Document of

The World Bank

FOR OFFICIAL USE ONLY

0gui. >VbF/-7v'

Report No. P-4449-TUN

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED LOAN

IN AN AMOUNT EQUIVALENT TO US01500 MILLION

TO

THE REPUBLIC OF TUNISIA

FOR AN

INDUSTRIAL AND TRADE POLICY ADJUSTMENT LOAN

January 28, 1987

fT'his document has a restricted distribution and may bE used by recipients only in the performance ofXthieir official duties. Its conlents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTSCurrency Unit - Tunisian Dinar (TD)

CY1985 Ten Months CY1986

US$1.00 = TD 0.757 US$1.00 = TD 0.7B1TD 1.00 = US$1.321 TD 1.00 = US$1.281

FISCAL YEARJanuary 1 to December 31

GLOSSARY OF ABBREVIATIONS

AFI : Industrial Land Agency(Agence Fonciere IndustrielLe)

API Industrial Investment Promotion Agency(Agence de Promotion des Investissements)

APIA : Agricultural Investment Promotion Agency(Agence de Promotion des Investissements Agricoles)

ASAL : Agricultural Sector Adjustment LoanBCT : Central Bank

(Banque Centrale de Tunisie)BDET : Economic Development Bank of Tunisia

(Banque de D6veloppement Economique de Tunisie)BNDT : National Bank for Tourism Development

(Banque Nationale pour le D6veloppement du Tourisme)BTKD : Tunisian-Kuwaiti Development Bank

(Banque Tuniso-Koweitienae de D6veloppement)CFF : Compensatory Financing of Export Fluctuations schemeCEPEX : Export Promotion Center

(Centre de Promotion des Exportations)CNEI : National Industrial Studies Center

(Centre National d'Etudes Industrielles)CNSS : National Social Security Fund

(Caisse Nationale de Securite Sociale)COTUNACE : Tunisian Export Credit Insurance Company

(Compagnie Tunisienne d'Assurance du Cr6dit a l'Exportation)CPI : Consumer Price IndexEMI : Electrical and Mechanical IndustriesFPC : Exchange Equalization Fund

(Fonds de Perequation des Changes)ICB : International Competitive BiddingMITAP : Medium-Term Industrial and Trade Policy Adjustment ProgramOCT : Tunisian Trading Office

(Office du Commerce de Tunisie)SME : Small and Medium EnterprisesSOE : Statement of ExpendituresSSI : Small-Scale IndustriesSTUSID : Tunisian-Saudi Company for Investments and Development

(Socit&6 Tuniso-Seoudienne d'Investissements et de Dnveloppement)TFD : Customs Formalities Tax

(Taxe sur la Formalit4 Douaniere)UTICA : Tunisian Association of Industry, Commerce and Handicrafts

(Union Tunisienne de l'Industrie, du Commerce et de l'Artisanat)VAT : Value-Added Tax

FOR oMcwL us ONLY

REPUBUC OF TUNSLIA

INDUSTRIAL AND TRADE POUICY ADJUSTMENT LOAN

Loan Suaary

Dorrower: The Republic of Tunisia.

Amount: US$150.0 million equivalent.

Terms: 17 years, including 4 years of grace, at thestandard variable interest rate.

Loan Description: The proposed Loan would support the firstphase of implementation of the Government'sprogram of industrial and trade policyreforms, within the framework of a generalmacro-economic restructuring program. TheGovernment's macro-economic restructuringprogram is focusing on measures to limitgrowth of domestic demand (wage and salary,budget and monetary policies), to stimulategrowth of non-traditional exports (exchangerate policies, export promotion), and toimprove the allocation and use of scarceeconomic resources (interest rateliberalization, gradual liberalization ofdomestic prices, investments and imports);it should also result in a more rapidcreation of new employment and reducedunderemployment. The principal actionsunder the medium-term industrial and tradepolicy adjustment program (MITAP) supportthe macro-economic restructuring programthrough: (i) a reform of the investmentcode, liberalizing investment entirelyexcept when incentives are asked for; (ii)a rationalization of policies on exchangerate coverage of foreign borrowings by banksand of central bank supervision of thefinancial sector; (iii) studies of thesocial security system, of the labor codeand of productivity standards with a view topromote employment; (iv) a reform ofinstitutions dealing with the industrial andtrade sector; (v) a follow-through ofexport promotion actions; and (vi) theinitiation of a tourism policy study withthe view to optimize the sector's capacityin economic and financial terms. Theforeign exchange provided by the Loan would

This document has a restricted distribudon and may be used by recipients only in the performance |of their official duts. Its contents may not otherwise be disclosed without World Bank authorization.

be used to finance general imports based ona negative list and technical assistance forthe study of productivity standards referredto i (iii) above.

Benefits and Risks: The reforms supported by the proposed Loanare expected to create a more favorableenvironment for overall economic andsectoral growth at a time of resourceconstraints. In particular, changes in theoverall incentives framework, investmentcode, reform of institutions supporting thesector and export promotion actions areexpected to make manufacturing a moreefficient producer of export products andimport substitutes. Risks relate to thelength and difficulty of the process,possible social and political pressures,unpredictable developments in the externalenvironment and uncertainties in theresponse of the private sector. These risksare limited by the Government's strongcommitment to the objectives of themacro-economic and sector adjustmentprograms, as evidenced inter alia by theactions already taken, and by the inherentflexibility of the phased medium-termapproach.

Estimated Disbursements: The proceeds of the Loan would be disbursedin two tranches: US$100.0 millionequivalent after effectiveness; and US$50.0million equivalent after implementation ofspecific actions, including an overallreview of the implementation of themacro-economic and sectoral reform programs.

Appraisal Report: This is a combined President's and StaffAppraisal Report.

Map: No. IBRD 18707 of December 1984 (Tunisia -

General Features).

Table ot Contents

Part I - THE ECONOMY ................................................ I

Part II - THE GOVERNMENT'S ECONOMIC ADJUSTMENT PROGRAM .............. 4

A. Structural Problems and the Needfor Structural Change .................................... 4

B. Recent Policy Measures Taken By the Government ............. 6C. The Short- and Medium-Term Adjustment Program .............. 8D. Medium-Term Projections ................................... 13E. Social Impact of the Adjustment Program .................... 17

Part III - BANK GROUP OPERATIONS IN TUNISIA .........................a 19

PMAT IV - THE MEDIUM-TERM INDUSTRIAL AND TRADE POLICY ADJUSTMENTPROGRAM ................................ * o . ...........****. 21

A. The Need for Adjustment ...... .... .......................... 21B. The Medium-Term Industrial and Trade Policy Adjustment

Program .. ....................... 231. The Incentives Framework ........ ..................... 242. Government Support and Regulatory Institutions ........ 293. Export Promotion ............................... 324. Money and Credit ............................. ...... 335. Taxation ................................... 366. Industrial Employment .... ............................. 387. Tourism Policy Study .................................. 39

Part V - THE LOAN ........................................... 41

A. Origin and Objectives ....................... . . . 41B. Action Program Under the Loan . .......................... 42C. Loan Aduinistration . .... 45D. Management, Coordination and Monitoring . . . 48E. Justification and Risk ..................................... 48

Part VI - RECOMMENDATION ........ 50

AE=

Annex I . ...... Country DataAnnex II . . ..... Status of Bank OperationsAnnex III . ...... Supplementary Project Data SheetAnnex IV . ............. Letter of Economic Development PolicyAnnex V .. ....... Letter on Industrial Development Policy

MAP

This report is based on the findings of an appraisal mission which sojournedin Tunisia in October 1986, comprised of Messrs. H. Bachsann (Mission Chief);E. Savaya (Deputy Mission Chief); B. de Vuyst; H. Dinh; A. Edwards(Consultant); J. Kientz (Consultant); and J. Lienert (Consultant).

[ITERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

REPORT AND RECOMMEDATION OF THE OF THE BRDTO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN

TO THE REPUBLIC OF TUNISIAFOR AN INDUSTRIAL AND TRADE POLICY ADJTSTMENT LON

1. I submit the following report and recomendation on a proposed loanfor the equivalent of US$150 million to the Republic of Tunisia. It wouldhelp to finance an industrial and trade policy adjustment program within theframework of a general macro-economic restructuring effort. The loan wouldhave a term of 17 years, including 4 years of grace, at the standard variableinterest rate.

PART I - THE ECONOMY

2. An economic report entitled "Tunisia - Country Economic Memorandum:Mid-term Review of the Sixth Development Plan (1982-86)", in two volumes(No. 5328-TUN), was distributed to the Executive Directors in October 1985.An economic mission to review the macro-economic framework of the VIIth Plan(1987-91) visited Tunisia in January 1986; its findings, as well as thoseobtained at the time of appraisal of the proposed Loan in October 1986, and byan IMF Article IV consultation mission in July 1986, are reflected in thispart and the country data attached in Annex I.

3. Tunisia is a medium-sized, middle-income country, with a populationof 7.4 million, and a per capita income of about US$1,200.-" Much ofTunisia is arid or semi-arid. Only 3% of arable land is irrigated, and areaswhere rain-fed agriculture is possible are subject to severe year-to-yearfluctuations in rainfall. Nevertheless, agriculture still occupies nearly oneout of every three Tunisians in the labor force. Tunisia's most important rawmaterials are phosphates, petroleum and natural gas. Known exploitablereserves of oil and gas are approaching depletion, and the limited newreserves require costly off-shore drilling. Barring large new oil and gasdiscoveries, and given the rise in domestic energy demand, Tunisia is expectedto turn into a net oil importer in the early 1990s. The low quality ofphosphate deposits constrains the expansion of the highly efficient Tunisianphosphate processing industry. The country also has considerable tourismpotential.

4. Tunisia has undertaken a massive effort to develop its humanresources, paying special attention to family welfare, education, and technicaland vocational training. As a result, between the early 1960s and the early1980s, the infant mortality rate declined from almost 160 to 79, lifeexpectancy at birth rose from 48 to 62 years, the adult literacy rate

1986 preliminary at current prices and 1986 average exchange rate.

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increased from about 151 to about 621, and average caloric intake per capitaincreased from 951 to 121% of minimum standard requiremmnts. An active familyplanning policy pursued by the Government led to a decrease in fertility andbirth rates. Even though mortality rates also decreased, the grossreproduction rate decreased markedly from 3.5% to 2.41 over the same period.However, mince net emigration of Tunisians abroad was sharply reduced byrestrictive measures taken in the EEC countries and Libya, the growth rate oEthe labor force accelerated, a main reason for the rapidly growing, seriousunemployment problem. Open unemployment reached 141 in 1983 and under-employment is extensive. These problems are particularly serious among youngschool dropouts.

