% 7.89% 7.94%

Sensitivity parameters

Sensitivity of private investment to macro security 0.90 0.90 0.90

Sensitivity of private investment to micro security 1.20 1.20 1.20

Key

Var

iabl

esK

ey

Para

met

ers

Key

Res

ults

Source: MACMOD-BI Model, simulation and macroeconomic framework of PRSP-2.Note. Scenario 1: The level of security expenditure increase only at the assumed 4% rate representing annales/annual increase(Business as usual) and no change on the current pattern of the size of security forces; Scenario 2: The assumed rate of 4% representing annales and the level of security expenditures decreases until 2015 (accelerated downsizing); Scenario 3: The assumed rate of 4% representing annales and the level of security expenditures decreases more slowly (gradual downsizing).

Conclusion and Next steps

3.31 The model developed in this policy note suggests that the pace of demobilization will depend on (i) the fiscal space created by the Government to expand overall public spendingand on efforts made to increase the efficiency of government spending; (ii) its capacity to switch from unproductive to productive spending; and (iii) the capacity of the private sector to absorb ex-combatants. The simulations presented above show that the optimal pace of demobilization is highly sensitive to the combination of these three factors. If the Government goes too fast, it might increase insecurity. If it goes too slow, it will reduce the rate of economic growth and delay private sector expansion.

30 It is worth noting that one can argue that this result is mainly driven by our assumption of the high sensitivity of private investment to macro/micro insecurity.

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3.32 The Government can play an active role in improving conditions for a fast but controlled demobilization process. Below are a series to recommendations aimed at promoting efficient reallocations of expenditures, improving fiscal space, increasing the efficiency of public spending and increasing the absorptive capacity of the private sector.

Reallocation of public expenditures

3.33 It is critical that budget savings due to demobilization are efficiently allocated to key public economic infrastructure, which would impact private sector growth. In the process of demobilization, the government can design supplementary pro-growth policies includingcomplementary safety nets, friendlier labor legislation, and rural infrastructure development policy.

Creating Fiscal space

3.34 The more the government can spend, the higher aggregate demand will be in the short run. A substantial level of government expenditures is also needed to improve the delivery of social and infrastructure services, which remain extremely deficient in Burundi, but affect economic growth in the long run. However, the question is how these expenditures should be financed without endangering fiscal and macroeconomic sustainability. There is no doubt that the government will need to create additional fiscal space through (i) improving domestic revenue collection (to a limited extent) without affecting private sector incentives, and (ii) mobilizing additional donor support, thanks to improved governance.

Improving the efficiency of public spending

3.35 There are several ways to improve the efficiency of public expenditures but a high priority is given to improving procurement procedures. A recent preliminary report by an independent consultant31 commissioned by the Netherlands Embassy in Burundi suggests that reforms of the government procurement processes could yield significant publics savings. In particular, the transformation of government-wide procurement practices (over a two year period) could lead to savings of close to 35 percent. Such savings could of course be reallocated to priority sectors to support the objective of alleviating poverty and reaching the MDGs. These efficiency savings are attractive in that they do not come from reducing expenditures (which can be costly politically), but from improvements in procurement practices, which ensure that funds are spent more efficiently. The report gives a set of recommendations. While some of these recommendations can be considered ‘quick-wins’ – yielding fiscal gains in the short-run, others will only create fiscal space in the longer run, and/or may even be initially costly. The possibilities for procurement reform are:

i. Leveraging Bargaining Power Effectively: The National Directorate for the Control of National Procurement (DNCMP) is central to the process of procurement (DNCMP approval for ministry demands is required at several stages). But there is an endemic lack of coordination across ministries (and functions) – which all act non-cooperatively, with very little communication between functions and departments. There are potentially large efficiency gains from coordination. If the ministries worked together, the government

31 PwC (2011) “Review of Government Procurement in Burundi in Support of the PER”.

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could sometimes act as a single buyer ('monopsony') and use its market power to pay a lower price. A possible solution is to establish an additional centralized procurement body (a Procurement Delivery Unit) within the Ministry in charge of Finance to coordinate the activities of individual cells and provide support, advice and training. The report suggests that the DCNMP is itself resource heavy. It should therefore be possible to shift some of its resources toward the proposed centralized procurement body. Cost savings could also be achieved by aggregating demand for government vehicles across Ministries. A government-wide pool car system is also a possibility.