5. Recget Econoic Developments. During the 1970s, the Tunisian economydid well. Rapid growth in the range of 7-8% was accompanied by substantialstructural transformation as manufacturing and tourism became more importantand their share in total exports increased. Economic performance benefitedfrom substantial terms of trade gains due to the rapid price increase of oil,allowing both consumption and domestic savings to increase and investment toremain high (over 30% of GDP). It also benefited from improved economicmanagement with a cautious shift toward a more liberal, market-orientedeconomy. The inflation rate remained modest, averaging 6.11 over the decade.The balance of payments current account deficit, averaging 5% to 6% of GDPover the period, was easily financed, much of it by direct foreign investment,and the debt service ratio was a low 10.71 in 1979. The only major problemwas a persistently high rate of unemployment/underemployment.

6. The VIth Plan (1982-86) proposed a number of policy reforms to facethe consequence of rising unemployment and the progressive decline in netenergy exports. Its sain objectives were employment generation, exportpromotion, regional development and public sector efficiency. Investmentpriority was given to agriculture, engineering industries and tourism. Theoverall rate of investment was projected to decline during the Plan period.To minimize the effects on economic growth and employment, measures wereproposed to increase the efficiency of existing investments and to encourage ashift to labor-intensive activities. They were to be accompanied by asubstantially tightened income policy, in particular cautious wage and salarypolicies, and a considerable slowdown in the growth of recurrent budgetexpenditures.

7. Economic performance, however, deteriorated during the Plan period.First and foremost, economic growth slowed down considerably, with the annualGDO growth rate averaging only about 3.71 coWpared to 6.31 targetted. Oilproduction virtually stagnated throughout the period; in 1982 and 1986 seriousdroughts depressed agricultural output and agro-industrial production;production and exports of phosphate rock and phosphate products suffered fromdepressed world market conditions; exports of manufactured goods wereadversely affected by a lower growth of demand in Europe, high domestic pricesand a sizable appreciation of the Tunisian Dinar vis-&-vis the currencies of*st competitor countries as well as the US dollar; tourism suffered from thesae problems as manufacturing industries, and furthermore was affected by theunsettled political situation in neighboring countries, which hit Tunisiantourism particularly hard.

8. Secondly, the Government was slow in adjusting domestic demand to thedecelerated economic growth. In contrast to the Plan's macro-economicobjectives, the investment rate remained high rather than declined, mainly dueto high public enterprise investments in energy and transportation, anddomestic consumption expanded rapidly, fueled by sharp increases in wages andsalaries in 1982 and early 1983. This strong demand pressure, facilitated byrather liberal credit policies, was reflected in rising inflation whichaveraged nearly 10.5% in 1981-84, compared to 8.01 over 1977-St. It alsocontributed substantially towards the marked worsening of the current accountdeficit of the balance of payments, which rose to 111 of GDP in 1984. TheGovernment's overall budget deficit also increased slightly from an average of2.71 of GD? in 1981-82 to 3.21 in 1983-84, excluding debt amortization. Thisreflected increases in recurrent expenditures due to higher wage and salaryoutlays; higher subsidy payments to households and public enterprises; andhigher public investments.

9. The trend observed during 1981-84 clearly could not be sustained.Faced with this deterioration, the Government started to implement a packageof policy measures aimed at stabilizing the economy as described in somedetail in Part II below. These measures together with the imposition ofdrastic foreign exchange and import restrictions, brought the balance ofpayments current account deficit back to about 7Z of GDP in 1985, despitereduced exports of oil, phosphate, and manufactured goods to Libya. Whilethis improved the immediate situation, the underlying disequilibrium was notresolved, and problems usually associated with controls, such as growingshortages of raw materials, semi-finished products and spare parts, appeared.For 1986, the Government expects a current account deficit of the balance ofpayments close to 91 of GDP. Meanwhile, the budget deficit rose to 3.71 ofGDP in 1985 because of a slow growth in revenues, despite a substantialdecline of subsidy payments in real terms. The authorities prepared arestrictive budget for 1986, as discussed below (para. 21).

10. Over recent years, the Government had consulted informally with theIMF on a wide variety of economic and financial issues, but had not asked forfinancial support. Before and during the July 1986 Article IV consultationmission, however, discussions started with the DMF on a possible stand-byagreement cum compensatory financing facility. As a result, on November 4,1986 the IDV Executive Board approved an 18 month stand-by arrangement in anamount equivalent to SDR103.65 million and a purchase of SDR114.71 millionunder the Compenaatory Financing of Export Fluctuations scheme.

11. Social Issues. Since independence, the country has gone a long waytowards meeting the basic needs of its population. Over 161 of GDP is nowdevoted to social programs, and the number of absolute poor declined from 171of total population in 1975 to 12.82 in 1980 (para. 48). This improvement waslargely concentrated, however, in urban areas. Since 1981, social issues havefaced a different context than in the 1970s, when an easy financial situationallowed a relatively unconstrained expansion of social services. On the onehand, the Tunisian population has become increasingly aware of and sensitiveto income distribution issues, and the beneficial effects of past rapidexpansion in social services have created a demand for improved standards insocial services delivery. On the other hand, the provision of adequate socialservices - education, health, urban infrastructure, housing - is beingincreasingly hampered by budgetary constraints. To reduce the financial

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burden of social services, the administration is reviewing the coat structureof the various types of social services, including free or below-costdelivery, the possible Introduction of some user fees, and improved socialinfrastructure management, in particular as regards hospitals. Also,decentralization of social facilities to deprived zones will have to beassessed carefully because the costs of servicing and maintaining them couldbecome prohibitive.

12. To reduce socio-economic differences, in particular between rural andurban areas, and between workers in the modern sector and those precariouslyemployed in informal activities, the Government is channelling more resourcesinto regional development and youth employment. Integrated rural programs arebeing developed to stimulate creation of productive jobs and grassrootsparticipation. Subsidies and credit facilities are granted for youngtechnicians to create their own enterprises and for entrepreneurs to createnew projects in underdeveloped regions. More efforts are needed, however, tostrengthen the coordination of vocational and on-the-job training with marketdenaad and to ensure that rural programs create economically viable andsustainable assets and activities.

13. External Assistance and Foreign Debt. During the second half of the1970s, foreign borrowing was modest and a large share of foreign funds wasprovided by public sources at relatively soft terms. At the end of 1979, debtoutstanding and disbursed was estimated at US$3.0 billion, or 42X of GDP; debtservice was less than 11% of export revenues. For reasons mentioned earlier(para. 8), the balance of payments deficit has increased substantially sincethen, as has foreign indebtedness. Total public foreign debt outstanding anddisbursed reached nearly US$4.4 billion (about 54t of GDP) at the end of 1985aid the debt service ratio rose to 222. However, the Tunisian authoritieshave always followed cautious debt management policies; while the share ofshort-term borrowings has increased slightly since 1980, Tunisia's overallforeign debt remains predominantly long- and medium-term, and debt servicerequirements are projected to increase only slowly. During 198-85, over 601of foreign loan disbursements were from official sources. and nearly 311 onconcessional terms. Nearly 702 of official disbursements came from bilateralsources (mainly Arab oil producing countries, France, Japan, the FederalRepublic of Germany), 201 from the Bank Group, and 101 from other multilateralsources. Overall borrowing terms were favorable, averaging 81 interest and15 years maturity.

14. The balance of payments and foreign debt outlook, including Tunisia'screditworthiness, are assessed in paragraphs 43-46 below.

PART II- THE GOVERNMENT'S ECONODMC ADJUSTIENMT PROGRAM

A. Strutural Problems and the Need forStru Stwi ChaDg

15. The brief description of recent economic trends and present situationas presented above highlights three major problems facing the Tunisian economytoday, one rather immediate, two somewhat longer term. The imsediate problemis the high and persistent deficit of the balance of payments current account,and the consequent rapid increase in the country's foreign debt. As mentionedabove, after a slight improvement in 1985, the decline in oil prices, lowertourism revenues, and lower workers' remittances have put further pressure on

the balance of payments in 1986. While tbhre is no danger of an immediatecrisis, the situation cannot be allowed to continue much longer. The twolonger term, but equally important, problems are the progressive decline innet hydrocarbon exports, requiring the development of other sources of exportrevenues and import substitution (non-traditional exports, tourism,agriculture), as well as the high and growing unemployment and underemploymentrate and the danger of an even worse trend given the high rate of growth ofthe active population, at a time of lower overall economic growth.

16. No single policy instrument can deal successfully with all threeproblem areas; only a carefully balanced and timed package of different policymeasures can do so. Such a comprehensive policy package should be based onthree main considerations:

(a) a return to an export driven growth strategsy, as was pursued quitesuccessfully until 1981, is a key to the success of any futuredevelopment program aiming to achieve satisfactory economic growthand employment creation, given Tunisia's limited domestic marketL1

and the fact that most obvious import substitution industries arealready well developed. With petroleum production ceasing to be amajor engine of export growth, and export possibilities in agriculturelimited by market constraints in the EEC, manufacturing will have tobecome much more export oriented than in the past, when it cateredprimarily to domestic demand fueled by high petroleum revenues. Thisrequires fundamental changes in industrial policies so as to increaseincentives to export. Such changes are also necessary to revitalizeexisting export oriented economic activities, such as tourism, and topromote efficient import substitution in agriculture where Tunisiahas some substantial comparative advantages;

(b) a major improvement in the efficiency of resource use and allocationis required. With the highly profitable production and export ofpetroleum declining progressively, economic resources in Tunisia,domestic as well as foreign and private as well as public, willbecome increasingly scarce. Under these circumstances, the countrycan only achieve a satisfactory rate of overall economic growth andan acceptable level of new employment creation if it uses andallocates these resources with the utmost efficiency. Theliberalization measures covering prices, investments and imports,included in the Government's economic adjustment program, serveprimarily to improve efficiency in the private sector by graduallyintroducing more competition, while proposed changes in budgetpolicies, public investments and public enterprise management wouldimprove efficiency in the public sector; and

(c) last but not least, economic development must become much more laborintensive in order to create more employment in spite of loweroverall economic growth. Future increases in production should beobtained mostly through increasing the number of employed workers andnew investments should serve mostly to create new employment. Thiswould be achieved through a marked change in relative factor costs,making labor less expensive relative to capital. Macro-economic

Less than 101 that of Switzerland or about 51 that of Spain.