ii. Improvements in Dealing with Suppliers: In some areas, current tendering practices are viewed as anti-competitive. The fact that suppliers have to pay for tendering documentation may put off small suppliers and favor larger bidders. In addition, successful bidders are required to pay a “performance bond” (due to risk of underperformance), typically around 10 percent of the contract. This is a barrier to entry for many local firms. On the other hand, a list of ‘trusted’ suppliers could reduce transaction costs and lead to significant efficiency gains.

iii. Private Sector Development: Ministries are often unable to pay local suppliers for long periods due to budgetary constraints. Good planning and timely execution of public expenditures should limit the build-up of arrears. The procurement report suggests that the role of government in the economic development of Burundi should be factored in when considering procurement activities.

Box 4: Netherlands Procurement Improvement Report: Summary of Recommendations

Promoting Private Sector Development

3.36 The demobilization process and its impact on PSD will be strengthened by structural reforms including the promotion of a private sector led growth. This mutual dependence suggests that to achieve its objectives, the government must implement effectively a well-defined strategy in these two areas. The first policy note highlights the main constraints to private sector led growth: low agricultural productivity; poor physical infrastructure; political instability and

Beyond the three themes of bargaining power, relationships with suppliers and private sector development, the report highlights several other possible areas for reform. Some of these are:

The time horizon of procurement plans should be extended – from 1 year to perhaps 3 years. This would facilitate longer term planning (but would not yield obvious savings in the short run).Burundi’s procurement operations are focused on purchasing operations; they lack other key elements of an overall procurement system (e.g., developing implementation plans, re-evaluating supplier performance). Approaching the procurement cycle more broadly is key to long-term effectiveness (but again, there is little scope for short-term efficiency gains through these measures).More transparency is needed with respect to the application of the Presidential Decree of 2010. It is not clear which volume of procurement goes through that route and whether the Decree is used as a channel for corruption.A great deal of information is available within the DNCMP and other procurement units, which is not well utilized – the information should be re-formatted and used (e.g., information on most frequently used suppliers and total spending by supplier).

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the threat of violence; poor governance; and a lack of economic integration. Addressing these constraints with a sense of urgency is crucial to PSD and to the success of the demobilizationprocess. However, the demobilization process could also affect PSD if insecurity is triggered by demobilization under poor private sector performance.

3.37 Agriculture value per worker (a measure of agriculture productivity) remains very low compared to other EAC countries. Whilst agricultural productivity averaged US$230 for EAC countries in 2000-07, it was only US$82 in Burundi. Agriculture has suffered from under-investment during and following the years of civil conflict, a situation that will quickly change if security continues to be restored. Beyond this, farmers lack incentives to introduce modern inputs, production is hampered by poor physical infrastructure (e.g. feeder roads) and agricultural markets are heavily distorted by government intervention. These problems are exacerbated by a lack of export diversification and high demographic pressures (2.8 percent population growth in 2009) on land use.

3.38 Infrastructure development is poor in Burundi and throughout EAC countries. Electricity provision in particular is dismal: modern electricity is available only to 2 percent of households, and Bujumbura accounts for two thirds of all connections. Per capita production of electricity is the lowest in the world. The lack of access to electricity is an important barrier to PSD. Similar problems are due to road infrastructure in rural areas where there is a great need for adequate access to all-season roads.

3.39 Poor governance is also an issue as evidenced by the recent Corruption Perception Index of Transparency International, in which Burundi is ranked 168th amongst 180 countries. In 2007, Burundi’s ranking was more favorable, at 131st. Other survey-based measures of governance indicate that Burundi performs poorly relative to other EAC countries. Burundi’s score on governance related CPIA sub-indicator is the main reason for its weak policy performance (as measured by the CPIA) (Table 4). Poor governance is a constraint to both investment (domestic and foreign) and effective government spending.

3.40 In the context of PSD, an opportunity for Burundi is to use greater economic integration in the EAC as a driver of growth. Membership in the EAC may yield gains from trade as well as from larger regional FDI, improved access to regional public infrastructure (crucial in light of Burundi’s landlocked position) and improved security. Each of these aspects of integration helpstackle growth constraints. FDI in particular can help Burundi gradually diversify its exports, while access to regional infrastructure will reduce costs of market transactions for both firms and households.

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ANNEX 1: A Theoretical Framework of an optimal downsizing strategy of the securitysector

The key relationships of the above model are the following:

1. Government Budget Constraint

GNA + wLA = T + A, (1)

where GNA is expenditure other than army wage bill, wLA is the army (or more generally, the security sector) wage bill, T represents tax and non-tax revenue while A represents foreign aid (the former depending on GDP while the latter taken to be exogenous). G and T further are decomposed as follows:

GNA = GPP +Gother, (2)

where GPP and Gother denote pro-poor, growth-enhancing expenditure and other current and capital expenditure (the latter including capital expenditure for security sector), respectively;32

T= t0 Y+ T0, (3)

where t0 and T0 denote income tax rate and lump-sum tax, respectively. Therefore, total government expenditure, G, is summarized as follows:

G = GNA + wLA (4)= GPP +Gother+ wLA (4a)

= GPP +GC, (4b)

where GC is current and capital expenditure not related with pro-poor and growth-enhancing spending. The basic assumption here is that for a given amount of foreign aid and non-army wage bill expenditure, a post-conflict economy can only increase pro-poor and growth-enhancing expenditure by either reducing the army wage bill or raising taxes, which does not dampeneconomic growth.33 Burundi’s total government wage bill accounts for about 8.5 percent of GDP while the security sector wage bill represents about 2.7 percent of GDP.

2. Demobilization/downsizing rate of the security sector

A rate of demobilization/downsizing is assumed such that:

LA,t = (1 - A,0 (5)

32 We recognize that the distinction between "pro-poor" and "other" current and capital expenditure is not the most appropriate to capture the possibility that investment in infrastructure may stimulate private investment. In this model, our aim was mainly to explain the rate of downsizing, which is among current security spending.33 In principle, higher taxes should lower disposable income and reduce consumption, which would reduce aggregate demand. But in a growth context the supply-side effects of higher spending may lead to an increase in gross income that mitigates and possibly offsets the increase in taxes.

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considered, to balance the government’s priorities.

3. Unemployment rates

Two relationships represent the unemployment rates of former security sector personnel (uA) and of civilians (uC):

uA(Y(IPRS,…), ), uA,Y < 0, uA, > 0, uA, Y < 0. (6)uC = uC(Y(IPRS,…)), uC,Y < 0.(7)

Equation (6) posits that unemployment (of former army soldiers) is increasing in the rate of demobilization/downsizing but falling in GDP (as IPRS, private sector investment, increases). Private investment is assumed to raise activity, which in turn serves to absorb former army officers. Crucially, the impact of the demobilization/downsizing rate on the unemployment rate is falling in GDP (due to its impact on IPRS)– the intuition being that in times when the private sector is developing rapidly, demobilized/downsized soldiers find jobs easily when they return to civilian life. Meanwhile, Equation (7) argues that the unemployment rate of civilians simply depends negatively on GDP and not on the demobilization/downsizing rate.

4. Macro and micro insecurity links

A function for micro and macro insecurity is assumed as follows:

p = p(LA, uA, uC, , ), pL<0, pu > 0, puu>0, p > 0, p > 0, (8)

denote efficiency index in procurement in security sector and the degree of integration of security forces in the country (that is the extent to which security forces are not isolated in the country, there is no elite forces treated discriminatorily) and p is the probability of insecurity. The probability of insecurity is increasing in the unemployment rate of former army officers and civilians, and at an increasing rate. Insecurity is more feasible (we extend Collier’s argument that it is a crucial determinant of prevalence of civil war) where there are many unemployed former army officers more susceptible to recruitment by rebel factions.

5. A measure of private sector development: Private investment relation

A function for private investment is assumed:

IPRS = IPRS(KPP, p(LA, uA, uC ), XD), IK > 0, Ip < 0, IXD> 0, (9)

where KPP = (1- PP,t-1 + GPP and 0< <1 is an efficiency parameter and XD denotes regional demand. The efficiency parameter captures the share of pro-poor, growth enhancing expenditure that effectively goes into pro-poor capital stocks. Private sector investment increases with higher pro-poor, growth enhancing capital stock, which captures complementary effect, lower probability of insecurity and higher external demand.