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projections indicate that if real salaries had continued toincrease by 4.5-52 per year, as was the case during thu 1970m,and if interest rate. had continued to be largely negative inreal term, not even half as many new jobs would be createdduring the period of the Vllth Plan (1987-91) as necessary toabsorb the rising number of now job seekers. Furthermore,priority must be given to the development of labor-intensivesectors with relatively low investment costs such as seall andmedium enterprises, electrical and mechanical industries, andagriculture. There is in fact, a substantial potential foremployment creation in these sectors.

B. Recent Poicy Measure Taken by the Governnent

17. The Government of Tunisia had recognized the importance of sucheconomic adjustments already during preparation of the VIth Development Plan(1982-86) and a substantial number of concrete policy changes have beenimplemented over the last few years, as detailed in this section, some of thembold and often unpopular. These efforts need to be pursued and expanded overthe coming years, along the lines presented in Section C below.

18. For the last four years, the Government has pursued strict wage andsalary policies. Since January 1983, when wage increases were delinked fromthe cost of living index, no general salary increases have been granted. As aresult, average real salaries have declined by more than 152. This declinehas eliminated the main source of the rapid increase in domestic consumptionexperienced during 1980-83. While the Government raised the minimum salary by102 in July 1986, other salaries were not increased in 1986 and are notplanned to be in 1987.

19. Exchange rate policies have become more flexible since mid-1985,resulting in a gradual downward adjustment of the exchange rate by over 18%vis-a-Yvis a basket of seven currencies between mid-1985 and mid-1986.Together with the formal devaluation of 92 announced in mid-August 1986, thishas reduced by about 272 the nominal exchange rate on a trade weightedaverage, more vis-&-vis the major European currencies (DM, FF), less visa--visthe U.S. dollar. While the real effective exchange rate has depreciatedsomewhat less by an estimated 222, these changes nevertheless made it possibleto more than offset the rise in the value of the Dinar in relation tocompetitor country currencies observed over the last couple of years, and soto improve the competitiveness of Tunisia's non-traditional exports.

20. The Government has also started to use interest rate policies as amore active instrument of economic policy making. For the first time in fouryears, general interest rates were raised by 1-2 points in April 1985 and by3-4 points for the particularly low special rates in the Spring of 1986.Together with the 1.7 point decline in the inflation rate in 1985, itself avery satisfactory achievement (from 8.2 to 6.5%), these nominal interest rateincreases raised real interest rates by 3-5 points; most rates are nowpositive in real terms, in line with the recomuendations of the Bank'sFinancial Sector Report (No. 5263-TUN of December 16, 1985). As agreed withthe IMF, interest rates have been set free on January 1, 1987 on about 751 of

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all londing operations (i.e. all except for export activities, agriculture,small and medium-aized business, and energy savings projects) and on overtwo-thirds of all deposits with co mme rcial banks.

21. Budgetary outlays. As mentioned above (para. 9), 1985 ended with aworse overall budget deficit (3.7% of GDP) in spite of a nearly 10% decline insubsidy outlay. (in real term) am Governmnt revenues from oil and importtaxes stagnated or declined slightly. In 1986, the situation improvedgradually, in spite of a further decline in revenues, refloctinglower oil prices and depressed imports. Through a number of tough masuresintroduced in a revised mid-year budget, the Government reduced total budgetoutlays (net of debt service) by some 8% in real terms as a first stop 1n aprogram of gradually reducing the size of public intervention in the economy.Sales taxes on alcoholic beverages and tobacco were raised; recurrentexpenditures (net of interest payments) hardly increased in real terms, andsubsidies to households and public enterprises as well as development outlays(net of debt amortization) were reduced by 19% in real terms. As a result,the overall deficit is expected to decline to 3.51 of GDP. The substantialreductions in subsidy outlays reflect the Government's policies of graduallyadjusting the prices of goods subsidized by the budget and the tariffs chargedby public enterprises for their services.

22. For several years, agricultural producer prices have gradually beendecontrolled and the ones still controlled (particularly cereals and milk)have been raised more rapidly than inflation. As a result, by end-1985,nearly 75% of domestic agricultural production was sold freely in the domesticmarket and/or exported. As agreed with the Bank under the Agricultural SectorAdjustment Loan (ASAL-Loan No. 2754 of 1986), producer prices will graduallybe aligned with border prices, while in the past they were determined by theestimated cost of production.

23. Investment controls, while not reduced, have been streamlined, andfocused more sharply on new investment priorities. Among others, renewalinvestments and investments in tourism (other than hotels) receive priorityand incentives similar to those of investments in other sectors.

24. Export promotion. A number of measures have been taken to stimulateexports, streamline export procedures, establish export credit and insurance,develop export marketing, and facilitate re-exports, in line witb therecommendations of the Bank's Industrial Policy Mission of January 1985. Theypertain to:

- elimination of export licenses, except for subsidized goods;

- partial elimination of export taxes;

- improvements in the system for reimbursing import duties and taxes,by including the Customs Formalities Tax (TPf) in the reimbursement,by granting reimbursement at the time of customs clearance or evenafter export, and by opening up the possibility of reimbursing theactual exporter (who is not necessarily the importer);

- improved customs arrangements for temporary admission andwarehousing (para. 96);

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increased opportunities for export pre-financing from 101 to 201 ofproject costs;

extending the authorized periods for settling export transactions andrepatriating the proceeds from 90 to 180 days;

expanded opportunities for forward coverage of exchange risks to 6-8months;

liberalizing the use of accounts in convertible currencies andincreasing the amounts that may be taken out of the country forbusiness travel;

introduction of a system of export credit insurance wi-h the firstpolicies issued by the Tunisian Export Credit Insurance Company(COTUNACE) in mid-1985;

establishment of a number of export companies, several of which havealready begun operations;

establishment in 1985 of an export promotion fund to finance avariety of export promotion measures;

establishment of two export promotion committees, one in the CentralBank (BeCT) and the other in the Ministry of Commerce and Industry, todeal with day to day problems at the working level.

C. The Short- and Medium-Term Adjustment Prorm

25. As indicated in paragraph 9 above, the package of policy changesimplemented by the Government over the last few years has shown some positiveresults, particularly concerning private domestic demand and the budgetdeficit; however, its restrictive elements have also created a number ofproblems, such as the lack of essential imports for directly productiveactivities. Over the coning years, two kinds of actions are of vitalimportance: (a) to maintain and strengthen the positive measures alreadytaken; and (b) to complement these measures through changes in other fieldsdestined to reinforce the effectiveness of the program and minimize itsadverse effects. Included in this second group are measures to restructurethe economy through a progressive liberalization ineluding prices, investmentsand imports. This program of macro-economic adjustment peasures is supportedby two policy based loans; one focusing on agricultuine (ASAL, signed October3, 1986), and the other focusing on iadustry and trade (this proposed Loan).It is described below, as well as ir.nthe Government's Letter of EconomicDevelopment Policy (Annex IV). It is' in agreement with the adjustment programpresented by the Tunisian Governmicent to the IMF as a basis for the recentstand-by arrangement and the CFF (para. 10).-

26. Wage and salaty policy. Maintaining cautious wage and salary policiesmay well be the single..most important policy measure to achieve a long-termsustainable balance of payments equilibrium and more rapid employment creation;it can also contribute significantly to achieving a rapid improvement in thepresent balance of payments deficit. Wages and salaries are an important

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determinant of (a) domestic demand and in consequence of import demand;(b) the cost of production of manufactured goods and services, and consequentlyof the competitiveness of Tunisia's manufactured exports and tourism; and(c) relative factor costs and, thus, the labor intensity oE future economicactivities and growth of employment. The Government is determined to maintainthe restrictive wage and salary policies started in 1983 and to limit thegrowth of the total wage bill to that of GDP during 1988-91, while limiting itto less than the increase of the CPI in 1986-87, when only the minimum wage israised. While such measures will slow down the improvement in the standard ofliving of the labor force already employed, they are necessary and adequate tospeed up the creation of new employment and, thus, reduce unemployment andimprove income distribution.

27. Exchange rate policy. An appropriate exchange rate, allowing forcompetitive exports of non-oil/non-phosphate goods and services is a vitalpre-condition for the success of an export-oriented growth strategy in Tunisia.The measures taken since mid-1985 have achieved this goal. The Government hascommitted itself to pursuing a flexible exchange rate policy with theobjective of maintaining the real effective value of the Dinar and ensuringthe international competitiveness of the Tunisian economy. Any adjustments inthe exchange rate will be reflected, among others, in domestic producer pricesfor agricultural products.

28. Regarding interest rates, as a result of measures taken in 1985 andearly 1986, most rates are now positive. Considering that most of these rateswere set free on January 1, 1987, they are expected to remain well above theexpected rate of inflation of about 6.51 p.a. during 1987-91.

29. As mentioned above (para. 21), budget outlays have been cutconsiderably in 1986. In the context of the VIIth Development Plan, theGovernment plans further reductions in the overall budget deficit over thecoming years; in order to achieve its balance of payments and foreign debttargets during the VIIth Plan and beyond (paras. 43-46), the Governmentintends to eliminate the overall budget deficit by 1991 at the latest (seeTable 1). This objective would be achieved largely through cuts inexpenditures, since budgetary revenue is already high (nearly 311 of GDP), andis likely to increase less rapidly than GDP, given declining oil incomes, lowgrowth of imports and the proposed reduction in many customs tariffs (para.35), as well as the tax incentives given for exports and regionaldevelopment. Even given the planned major Government effort to mobilize newsources of revenues (improved collection of direct taxes, full introduction ofthe VAT, introduction of additional sales taxes on luxury goods), a gradualdecline in total budget revenues as a percentage of GDP is virtuallyunavoidable.

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Table 1: OVERALL BUDGET TARGETS

(In percentage of GDP, net of debt amortization)

Average Annual1985 1986 1987 1988 1991 Growth 86-91

Actual Estimates - Projected - In Real Terms

Revenues 31.5 30.9 30.0 29.0 27.0 0.2

Recurrent expenditures 23.9 25.0 24.0 23.0 21.0 -1.3Capital expenditures 11.3 9.4 8.0 7.5 6.0 -2.3

Total Expenditures 35.2 34.4 32.0 30.5 27.0 -1.6

Overall deficit 3.7 3.5 2.0 1.5 -

30. Under these circumstances, gradual achievement of a balanced overallbudget requires substantial reductions of expenditures in real terms as wellas in relation to GDP. These can be achieved without impairing the provisionof appropriate social and economic services by the Government, through carefulsetting of priorities among budgetary outlays. The recommendations of theBank's recent Public Expenditure mission will be providing an important inputinto this task. For recurrent expenditures, it ran be achieved primarilythrough two measures: (a) a considerable slow-down in the growth of salaryoutlays as the hiring of civil servants will be limited to a maximum of 21p.a., and salary increases will be as limited as in the private sector; and(b) a systematic reduction in subsidies of 51 p.a. in nominal terms.Achievement of the latter objective will be aided by the public enterprisereform that the Government started in 1985 and plans to pursue more vigorouslyover the coming years; this reform aims at reducing the number of publicenterprises and decreasing the deficits of the ones that will remain in thepublic sector. In addition, the Government is in the process of devising newpolicies to focus consumer subsidies more strongly on the really needy and todo away with the present across-the-board subsidization of the entirepopulation (para. 49). For capital expenditures the reductions will beachieved by reducing Government subsidies and capital contributions to theremaining public enterprises, whose capital requirements will be progressivelycovered by their own increasing cash flow generation and by borrowings fromdevelopment banks. Direct Government investments in social and otherinfrastructure would be maintained at about the present level in real terms.

31. Monetary and credit policies have been quite expansionary over recentyears, with growth of money circulation (22) exceeding that of GDP by asubstantial margin (17X p.a. vs. 141 p.a. on average during 1981-85) in spiteof comprehensive Central Bank controls. The Government intends to prevent thegrowth of money circulation during 1986-91 from exceeding that of GDP, andwill keep it below that under normal circumstances. Given the considerableprojected decline in the Government's overall budget deficit and, thus, in its

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need for new borrowing, tighter monetary and credit policies can be followedwithout hampering productive investments in the private sector. As agreedwith the IDF, this tighter and more careful management of money and creditwill be achieved through a major change in the Central Bank's instruments ofmoney supply mangenent. In particular, Central Bank discounts at fixed rateswill be limited to priority sectors (agriculture, exports, SSIs, energysaving), while the banks will have to raise the bulk of their funds on themoney market at the daily rate, subject to ceilings based on their deposits.

32. The liberalization program. As mentioned above (para. 16), a majorimprovement in the allocation and use of economic resources, as well as in therelative incentives for export production compared to production for thedomestic market, are key pre-conditions for Tunisia to achieve satisfactoryeconomic growth and employment creation at a time of tightening balance ofpayments constraints. Progressive liberalization of the economy andintroduction of more competition - domestic as well as foreign - is the onlyeffective way to achieve this. Given the fact that Tunisia's modern sectorbas operated for decades in a highly controlled and well protectedenvironment, the necessary phasing out of controls on prices, investments andimports should be closely coordinated. The Government is determined tocomplete the phasing out of controls before the end of the VIIth Plan (1991).

33. Price controls. In addition to the ongoing gradual decontrol ofagricultural producer prices, the Government intends to abolish price controlsfor all manufactured goods by 1991, with the exception of a small number ofkey staples such as bread and edible oils. In a first phase (1986 -mid-1988), controls will be abolished (i) in well established industries wherethe number of domestic producers is sufficiently large to ensure appropriatecompetition. The list of such industries, which account for about 602 oftotal manufacturing output, and a schedule for the decontrol of their pricesis included in the Letter of Economic Development Policy. In accordance withthat list, prices have been liberalized on September 1, 1986 for a first groupof products, and for a second group on January 2, 1987; and (ii) for allproducts whose imports will be liberalized over the same period, i.e. all rawmaterials, spare parts, capital goods and most semi-manufactures. Theseaccount for an estimated additional 12-15% of total manufacturing output. Ina second pbase (mid-1988 - end-1990), the controls will be abolished in allother industries. With respect to those products for which price controlswill continue for an interim period, a new more flexible price control systemwill be introduced in early 1987, which avoids the major shortcomings of thepresent cost-plus system, such as over-investment, low use of installedcapacities, and lack of incentives to control production costs, includingenergy use. The new system will allow the enterprises to adjust pricesunilaterally and to apply the new price following a reasonable lapse of time,provided there is no justified objection on the part of the Government.Criteria for price adjustments would include-in addition to changes inproduction costs-the stated objective of gradually closing the gap betweencontrolled domestic prices and prices to be paid for imports so as to avoid tothe extent possible any major and abrupt price changes at the time prices andimports of a given good are liberalized. Prices, thus, would become moremarket oriented.

34. Investment controls. At present, all new investments need Governmentapproval, including replacement investments and expansions of existinginstallations. At the same time, investment incentives are provided tovirtually all approved investment projects. As discussed in detail in Part IV

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of this report (paras. 69-85), the new investment legislation to be introducedin early 1987 foresees the inmediate, full decontrol of all investments.Government approval will be limited to the granting of a number of specialinvestment incentives; however, these will be available only to a restrictednumber of high priority projects, particularly export industries and newinvestments creating employment in the most underdeveloped areas of thecountry.

35. Import liberalization is the third essential liberalization measurewithout which the effects of price and investment liberalization would remainvery limited. It is also essential to improve incentives for exportproduction, by making production for the local market less attractive.The Government intends to take two sets ot measures in this respect:

(a) to phase out all quantitative restrictions an imports before the endof 1990 except for a limited number of infant industries which mightreceive quantitative piotection not exceeding three years inexceptional circumstances. In line with the country's importpriorities, liberalization has started with spare parts for use inindustry, agriculture, hotels, hospitals and other services, rawmaterials and semi-finished products for enterprises that export atleast 25% of their output, and capital goods for new investmentprojects approved by the Industrial Investment Promotion Agency(API), the Agricultural Investment Promotion Agency (APIA) and theTourism Investment Board after October 1, 1986; these measures becameeffective in November 1986. They were followed on January 2, 1987,by the liberalization of semi-finished products for firms that arewell integrated or that export at least 151 of their output, as wellas all other raw materials and spare parts. Imports of capital goodsand of the remaining semi-finished products will be decontrolled byJanuary 1988. As a result of the above measures, about 75% of allimports would be liberalized by the end of 1988. During 1989-90, allremaining quantitative restrictions, essentially on consumer goodsimports, would be phased out; and

(b) to reform the tariff system by reducing high import tariffs and thedisparities in the levels of effective protection between thedifferent sectors of the economy with the aim of achieving a lowerand reasonably uniform effective protection rate of about 25% by theend of the VIIth Plan. To achieve this objective, the Governmentintends to prepare a program of gradual tariff reductions forimplementation over the 1989-91 period. As an interim measure, ithas amended the present tariff system on January 1, 1987 so thatthere is a universal minimum tariff of 151, all existing tariffsbetween 25% and 311 are reduced to 25% and all tariffs presentlybetween 321 and 56% are reduced by 6 percentage points, and allhigher tariffs are reduced to a maximum of 501. Not later thanJanuary 1, 1988 all tariffs then being between 251 and 34% will bereduced to 25% and all tariffs between 351 and 501 will be reduced by9 percentage points. The Government intends to replace some of thesereduced import tariffs by domestic sales taxes covering imports aswell as domestically produced goods.

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36. In line with its policy of progressive import liberalization, theGovernment also decided in the Fall of 1986 to apply for full membership inGATT. Tunisia has been a provisional member for several years.

37. The entire macro development program, as described above and in theGovernment's Letter of Economic Development Policy (Annex IV) would bemonitored by the Ministry of Planning and Finance (with assistance from theMinistry of Industry and Commerce and the Central Bank) and by Bank missions(parn. 141). Bank confirmation of satisfactory progress in implementation ofthe overall program would be a condition of second tranche release (para. 139).

D. Medinu-Tenm Proiecons

38. As mentioned above, the economic adjustment program is aimed atachieving three major objectives. First, the direct export promotion measurestogether with the exchange rate adjustments and reduced import protectionwould stimulate the growth of non-oil exports to over 7% p.a., compared to anestimated 3.3% achieved during the VIth Plan. Second, the pricing andinvestment incentive policies aimed at raising the efficiency of resourceutilization and allocation would reduce the investment rate from 28Z of GDP inthe last five years to 22% during the VIIth Plan without seriously affectingoutput growth, and would reduce the incremental capital-output ratio from thepresent high level of 10.4 to 6.3 between 1986-91. Third, the substarLialchanges in relative factor costs would stimulate the creation of newemployment, expected to average between 50,000 and 55,000 new jobs p.a. or a2.5-3f p.a. increase over the Plan period. Even this nearly 16% increase overthe VIth Plan actual figures, however, will only permit absorption of about70% of new job seekers.

39. Concerning growth of GDP (Table 2), the decline in the production andexport of oil tends to overshadow at first glance the projected substantialimprovements in the non-oil sectors, particularly when compared withhistorical performance. Such improvement is vital for Tunisia to achieve asatisfactory overall growth over the coming years. Table 2 shows that eventhough the average GDP growth of the VIIth Plan is somewhat lower than that ofthe VIth, the growth of non-oil industries is substantially higher (5.8%compared to 4.21 p.a.). Agriculture's performance (4.3% compared to 4% p.a.)is a reflection of the exceptionally good recovery of agriculture in 1987following a decline in 1986; the projected 3.5% p.a. growth of the sector inother normal years is significantly better than the 1.61 achieved during the1976-81 period. Output of the non-oil productive sectors is expected toincrease rapidly, as a result of direct measures stimulating the agriculturaland industrial sectors (improving productivity and efficiency of rain-fed andirrigation agriculture, improving land use policy, strengthening exportpromotion measures and institutions) and indirect measures affecting theincentives framework. Developments in the oil sector are heavily influencedby world oil prices, as the production of small oil fields would only becomeattractive if oil prices increase again substantially. The present outlook isfor production of crude to decline to 3.6 million tons by the end of the VIlthPlan, while in early 1986 the projection had been for 4.4 million tons. In1985/86, actual production averaged 5.2 million tons. Production ofassociated gas would decline in parallel.

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Table 2: GROWTH OF OUTPUT AND EXPENDITURES '(Annual growth rates in percentage)

1976-81 1981-86 1986-91(Actuals) (Preliminary) (Projected)

GDP (up) 6.1 3.6 3.4Agriculture 1.6 4.0 4.3Industry 8.9 3.0 3.1Hydrocarbon (8.3) (0.2) (-5 .9)Non hydrocarbon (9.2) (4.2) (5.8)

Services 6.5 3.9 3.4Consumption 7.4 4.2 2.7Private (7.8) (4.1) (2.9)Public (5.8) (4.5) (2.0)Gross Investment 6.6 -3.9 4.0Imports GNFS 10.8 -2.4 1.6 '6

Exports GMFS 8.5 0.8 2.8

/a Constant 1980 prices and calculated by least squares.lb Growth rate is exceptionally high because bad weather conditions in 1986

provide a low base.Ic Due to reduction in oil imports on account of the new refinery.