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6. The optimal problem of the government

Finally, the problem of the government (or donor) is to choose the optimal pace of demobilization/security sector downsizing that maximizes its utility function subject to its budget constraint:

max UGOV = Y – C(Y0, I0) s.t. GPP + GC = T + A (10)

where C can be considered to be the net present value of the total cost to government of insecurity. The cost is a function of loss of output, Y0 , and investment, I0 , due to insecurity, defined as difference between observed and potential output and investment without any insecurity, Y* and I*:

Y0 = Y- Y*, (10a)

I0 = I- I*. (10b)

Cost is assumed to increase as loss of output and investment:

C y0 > 0, C I0 > 0. (10c)

GDP can be decomposed as sum of YGOV and YPRS, i.e., output in government and private sector, respectively. YGOV and YPRS are assumed to be decomposed as follows:3435

YGOV C + (1- PP, (11)

YPRS GOV + (1- PRS, (12)

where KPRS -over effect from government sector.

Capital stock in private sector accumulates as follows:

KPRS = (1- ) KPRS, t-1 + IPRS, (13)

depreciation rate.

The expression can be reformulated as the unconstrained maximization problem, with LA, IPRS and uAdecision variable:

34 We recognize that there are relative price problems in equations 11-12 as well as in the definition of total GDP. Actually, it is assumed that the same good is used for consumption and investment, public and private, then the relative price problem is at the level of the definition of total GDP only, which should be in principle: P Y = PGOVYGOV + PPRSYPRS, where P is the GDP deflator. 35 Production function for private sector does not explicitly depend on labor for modeling short-cut. However, private sector output and labor are implicitly related through unemployment rates.

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max UGOV = YGOV GOV + (1- KPRS}- C(Y0, I0)

= C + (1- PP}+ (1- - PRS, t-1 + IPRS}- C(Y0, I0)

= (1+ ) { GC + (1- )( T + A - GC)}+ (1- ){(1- ) KPRS, t-1 + IPRS}- C(Y0, I0)

= (1+ ) { (2 -1)GC + (1- )( T + A )}+ (1- ){(1- ) KPRS, t-1 + IPRS}- C(Y0, I0)= (1+ ) { (2 -1)(Gother + wLA( )) + (1- )( t0 Y + T0 + A )}+ (1- ){(1- ) KPRS,

t-1 + IPRS}- C(Y0, I0)

= (1+ )(2 -1)wLA( ) + (1+ )(1- ) t0 Y+ (1- )IPRS(p(LA( ), uA( ), uC(Y))) -C(Y0, I0)

+ Const (14)

where Const -1)Gother - 0 + A) + (1- - PRS, t-1, which collects terms independent from the rate of demobilization/downsizing.

7. The solution of the model

The appropriate first order c

(1+ )(2 -1) wLA,0 = {(1- (1- C y0 Y0,Y) - C I0 I0,I}IPRS,p(puAuA, ( ) - pLLA,0) (15)

where the left-hand side is the marginal benefit of demobilizing/downsizing; the right-hand side is the marginal cost in terms of a greater probability of insecurity. The first order condition

A,0(+),C Y0(-), C I0(-), IPRS,p(-), pL(+), puA(-), u (-)) (16)

The last term is of interest – the optimal rate of demobilization/downsizing is lower where there is a greater impact of demobilization/downsizing on unemployment (because the subsequent unemployment increases the risk of a return to civil war). Because, as assumed in this model, the impact of demobilization/downsizing on unemployment is attenuated when the response of the private sector investment is strong, the simple prediction of this model is that the optimal rate of demobilization should be greater when the marginal impact of the probability of insecurity on private investment is high. More generally, the key links proposed in this model suggest that the rate of demobilization/downsizing is not constant, but rather reflects the evolution of the private sector. If the key building blocks of this simple model are correct, the implication is that in years where the private sector is booming, the demobilization/downsizing rate should increase as a result – because the possible negative impacts of demobilization/downsizing are unlikely to materialize.