Source: Ministry of Planning and Finance and Appraisal Mission estimates.

40. The two major exports of goods (table 3), oil and phosphatederivatives, are affected by two factors in addition to a depressed priceoutlook!'. The coming on stream of the refinery extension at Bizerte willreduce crude oil exports by 1.5 million tons, as more Tunisian crude will beprocessed locally for domestic consumption. While recently completedfertilizer plants could increase exports of phosphate derivatives by over 91p.a., it is likely that this capacity cannot be fully utilized in view of theprojected glut in world supply, and of the poor quality of indigenousphosphate rocks. These exports are, thus, expected to grow by little morethan 7.51 p.a. during 1986-91.

41. In consequence, manufacturing industries (other than phosphateprocessing), tourism and agriculture will have to become the major engines offuture export growth. Assuming that the policy measures concerning theagricultural sector agreed under ASAL are implemented in a timely fashion,there should be a significant reduction in the agricultural trade deficitthrough reduced imports and increased exports. Overall, manufactured exportsexcluding phosphate derivatives are expected to grow at 9.31 p.a., with thegreatest potential in electrical and mechanical products, textile and othermanufacturing industries. Tourism is expected to resume a more satisfactorygrowth at 61 p.a., albeit not at the rate experienced during the late 1970s(over 91 pa.).

The medium-term projections assume an oil price of US$13.5 per barrel in1986, gradually increasing to US$19, in current prices, in 1991, whilethe price of TSP, the major fertilizer product of Tunisia, is expected toincrease from the present level of US$130 to US$169 per metric ton.

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Table 3: GROWTE OF EXPORTS

(Average Annual growth rates, constant 1980 prices)

1976-81 1981-86 1986-91 1986 Share(Actual) (Preliminary) (Projected) of Exports

(Preliminary)

Agricultural Products 2.4 0.7 4.0 3.5Crude Petroleum 7.4 -4.9 -20.2 15.0Phosphate + Derives 2.7 4.1 7.5 13.5Processed Food -3.4 8.5 5.5 4.8Textiles 23.7 3.7 7.8 18.7ElectricaltMechanical 23.9 8.3 12.5 4.5Other Goods 6.8 1.6 20.0 2.4NFS 9.2 2.4 6.1 37.6Total Exports, GNFS 8.5 0.8 2.8 100.0

Total, excludingpetroleum 9.0 3.3 7.3 85.0

Source: Ministry of Planning and Finance and Appraisal Mission estimates.

42. Concernina imports, the pivotal role of exports in generatingeconomic growth will require corresponding increases in imports, particularlyof raw materials and intermediate goods needed for industrial growth; growthof these imports is assumed to be at par with industrial growth, allowancebeing made for the expected improvement in efficiency. The elasticity ofenergy consumption would decline to 1 during the VIIth Plan, compared to 1.3at the present time, reflecting a continued energy conservation effort beingsupported, in part, by a recent Bank loan. Total energy imports are expectedto decline by 5.91 p.a. throughout the period, partly as a result of therefinery extension mentioned above. In addition to stimulating exports, thepolicy measures proposed by the Government are expected to substantiallysti=wlate import substitution of agricultural products. As a consequence, thegrowth rate of food imports is expected to decline substantially from 5.31p.a. during 1977-86 to slightly less than 1% during the VIIth Plan, despite arapid growth of the population (2.5% p.a.) and of food processing industries(41 p.a.). The greatest potential in this category includes wheat, barley,milk and beef. Imports of other consumer goods are likely to remain lowduring 1986-88, due to the impact of short-term stabilization measures, whichare expected to keep growth of domestic consumption below that of total GDP;they are expected to pick up rapidly thereafter as growth resumes and theimpact of import liberalization begins to be felt.

43. Balance of payments and external debt. Emigration has slowed down inthe face of weakening demand for foreign workers in Europe. in Libya and inthe countries of the Arab peninsula, and therefore inflows of workers'remittances are expected to decline slightly in real terms. -Over the pastfive years, these remittances have averaged over 161 of commodity exports,

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equivalent to about 4t of GDP. Given this and the above-discussed export andimport outlook, the current account deficit is expected to decline from aboutUS$810 million, or 9.21 of GDP in 1986, to about US$400 million, or 3.41 ofGDP in 1991. In view of the depressed oil price outlook and assuming no majornew oil field discoveries, direct foreign investment is expected to remain atthe current level in real terms, with non-oil investments increasing rapidlybut oil investments declining substantially.

Table 4: TUNISIA - PROJECTED BALANCE OF PAYMENTS

(Millions of current dollars)(With adjustment )'t

Actual Projected1985 1986 1987 1991

Exports of Goods and NFS 2,699.9 2,638 2,920 3,894Imports of Goods and NHS 3,207.1 3,374 3,529 4,242Net Factor Services + Transfers -81.4 -75 -84 -50Current Account Deficit 588.6 811 693 398Net Foreign Investment 139.5 137 118 195Public M & LT Borrowing (gross) 750.6 1,130 1,301 1,018Amortization on N & LT Debt 436.5 567 588 821Public N & LT Borrowing (net) 314.2 562 713 197

Selected Financial Indicators

Debt Service Ratio (I of exportsof goods and services) 22.4 29.3 28.0 27.9

Current Account Deficit(1 of GDP) 7.1 9.2 7.9 3.4

/a This includes the effects of the Government's adjustment program describedherein.

Source: Ministry of Planning and Finance and Appraisal Mission estimates.

44. Gross foreign loan disbursements required to finance such a currentaccount deficit, to repay maturing debt and to increase reserves to a levelequivalent to 1.6 month of imports by end 1988, would average about US$1.2billion annually during 1987-91. Over 701 of this would come from officialsources, compared to 601 in the last three years. Debt outstanding anddisbursed as a percentage of GDP would increase from an average of about 551in 1985/86 to about 611 ia 1991 (after a peak of 671 in 1988), while the debtservice ratio would be 27.91. Average borrowing terms are not expected toharden much. The average interest rates would remain in the 6-7S rangebetween 1987-91, while the average maturity would be within the current rangeof 15-17 years.

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45. This scenario obviously hinges on the policy changes to be initiatedduring the next few years, in particular on a timely implementation of policymeasures to accelerate exports, reduce public investments, slow down growth ofdomestic demand and liberalize the economy by phasing out regulations andcontrols. As mentioned in Section B above, the Government has already takenseveral steps in implementing such a strategy. Considering its long record ofprudent external debt management, there are good grounds to assume that Tunisiawill implement the necessary policy changes along the lines discussed above andremain creditworthy for a continued high volume of Bank lending.

46. Domestic resource mobilization. With exports growing faster thanimports, the resource gap is expected to decline to about 31 of GDP by the endof the VIIth Plan. This still rather high overall gap, however, disguises astrenuous effort in savings mobilization in the non-oil sectors. Indeed, thenon-oil resource gap declines from an average of 14% of GDP in 1984/85 toabout 2.61 in 1991. The marginal propensity to save over the period 1987-91is estimated at a high 26% (in current prices), assuming successfulimplementation of the structural reforms to control domestic demand. LimitingCentral Government current budget expenditures to below 211 of GDP and capitalexpenditures net of debt repayment to about 6% of GDP by the end of the VIIthPlan period should allow public sector savings to finance over 70% of publicsector investment (including public enterprises), up from 432 in 1984/85, andshould increase the percentage of overall investment financing by domesticsavings to about 901 on average over the period. While this would help toreduce the pressure on the balance of payments, it also gives a clear signalto the private sector that the public sector investment.program will not leadto a crowding out of private investments but rather will supplement it byproviding the necessary infrastructure.

47. The medium-term framework discussed above corresponds largely withthe Government's own planning scenario for the VIIth Plan. While there areclearly downside risks involving such exogenous factors as the growth of thevorld economy, in particular in the EEC countries, and movements ininternational prices, it is clear from the analysis of the recent past thatthere is no alternative to the proposed export-oriented strategy. Slowerexport growth would lead rapidly to slower GDP growth, in order to keep thebalance of payments manageable. Such a situation would greatly worsen theunemployment rate. As mentioned above, even implementation of the fullstructural adjustment program will not allow absorption of more than 70% ofnew job seekers during 1987-91; any lesser effort would further worsen theunemployment situation with serious political and social consequences.

E. Socia Inpact of the Adjustment Programp

48. According to the latest household survey, almost 12.8% of the totalTunisian population (823,000 persons) was living below the absolute povertylevel in 1980.1' Most of the poor and lower income groups are located inrural areas, followed by smaller towns; these groups account for about 141 of

In 1980, the absolute poverty level was TD 60/person/year in rural areasand TD 120/person/year in urban areas.

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the total rural population, and 122 of the total urban population. They arelargely employed in agriculture (431) ard construction (161), wheresignificant underemployment exists. Over 18S of the total work force inconstruction, 161 in agriculture, 141 in mining and 10 in transport areconsidered to be poor. They spend almost 851 of their budget on fulfillingtheir basic needs for food, housing and clothing.

49. The Government's program of economic adjustment could worsen thesituation of the absolutely poor in two major ways: (i) through the gradualreduction of budget subsidies; and (ii) through increases in consumer pricestriggered by changes in the exchange rate and increases in agriculturalproducer prices. The present system of consumer subsidies is clearlyi portant to the well being of the poorest segment of the population, as suchsubsidies account for nearly 191 of their total expenditures - 20% for theurban poor and 171 for the rural poor. However, the subsidies overwhelminglyprofit the better off segments of the population, with over 601 of allconsuser subsidies going to the highest income groups, and only less than 1OZgoing to the absolute poor, particularly to the urban poor (61). Thissituation means that while it would appear socially and politically impossibleand undesirable to deprive the absolutely poor from the support they currentlyreceive, there is ample room to reduce consumer subsidies by as much as 901without taking away anything from the really poor. This requires that waysand means be found to target this assistance more directly to the really needy.The Government is clearly aware of this situation; it recently established aSpecial Commission to study how to target and efficiently distribute consumersubsidies, so as to gradually introduce a more focussed and less expensivesystem of support for the poor as overall subsidy outlays are reduced.

50. The adjustment program also includes a number of important measuresdesigned to improve the situation of the poor: (a) the rural poor,particularly in rain-fed areas, will profit from increased agriculturalproducer prices as well as from increases in agricultural production fori port substitution and exports; (b) the urban poor will profit from theincrease in the minimum wage introduced in mid-1986; (c) both groups willprofit from the stimulating effects of the adjustment measures on employmentcreation, as export industries, agriculture and tourism are all relativelylabor-intensive sectors. As the bulk of the absolute poor are employed insectors with a high underemployment rate, the expected more rapid creation ofmew employment and decline in underemployment ought to have a sizable effecton the standard of living of the poor labor force employed in the modernsector. Given the considerable under-utilized production capacity existing inseveral key export sectors such as textiles and tourism, the adjustmentprogram is expected to show a positive, although limited, impact on employmentalucst imnediately; in the longer term, it will be more pronounced. Asreferred to in para. 16, continuation of past macro policies would havelimited the creation of new employment in the Tunisian economy to little morethan 35,000 per year on average over the period of the VIIth Plan; this isless than half the expected number of new job seekers. As a result of themcro sad sector adjustment programs, supported by the Bank, the number of newjobs created over this period is expected to average between 50,000 and 55,000p.a., quite a substantial difference; and (d) given the fact that the informalsector will benefit little from minimumn wage changes and the other measuresmentioned above, the Government has initiated several specific programs forthe support and development of this sector (para. 12).

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PART m - BANK GROUP OPERATIONS IN TUNEIA

51. Since 1962, the Bank haa committed to Tunisia seventy-two loans andten IDA credits amounting respectively to US$1,625.5 million and US$75.2million (net of cancellations) of which forty-five loana and credits have beenfully disbursed. Annex II contains a summary statement of Bank loans, IDAcredits and IFC investments as of September 30, 1986. Project implenentationis generally satisfactory. As of September 30, 1986, overall disbursementsamouated to 561 of appraisal estimates, which is in line with experience inother countries in the region. Disbursement performance for agriculture,energy, water supply and sewerage, highway and port projects has generallybeen above the country average, while longer than average disbursement delayshave been experienced for education, healtb, technical assistance and urbanprojects, due to project-specific problems that are being addressed throughsupervision missions and sector discussions. In a number of sectors,important policy changes and institutional improvements have been achieved,and autonomous agencies have been created or strengthened to ensure theefficient management of the related sectors or sub-sectors.

52. The Bank's lending strategy in Tunisia aims at supporting thecountry's transition from a situation of reliance on petroleum exports to asectorally-balanced post-hydrocarbon era through appropriate changes ineconomic policies and programs as described in Part II above, while takingmeasures to increase employment and target development to low income groups.In support of the above, the overall objective of Bank lending is to emphasizeprojects which have a direct and rapid impact on production, employment andexports (or import savings) and which minimize Government net contributions.The focus of lending for agriculture and industry meets this objective. Inaddition to the above, proposed Bank lending would focus on improvement ofpublic enterprise performance, conservation and development of energyresources, and continued support to the social sectors and operations targetedto low income groups. For the latter, attention would be given to increasedefficiency and cost-effectiveness of institutions and investments, and tolinkages with directly productive sectors (e.g., education reforms stressingvocational training). We envisage only marginal lending for basic economicinfrastructure, focussed in areas where Bank guidance would still be useful,such as rural water supply and highways maintenance.

53. Past Bank lending emphasized support for long-term investmentB ininfrastructure and social development, with increasing support in recent yearsfor agriculture and industrial financing. Bank/IDA comuitments to date aredistributed as follows: urban, water supply and sewerage, 231; agriculture,291; industry. 201; transport, 131; energy, 91; education, 4X; and health andtechnical assistance, 11 each. Within the broad framework noted in theprevious paragraph, in our future lending, we expect a continuation ofpolicy-based lending and traditional project lending in priority areas, forexample,in the next couple of years, highway maintenance and forestry andcredit lines to small-scale industries and agriculture.

54. The dialogue between the Government of Tunisia and the Bank onindustrial development is of long standing and has kept evolving over time.Through its first loans to industry, the Bank aimed at providing general

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support to industrial development; later on, it aimed at promoting industrialexports and labor-intensive industries, and financing high priority industries(e.g. electrical and mechanical industries (EMI) and small-scale industries(SSI) ) in support of their priority in the Government's strategy. Banksupport to industrial development in Tunisia has consisted mostly of lines ofcredit to the Economic Development Bank of Tunisia (BDET), which has nowreceived eight Bank loans totalling US$129.16 million (net of cancellations)of which US$11.39 million remain undisbursed as of September 30, 1986. Mostof these funds financed manufacturing industries; first through unrestrictedlines of credit (Loan 1504-TUN and part of Loan 2113-TUN), then through linesof credit with special foci: on SSIs (Loans 1505-TUN and 1969-TUN) and EMI(Loan 2113-TUN). A credit line for a pilot SSI scheme (Loan 1505-TUN in 1978)prepared the ground for a US$30 million loan to SSIo (Loan 1969-TUN in 1981)that used for the first time commercial banks along with BDET as anintermediate. Two 1985 loans, for export industries (Loan 2522-TIN) and forEMI (Loan 2554-TUN), also used two of the new bilateral development banks,Tunisian-Kuwaiti Development Bank (BTKD) and Tunisian-Saudi Company forInvestments and Development (STUSID) as intermediary along with BDET.

55. In addition to the lines of credit provided to BDET, four loans weremade directly to industrial enterprises in Tunisia: the first was in 1974(Loan 1042-TUN) to the Gafsa phosphate mining company to introduce advancedmining technology. It was followed in 1984 by a technical assistance loan forthe mining sector (Loan 2346-TUN). A loan to SOGITEX in 1981 (Loan 2012-TUN)aimed at rehabilitating the textile industry. Finally, a foundry project(Loan 2301-TUN) was approved in 1983 to modernize and expand a large foundry,SOFOMECA, which should help improve the integration of the EMI sector inTunisia. In 1982 the Bank made a loan to the Government which included acomponent to develop and promote new industrial projects (Loan 2197-TUN). Thetwo main agencies involved were CEPEX (to study export promotion) and CNEI (tostudy specific sub-sectors and their potential for growth).

56. The Bank's economic and sector work will address the increasingcomplexity of the macro-economic and sector problems that Tunisia will face inthe medium term, and continue to focus on strengthening the macro-economic andsector base for our lending program. However, while in the past it was mainlydevoted to the study of major structural problems, it is now focused onimplementing the policy recommendations of these studies through sectorlending in agriculture, industry and trade, public enterprises and transport;it will therefore concentrate on the following msin tasks: (a) preparation andmonitoring of the macro-economic framework of the VIIth Plan, which providesthe policy base for structural adjustment and sector lending; (b) review ofpublic expenditures under the VlIth Plan to provide guidance for the necessaryreductions in budget outlays and a basis for support through structuraladjustment lending; (c) assessment of public enterprise reforms prepared bythe Government to reduce their drain on the state budget; and (d) monitoringof the agreed macro-economic and sector policy changes. The program alsoincludes studies on education administration and finance, municipal financeand development, energy pricing, and the impact of the adjustment program onvarious income groups.

57. The Bank accounted for about 272 of total comuitments from officialsources to Tunisia during 1982-1985. Its share in total debt outstanding anddisbursed at the end of 1985 (including loans from private sources) reached

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about 12.11 and its share in debt service during 1985 was 13.61 (excludingIDA). The share of the Bank in Tunisia's disbursed external debt is expectedto increase to about 231 and it. share in the debt service to about 21% in1991.

58. As of September 30, 1986, IFC's net commitments in Tunisia totalledabout US$18.5 million. IFC has supported BDET to foster development projects,and the National Bank for Tourism Development (BNDT) to promote and invest intourism projects. It has also assiuted the Sociht6 Touristiouc et H8teliAre,a large hotel development; the Industries Chimipues du Fluor (ICF), a producerof aluminum fluoride from local fluorspar for export; and the Sociht6 d'Etudeset de DAveloppement de Sousse-Nord for an integrated tourism developmentproject. In FY85, IFC approved an equity investment in Fluobar, a project toprivatize, rehabilitate and expand an existing fluorspar mine. Twoinvestments in Tunisia Leasing Company, the first leasing company in Tunisiato provide financing to the industrial sector, were approved in FY85 andFY86. In FY86, IFC also approved an equity investment in Soci6th Industriellede Textiles (SITEX) which would help privatize an existing state-owned textilemill, and an equity investment in Adwya S.A., a company which will producepharmaceutical products from imported active ingredients. In FY87, IFCapproved an investment in Rozzi Edilizzia Industrializzata Tunisia (REITSA).This project's objective is to manufacture a panel-based, integratedconstruction system for use in low-rise, medium cost housing.

PART IV - THE MEDIUM-TERM INDUSTRIAL AND TRADE ADJUSIMENT PROGRAM

A. The Need for Adjustment

59. Tunisia, like many other countries that became independent in theL950s and 1960s., began developing its manufacturing industry by concentratingan import substituting activities. In line with the shift in developmentstrategy to open up the economy, Tunisia put gradually more emphasis onexport-oriented industries during the 1970s, particularly textiles, whilestill pursuing an import substitution strategy behind a high level ofprotection. To generate employment without placing producers for localmarkets under excessive competitive pressure, the export industries weregrouped into an enclave environment called off-shore industries. A policy ofrelatively generous investment incentives was followed to promote the growthof manufacturing. Where progress was lacking despite the higb protection andinvestment incentives, the public sector seized the initiative and publicenterprises were established. These now account for a significant share ofmanufacturing value added and investment (nearly 60%) with a particularly highconcentration in phosphate processing, building materials andelectro-mechanical industries. Generous investment incentives, relatively lowinterest rates, and rapid increases in wages resulted in manufacturing..industries that are rather capital intensive, particularly among public R

enterprises.

60. These policies were quite successful during the 1970s and early1980s, when they resulted in a rapid increase in manufacturing production andexports, averaging about 91 p.a. each in constant prices over 1971-1984, ornearly twice the growth of total GDP and total exports. Nevertheless,manufacturing remained a small part of the economy, accounting for only 142 ofGDP ln 1985, and about 201 of employment; it also remained .ittle.;export-oriented. Although manufactured exports accounted fkr otie thi0d-of

total exports in 1985, only the;resource-based phooptate processing industry(821 exported) and the largely off-shore textile industry (45% exported) aremajor exporters. All other manufacturing sub-sectors sell on average cver 901of their production on the domestic market. This overwhelming orientationtowards the domestic market did not present much of a bottleneck during the1970. and earlj 1980s when manufacturing was still very small, possibilitiesfor import substitution were large, and domestic demand expanded rapidly,fueled by the two massive world-wide oll price increases and substantialincreases in local salaries. tr. mid-3P980s, however, the limits of thepast growth strategy became obvlous: by ik,n the sector was no longer thatsmall, the most obvious import substitutiion activities were all covered andgrowth of domestic demand slowed down markedly because of declining oilproduction and oil prices as well as wage freezes that began in early 1983.This revealed the very small size of the domestic market wnich, as mentionedbefore, is less than 10% that of Switzerland or 51 that of Spain.Furthermore, at about the same time, the only two export-oriented sub-sectorsencountered increasing export difficulties; phosphate-based fertilizer becauseof depressed world market conditions and textiles because of increasingprotectionism and sLow growth of demand in Western Europe.