It should also be noted that if aid flows (or tax revenues) decrease (as is expected in Burundi) in this model, the optimal response by the government is to increase the rate of demobilization/downsizing, since ceteris paribus, the marginal return to pro-poor and growth-enhancing expenditures has increased – there is an even greater need to demobilize/downsize quickly to free up resources to direct toward pro-poor activities. This could have the undesired

57

consequences already mentioned earlier if the private sector investment remains weak to create jobs.

8. An extension of the basic theoretical model

The basic model presented above yields a general principle – the optimum rate of demobilization should not be constant. Demobilization/downsizing should be done more rapidly when the private sector is performing strongly and ex-combatants/soldiers are being absorbed into productive work. And whether the private sector is performing strongly or not depends itself on the rate of demobilization; affects P, which in turn affects investment and output.Demobilization/downsizing should slow down if private sector growth remains sluggish - the fiscal gains of rapid demobilization would be outweighed by the instability resulting from an increase in unemployment. The simplest rule would be to have a constant rate of demobilization in order to reach a given target within a specified time period. Could this approach be optimal? A reasonable extension to the model suggests it might be. So far the process of demobilization has been assumed to be costless. This is clearly not the case. Dropping this assumption changes the government budget constraint:

GNA + wLA + B( LA) = T + A (17)LA) is the cost associated with a given rate of demobilization/downsizing, and B > 0.

The optimization problem becomes:

max UGOV -1)wLA - 0 Y– A))+ (1- )IPRS(p(LA( ), uA( ), uC(Y)) }- C(Y0, I0)+ Const (18)

with the new first order condition being:

-1)wLA,0 = {(1- I0}IPRS,p uA - pL A,0) (19)-

There is an additional cost to demobilizing/downsizing – - on the right-hand side. Other things equal, this means that a lower rate of demobilization/downsizing is optimal. Further results require additional assumptions on the functional form of B. If B is linear

-up demobilization centers), B is a constant and it will remain optimal to change the rate of demobilization according to the evolution of the private sector. If B is convex, then B > 0 and there is a preference in the model for demobilization smoothing. To the extent that the operational costs of demobilizing are convex, the optimal rate is closer to being a constant rate of demobilization. Perhaps more true to reality, B could be interpreted as the political difficulty associated with a given rate of demobilization – it may be that politicians are more comfortable with a steady rate of demobilization, which they know will achieve specific year-by-year targets, even though it may come at the expense of efficiency.

58

ANNEX 2: Conceptual Framework of the Burundi MACMOD Model

Table 2A: Projection of productive development sectors (GDP resources), summary of elasticities

ELASTICITIES GDP RESOURCES

Hum

an c

apita

l

Priv

ate

capi

tal

Capi

tal

infr

astr

uctu

re

Expo

rt P

rice

Rela

tive

impo

rt

pric

e

Reve

nue

Curr

ent

expe

nditu

res

(Bud

get)

Capi

tal

expe

nditu

res

(Bud

get)