61. Two other weaknesses bi:ame increasingly apparent over the lastyears, namely the extreme dependence of manufacturing production upon importsand the high production costs. Given Tunisia's very limited endowment withraw materials, food processing aad ferttli.;zer production are the only twosub-sectors that use a significant aaauvt of domestic inputs and the latter iscrucially dependent on imports of sulfur. 4 <Ths,, when foreign exchangeearnings fell in 1985, the sharp import restrictions introduced in consequencehave seriously hampered the normal functi.vtoig of manufacturing enterprises,as the country.simply could not afford to import all the inputs needed topermit these enterprises to produce at or near capacity.

62. Production costs became high for a variety of reasons, but mostimportantly because of inefficiencies fostered by hlgh import protection andlarge investment incentives granted almost indiscriniinately to' newenterprises, leading to an uneconomic choice of projects, highover-investments, sloppy management, low labor productivity and little regardfor quality. In addition, labor costs were quite high, in particular afterthe large raises in salaries in 1982 and early 1983 which were exacerbated byhigh social security charges on employers. !inally, the appreciation of theTunisian Dinar during the early 1980s eroded the copetitiveness ofmanufactured exports.

63. Over the coming years, economic policies in the manufacturing sectorwill have to focus predominantly on stimulating exports, particularly innon-traditinnal sub-sectors, and this for two reasons: (i) togetber withtourism, manufactured exports will have to make up for most of-the decliningoil exports as well as for stagnating workers' remittances; and (ii) given thevery limited size of the domestic market, manufacturing production can growonly at a satisfactory rate and create a satisfactory amount of new employmentif the sector starts to export on a mich larger scale. In fact, in manysub-sectors, satisfactory economies of scale,can only be achieved ifproduction for the domestic market is supl1erented by substantial productionfor exports. The fact that Tunisian export industries tend to be particularlylabor intensive is an additional argument in favor of manufactured exports ata time of increasing unemployment and underemployment.

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64. To implement such an export-oriented growth strategy, Tunisia cancount on a number of comparative advantages, in particular its geographiclocation and easy access to Western Europe (roll-on/roll-off service), veryimportant for fashion products, its well trained labor force and its politicalstability. Substantial export possibilities exist in textiles and leathergoods, EMI's and a number of miscellaneous industries. Implementation of themacro-economic adjustment program as outlined above, supplemented by theindustry specific program of adjustments outlined below will go a long way tostimulate such exports.

65. The development strategy for the manufacturing sector should in theshort tern concentrate on improving the efEiciency of existing manufacturingactivities and increasing capacity. utilization by intensifying competition,both domestic and foreign, to which the sector is exposed. In the longerterm, it should aim to concentrate investments more strictly on theeconomically most profitable activities, by enhancing the responsiveness ofallocating factors of production to market signals. All the policy measuresrequired to implement the short-term strategy - such as maintaining anappropriate exchange rate, increasing the reliance on the market and onadjustments in relative prices to achieve better resource allocation, andutilizing both domestic and foreign competition to improve the efficiency ofdomestic production - are consistent with the longer-term strategy.

B. The Medium-Term Industria and Trade Policy Adjiatment Program

Objectives

66. The Medium-Term Industrial and Trade Policy Adjustment Program(MITAP) complements and reinforces the macro-economic policy adjustmentprogram with three specific objectives in mind:

(i) to stimulate growth of manufacturing production in theshort-term through better use of existing installations and inthe longer term through an increased private sector role ininvestments;

(ii) to stimulate exports of manufactured products, other thanfertilizers; and

(iii) to stimulate creation of productive employment in manufacturingindustries.

Waile the macro-economic adjustment program is essential to the creation of anoverall economic climate conducive to the achievement of the above objectives,there is a wide range of sectoral measures that can, and ought to be taken soas to strengthen the program in these three respects.

67. First and foremost, establishing an appropriate incentives frameworkis essential to the achievement of all three of the above objectives. Thisframework has to provide adequate incentives for private investors, encourageinvestments for exports, promote better capacity utilization and encourageentrepreneurs to invest in labor-intensive sectors and technologies.Decontrolling of investments, including the phasing out of Central Bankcontrols on individual credit applications, is important to encourage privateinvtments. Reducing labor costs to employers will help achieve all three

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objectives, be it through reduction in unit costs or through increasedproductivity. More flexible rules for hiring and laying off workers wouldfacilitate the process of enterprise adjustment and make entrepreneurs morewilling to hire additional employees. Last but not least, furtherimprovements in government institutions dealing with private investments andexports and further streamlining of government regulations concerning importsand exports are an important part of the program.

68. Linked to the objective of stimulating private investment is theissue of public enterprise reform and privatization, consistent with theGovernment's desire to get the public sector out of manufacturing activitiesas rapidly as possible. Given the preponderance,of public investments in thissector, this, obviously, is a long term process. This Loan is preparing theground for this change through its macro and sectoral policy changes to makeit more attractive for private entrepreneurs, not only to invest in newprojects, but also to take over public enterprises. This Loan is not directlyconcerned, however, with public enterprise reform and privatization; thiswould be the main task of the Public Enterprises Mission, scheduled forJanuary-February 1987, in preparation for a possible Public Enterprise SectorLoan.

L The Ineentives Framework

69. The new investment code to be implemented in early 1987 as part ofthe Industrial and Trade Policy Adjustment Program, brings about a number ofimportant improvements over the existing law; it is a major step in thedecontrol of the economy. First and foremost, it abolishes all Governmentinvestment licensing and controls. Government authorization would be requiredonly for the granting of special investment incentives which will be availableto no more thau an estimated 25-30% of all new investments; all investmentsnot eligible for such incentives, or not requesting them, can be implementedwithout any prior Government approval. Second, the number and importance ofincentives is reduced substantially and those incentives no longerdiscriminate among sectors or against labor-intensive, small and replacementinvestments. Third, incentives are to be granted almost automatically to allenterprises meeting specified criteria. This would reduce to a minimum, thediscretionary power of the Government's Incentives Approval Committee.Finally, Government considers these incentives as temporary measures to bereviewed and possibly phased out by the end of the VIIth Plan.

Reurd qM

70. Tunisia's present investment laws require prior Government approvalfor all manufacturing investments by the Industrial Investment PromotionAgency (API), whose Board includes representatives from all the main economicministries. Once approved, all investments automatically get a wide range ofincentives, except replacement and renewal investments and those creating lessthan ten new jobs. The incentives themselves are divided into two separatesystems; one, applies only to firms exporting all their output, though limitedhome market sales are authorized; most of these firms are in practice offshoreprocessing operations, many are foreign-controlled, with a heavy concentrationin clothing. The law gives tax and import duty exemptions for all imports ofinputs and capital goods, and exemptions from profit taxes for 20 years, plusother tax concessions. The other system applies to some 951 of allinvestments in Tunisian manufacturing, including firms which export part oftheir output. This law exempts capital goods imports, for new and extension

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projects, from all customs duties (in excess of the minimum duty), and givessome direct tax relief to all firms. Partial exporters and investments inparticularly underdeveloped areas of the country get substantial additionalprofit tax concessions; the former can obtain tax and duty-free those rawmaterials and semi-finished goods to be incorporated in exports, and thelatter benefit from reductions in social charges, get job creation subsidies,and subsidized industrial land. Concessions are also given to encouragemulti-shift operations, the development of local capital goods manufacturing,more technologically advanced operations, energy savings and above-averagelevels of Tunisian value added.

71. The present system bas been regarded as too bureaucratic andineffective in screening out poor projects; incentives were judged to be toocomplex, insufficiently selective, and often unnecessarily generous. Theytended to favor capital rather than labor-intensive projects and todiscriminate against small projects and replacement investments. The systemdid not focus enough on Tunisia's main current economic priorities, such asexport promotion and employment creation. Finally, the comprehensiveinvestmeut control system is no longer in tune with the general liberalizationof the economy and massive incentives are no longer justified, given the factthat the new macro-economic policies will remove many of the distortions whichthe existing system sought to compensate for. Accordingly, a new investmentlaw has been drawn up and discussed in detail with the Bank. It will bepresented to the National Assembly before this Loan becomes effective andshould be adopted well before the second tranche release. Incentives forcompanies exporting all their output are little affected by the proposed newlaw even though they are now dealt with in the same code as the ones applyingto other companies. For other enterprises, however, the changes aresweeping. The new law is simpler, more selective in granting specialincentives, but at the same time it is more balanced and neutral in terms ofgiving appropriate encouragement to all investments (including those outsidethe mnufacturing sector) through automatic "common law" concessions.

The Continued Need For Incentives

72. There are a number of reasons to maintain a reduced arsenal ofinvestment incentives to be granted on a selective basis during the period ofthe VIlth Plan: (i) since import protection and price controls are beingphased out only gradually (1986-90), existing distortions will not beeliminated immediately and some investment incentives will continue to beneeded to compensate for these. In particular, it is necessary to improveafter tax returns from production for exports vis-a-vis that for the homemarket (at present, generally far more profitable); (ii) continued incentivesare also needed to attract foreign investment, particularly in production forexport since virtually all competitor countries offer a wide range of tax andother incentives, and the few who do not, have far lower rates of both directand indirect taxation; (iii) the prevailing imbalance in the provision ofGovernment infrastructure to the detriment of outlying areas justifies thegranting of special investment incentives in those areas to rectify thissituation; and finally (iv) the macro-economic changes now being introducedare not selective enough to permit a sharper focus on employment creation inthe most disadvantaged parts of the country, one of the government's mainpreoccupations; in most countries, salaries tend to be lower in outlying areasthan in industrial centres, but the current nationwide system of wage fixing

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means that this is not presently the case in Tunisia. Until this can bemodified, other means will have to be used to reduce labor costs in the Westand the South.