Agric

ultu

re

Com

mer

ce a

nd

Indu

stry

Tran

spor

t, Pu

blic

w

orks

and

Eq

uipm

ent

Ener

gy a

nd m

ines

Tele

com

s

Adm

inis

trat

ive

gove

rnan

ce

Econ

omic

go

vern

ance

Primary sector

- Non-export agriculture 0.6 0.3 0.1 0.05 0.2 0.1 0.06

- Export Agriculture 0.6 0.15 0.05 0.05 0.4 0.1 0.03

- Livestock 0.6 0.1 0.05 0.05 0.25 0.1 0.04

- Forestry 0.6 0.05 0.1 0.05 0.1 0.01

- Fishing 0.6 0.1 0.1 0.05 0.2 0.1 0.055

Secondary sector

- Industry

- Agro-industry 0.8 0.2 0.2 0.1 0.6 0.3 0.1 0.03 0.005

- Food industry 0.6 0.25 0.2 0.1 0.8 0.2 0.01 0.005

- Texti le industry, leather et vannerie 0.3 0.01 0.01 0 0.09 0 0.001

- Other industries 0.6 0.25 0.15 0.1 0.8 0.2 0.005

- Artisanat 0.7 0.1 0.05 0.05 0.1 0.1 0.005

- Construction 0.25 0.2 0.15 0.3 -0.5 0.3 0.25 0.2

- Energy and mines 0.3 0.01 0.2 0.05 0.2 0.07 0.05 0.2

Tertiary sector/services

- Public administration 0.4 0.4 0.3 0.03 0.2 0.07

- Transport and communication 0.35 0.2 0.2 0.3 0.2 0.2 0.05 0.2

- Commerce 0.35 0.2 0.3 0.1 0.2 0.005

- Other private services 0.3 0.2 0.3 0.1 0.2 0.005

GDP at factor costs

Indirect taxes (menus subsidies)

GDP at market price

Short term factors

Past

tren

ds

Long term factors Public Expenditures (MTEF)

Source : INT-DEC, estimation en panel, calibrée en tenant compte des spécificités de l’économie du Burundi

Sectoral growth is a function of past trends, long term factors, short-term factors, and medium term factors:(i) Past trends ;(ii) Long-term factors :

o Human Capital = function (workload, quality of work, which itself depends onthe level of education and health (based on efforts in these areas))

o Private Capital = function (capital stock = initial stock + investment -depreciation)

o Infrastructure = function (infrastructure spending (expenditures obtained from MTEF))

59

(iii) Short-term factors :o Incentives to produce = function (price exports, relative prices and imports,

income (which measures potential markets))o Spending multiplier effects, they are taken into account through the elasticity of

overall government current and capital expenditures: traced in the Government’s Financial Operations Table);

(iv) Medium terms factors :o Medium-term effects that give an interest signal on the sector, facilitations and

incentives, captured through the MTEF, which gives the proportions of public spending, and thus identifies the sectors directly affected.

Investment is modeled as follows:

Private investment growth rate = function (Income, public investment, domestic credit, FDI, Transaction costs and risks, Micro Security, Macro Security)

o Transaction costs and risks = function (Governance legal and Judiciary, Economic and Financial Governance).

The model captures the progress in terms of governance through the efforts of the government to improve the level of governance, as measured by spending on these strategic objectives or missions (MTEF expenditure and elasticities);

o Micro Security = function (security spending; and Judicial and Legal Governance)

The model captures the progress at the micro security level through the efforts of the government to improve the level of security, measured through spending on Homeland Security and the Ministry of Justice (MTEF expenditure and elasticities). These expenditures will improve the security and justice through the size of police forces and technical capacity building (training and means of action) on the one hand, and secondly to improve judicial and legal services (technical, training and number, modernization, increased presence);

o Macro Security = function (unemployment rate (risk of social explosion); level of homogeneity of the military (army attack risks))Unemployment rate is modeled from a function derived from the OKUN’s law

represents the change in the unemployment rate, and g(Y) denotes real GDP growth rate.

In practice, the model takes a point of departure and elasticities to project the unemployment rate, which is then used as a leading indicator of the macro security level;This projection of the unemployment rate shows that what matters is the existence of the employment created with GDP growth, regardless of whether generated by the public or the private sector. In general, what matters for the security risk is more whether the people are employed; whether they are employed in the security sector or the non-security sector is not very important. For the case of a country like Burundi, where the weight of the private sector remains low, it would not be very relevant to distinguish private sector and government jobs.

o FDI is also affected by both micro security and macro security.

60

Table 2B: GDP projection jobs, summary of elasticities

Past

tren

ds

Rev

enue

Publ

ic in

vest

men

t

Dom

estic

cre

dit

Fore

ign

inve

stm

ents

Stre

ngth

enin

g of

Ju

dici

airy

gov

erna

nce

and

inte

rnal

sec

urity

(m

icro

-sec

urity

)

Stre

ngth

enin

g of

na

tiona

l def

ense

(M

acro

-sec

urity

)

Une

mpl

oym

ent r

ate

(mac

ro-s

ecur

ity)

GDP at market priceImports of goods and nonfinancial services 0.80 0.20Total of resourcesExports of goods and nonfinancial services 0.80Gross investments - Public investment 1.00 - Private Investment 0.05 0.50 0.15 0.20 0.30 0.03 0.02 -0.02 - Variation of stockFinal consumption - Public consumption 1.00 - Private/household consumptionTotal of uses

Source: INT-DEC, panel estimation, calibrated taking into account Burundi’s economy characteristics.

a) Tracking Model:Maintaining the overall level of spending, while allowing changes in spending patternsScenario 1: Increased security cost is compensated by a proportional reduction in public

spending toward social and productive sectors. Multiplier effect: the overall level of expenditure does not change and there is no changein the multiplier effects.Effect on growth:

o Increased security spending (or improved level of security) leads to higher private investment (higher private capital) and to stronger growth.

o Reduction in spending toward productive sectors lead to a decline in the growth of productive sectors, leading to a decline in the overall growth.

Growth of the economy will be the result of two conflicting effects.

Scenario 2: Decreased security cost is compensated by a proportional increase in public spending toward social and productive sectors.

Multiplier effect: the overall level of expenditure does not change and there is no change in the multiplier effects.Effect on growth:

o Reduction in security spending (or decreased level of security), causing a decline in private investment, leads to loss of private capital and lower growth.

o Increased productive expenditure, thus stronger growth of the productive sectors, leads to robust overall growth.

Growth of the economy will be the result of two conflicting effects.

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ANNEX 3: Downsizing profiles

Table 3A: Security sector alternative downsizing profile2012 2013 2014 2015 2016 2017 2018 2019 2020 Average

In million of FbuBusiness as usual scenario ( No change; only annales considered)

Army 49162.1 51128.5 53173.7 55300.6 57512.7 59813.2 62205.7 64693.9 67281.7 57808.0Police 32084.7 33368.1 34702.8 36090.9 37534.5 39035.9 40597.3 42221.2 43910.1 37727.3

Accelerated downsizing scenario (Arusha targets reached in 2015)Army 49162.1 49160.1 49153.0 49145.9 51111.8 53156.2 55282.5 57493.8 59793.5 52606.6Police 32084.7 32111.4 32138.2 32165.0 33451.6 34789.6 36181.2 37628.5 39133.6 34409.3

Gradual/moderate downsizing pace scenario (Arusha targets reached in 2020)Army 49162.1 50975.2 52590.1 53873.2 55131.7 56304.9 57444.5 58607.2 59793.4 54875.8Police 32084.7 33334.7 34598.7 35766.8 36565.1 37343.2 38060.2 38593.0 39133.3 36164.4

SizeBusiness as usual scenario ( No change; only annales considered)

Army 28131 28131 28131 28131 28131 28131 28131 28131 28131 28131Police 16831 16831 16831 16831 16831 16831 16831 16831 16831 16831

Accelerated downsizing scenario (Arusha targets reached in 2015)Army 28131 27048 26004 25000 25000 25000 25000 25000 25000 25687Police 16831 16197 15587 15000 15000 15000 15000 15000 15000 15402

Gradual/moderate downsizing pace scenario (Arusha targets reached in 2020)Army 28131 28047 27822 27405 26966 26481 25978 25484 25000 26813Police 16831 16814 16781 16680 16396 16101 15779 15385 15000 16196Source: Burundian authorities; IMF; Own calculations.

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References

1. Collier, P. (1994) “Demobilization and insecurity: A study in the economics of the transition from war to peace”, Journal of International Development, 6(3):343-351.2. Davalos, M. & McLeod, D. (2008) “Postconflict employment creation for stabilization and poverty reduction”, available here:

http://www.fordham.edu/economics/mcleod/PostConflictEmployment10.pdf

3. Dabla-Era, Jim Brumby, Annette Kyobe, Zac Mills, and Chris Papageorgiou, "Investing in Public Investment: An Index of Public Investment Efficiency," Working Paper No.11/37, International Monetary Fund (February 2011).4. Gilligan, M., Mvukiyehe, E. & Samii, C. (2010) “Reintegrating rebels into civilian life: quasi-experimental evidence from Burundi”, Typescript, Columbia University and New York University.5. Nganou, J. P. & E. Kebede (2010) “Economic Development in the Post-Conflict Burundi: From Destruction to Production”, World Bank Draft Working Paper.6. Weinstein, J. M. & K. Imai (2000) “Measuring the Economic Impact of Civil War”, mimeo, Harvard University.