The New vhestment Law

73. The new law brings about six important changes:

a) All investment controls are abolished. No prior investmentauthorization will be required, only a simple declaration forstatistical purposes.

b) Only a limited number of investments, considered particularlyimportant to the economic and social development of Tunisia,will be eligible to receive special investment incentives afterapproval by the Investment Incentives Approval Committee, thesecretariat of which will be provided by API (para. 90). Theywill apply only to enterprises exporting part of their output,to those creating new jobs in certain high priority areas of thecountry and to those introducing new, improved technologies.

c) Special incentives are to be granted automatically, providedspecified criteria are met. The two main criteria - exportsand location - are clear cut. Only the relatively minorincentives for the acquisition and adaptation of newtechnologies are based upon an approval process that involves,unavoidably, a judgmental element.

d) The incentives will no longer make any distinction betweenprojects of different sizes, nor among new, extension orreplacement investments; thus, small and replacement investmentswill no longer be discriminated against.

e) The new incentives will be much less generous than under the oldlaw, as some major ones are being withdrawn. In particular,only off-shore enterprises exporting all their output willcontinue to benefit from cuts in tariffs on capital goodsimports. Thus, the bias in tariff exemptions againstlabor-intensive projects has been reduced markedly, even thoughcapital goods remain exempt from turnover taxes, whetherimported or purchased domestically.

f) All incentives, apart from some relating to export operations(e.g., duty exemptions on materials imports and export profits)and to encourage multi-shift production, are temporary innature; they are either linked to the act of investing, orextend over a maximum of six years (ten years for off-shorecompanies).

74. As is the case now, a number of other investment incentives areavailable as "common law" rights to investments in all sectors without needfor prior Government approval. They affect in particular, those enterprisesexporting part of their output. In addition, they provide encouragement

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linked to the introduction of multi-shift work. All were available alreadyunder the old law but could only be obtained after prior Government approvalof the investment project.

75. A general incentive to new investments is provided under these"comon law" provisions in the form of an exemption from the income or profittax on that part of personal income or enterprises' profits used to subscribeto the initial share capital of a new enterprise or to increases in itscapital. For individuals 301 of the amount invested will be tax-exempt, forcompanies 502; for share capital subscriptions in enterprises exporting onefifth or more of their output, exemption will be increased to 501 and 702,respectively.

76. The most important "common law" concessions are those given to directas well as indirect exporters in all sectors:

a) Imports of products to be processed for re-export will beadmitted tax- and duty-free under temporary admission orindustrial warehousing systems.

b) Local purchases of products and services needed for exportproduction will be free of turnover taxes.

c) Exemption from company profits tax of the same proportion ofprofits as exports form of company turnover.

77. To encourage better capacity utilization through multi-shiftproduction, half of employers' contributions to the National Social SecurityFund (CNSS) will be borne by the Government budget for workers hired for newlyintroduced additional shifts, except for continuous process industries.

78. Two special incentives are given, after Government approval, to thoseexporting one fifth or more of their output. They will be:

a) Exemption from tax on distributed profits, or interest, up to101 of the nominal value of the shares, during the first threeyears of operations (20 years for off-shore companies).

b) Accelerated depreciation provisions.

79. In addition, the following special concessions are to be given toencourage the creation of new jobs in particularly underdeveloped areas of thecountry:

a) In "centers of first priority" designated as such in theregional development scheme where there are Governmentindustrial estates run by the Industrial Land Agency (AFI), or,on AFI approved sites, the cost of infrastructure on suchestates or sites will be borne by Government. In "centers ofsecond priority" the Government will bear half the costs.

b) The Government will bear the cost of the employers'contributions to CNSS and to the housing fund for three years(six years in "first priority centers") with regard to new orextension projects in the most underdeveloped areas, and will

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also exempt these employers from the training tax for threeyears. The total benefit of this incentive is equivalent to191 of wage costs.

c) Of much less importance are the limited profit-tax exemptions,reducing such taxes to a rate of 5-10 for a period of7-10 years.

80. New investments in particularly underdeveloped regions will, thus, nolonger profit from cash subsidies for job creation. However, exemptionsgranted from contributions to the main social security fund and the housingfund are somewhat more generous than under the old system; while the oldsystem gave on average exemptions equivalent to 10.6% of the total wage billover 4 years, the new one will give a 17% exemption for 3 years (plus 14% foran additional 3 years in "first priority centers"). The primary focus of theregional incentives, nevertheless, is on removing the disadvantages of theseareas in respect to infrastructural services. In fact, the most importantincentive granted under this title consists of the Government providing highpriority infrastructure.

81. Finally, a number of minor special advantages are granted:

a) Introduction of adapted new technologies will be encouraged bythe Government bearing part of the extra training and othercosts involved up to a maximum of 52 of equipment costs, or1D200,000, whichever is smaller;

b) To encourage domestic production of capital goods, all importedinputs used in the production of such goods will bear a tax notexceeding that applicable to imports of the equivalent finishedcapital good; the arrangements would be agreed uponcase-by-case. Furthermore, the Government can subsidize fullyor partially the purchase of patents;

c) To encourage the reopening of closed enterprises (by a newowner), the Government can grant special fiscal advantages andsubsidize social contributions by employers.

82. As already noted, the new proposed law represents a substantialimprovement over the old code. Clearly, the most important change,representing a major step in liberalizing the economy, is that investmentswhich request no special incentives will in the future need no priorGovernment authorization. This improvement is reinforced by the fact that theproportion of investments qualifying for special incentives - almost all atpresent - will be substantially reduced since special incentives will begranted more selectively. Firms which do not export and which are based inindustrial areas along Tunisia's East coast will get no incentives at all(apart from the few qualifying for limited concessions for technologicaltransfer or capital goods production). Approximately 70% of new projects arenot likely to qualify for special incentives and so will not need to apply forany kind of Governmnt approval under the new system. Moreover, it is likelythat the number of new projects actually applying for special investment

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incentives will be even lower since many promoters of small projects in themost underdeveloped areas qualifying for such incentives, may often not botherto request them; for example, if they are not intending to locate on an AFIindustrial estate, if employees are not officially registered (as is often thecase in the informal sector), and if there is no formal share capital or nodividends are paid, there are no benefits to be derived.

83. Another major change is that the system should be far more simple andautomatic in operation. An a consequence, the discretionary investmentapproval powers that have hitherto dominated API's activities, should becomevery limited and of only minor significance and will be transfered to anindependent committee (para. 90). This is particularly so since manyimportant incentives, including most of the ones for exporters, aresector-neutral and available as "common law" rights, including tonon-manufacturing enterprises, as part of the general tax and customs codes.They could thus be obtained automatically without approval by the newInvestment Incentives Approval Conmittee.

84. The final big change it; that the special incentives themselves areless generous, less complex to apply, and not discriminatory against smallerprojects, replacement investments, or labor-intensive enterprises. Mostimportantly, the new law will no longer grant duty-free imports of equipment.On the other hand, all import tariffs on equipment goods will be reduced inthe 1987 budget law, with the objective of achieving a level of effectiveprotection of around 251 for such goods.

85. An interim measure, however, is envisaged to cover the period betweenthe introduction of the new investment law in early 1987 and theliberalization of capital equipment imports at the beginning of 1988. Aprocedure is being established to allow those firms whose investments will nolonger need approval to receive the necessary authority to import the capitalequipment.

2. Governmet Support and Re atory n ns

B6. Implementation of the macro-economic adjustment program and the fulldecontrol of investments in early 1987 will require major changes ininstitutions dealing with the manufacturing sector to reflect the shift inemphasis from control to promotion. Furthermore, overlapping responsibilitieshave to be reduced, coordination has to be improved, and the participation ofthe private sector has to be strengthened; among others, the private sectorhas to assume greater responsibility in financing the institutions thatsupport the manufacturing sector. The role of these institutions wasinitially conceived to assist the private sector by providing guidance andinformation to local and foreign investors and facilitating the launching ofprojects. Over the years, however, their role evolved into that of protectingexisting industries through increasingly tight investment regulations andcontrols. As new needs arose, over 10 of these institutions were createdincluding API, AFI, CEPEX, CNEI, and three technical centers.

87. The most visible of these institutions is API, created in 1973 topramete investment. The initial objectives were to assist investors byproaiding information and technical advice to overcome bureaucratic hurdlescreated by the Government. Since then, API has become predominantly aninvestment regulating agency, approving new projects in certain sectors and

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not in otbers, often on the ground of product saturation in the local market.In recent years, this role has gained added importance as the foreign exchangeshortage required the securing of API's agreement before an import license forinvestment goods can be granted. API also provided some technical assistanceto SSIs and follow-up on project implementation. Its pre-investmentidentification activities were assisted by the CNEI, which was initiallycreated to provide technical and managerial assistance to SSIs. CNEI nowconcentrates its efforts on sectoral surveys and studies for large projects,predominantly in the public sector. Technical assistance in post-investmentphases is now provided by the three technical centers (leather and footwear,mechanical and electrical industries, building materials). Industrial estatesare established by AFI. Exports are promoted by CEPEX aided by a new privategroup, the Federation of Exporters (FEDEX), a specialized organization withinthe largest employers organization in Tunisia, the Tunisian Association ofIndustry, Commerce and Handicrafts (UTICA).

88. The Government is fully aware of the need to refocus several of thesepublic institutions, streamline their activities and improve coordinationamong thes. In the longer term, it also envisages to turn many of them overto the private sector, or at least have them financed by the private usersthrough charge-back schemes. Recently, the head of API was also made thepresident of AFI, while senior managers of these institutions have been namedto the board of one another. API now collaborates closely with developmentbanks and with the technical centers in the preparation of projects. Thepresidents of the technical centers are also non-voting members of API's Boardof Directors. CEPEB and the Tunisian Trading Office (OCT) are in the processof creating joint representative offices abroad. Reflecting the investmentliberalization decision, API's department of investment approval and controlhas been replaced by a legal department which plays a much reduced role,largely to determine whether investments requesting incentives are eligibleand qualified.

89. These efforts need to be continued and strengthened. In particular,the introduction of the new Investment Code will alter completely the natureof API's activities. With investment control fully abolished in early 1987,its role has to revert to that of an investment promoter. It will need toactively seek and identify new investment opportunities, as well as to promotesubcontracting and industrial linkages. The MITAP would seek to strengthenthis role through merging CNEI and AFI into API. CNEI's many years ofexperience and knowledge on industrial sector studies will be a considerableasset in this endeavor.

90. Since the new Investment Code abolishes investment licensing, thereis a need for an approval process of speciar investment incentives only. APIwill continue to act as secretariat to the Approvals Connittee in charge ofimplementing the Investment Code. To leave no doubt in the mind of investors,as well as of API itself, on the priority to be attached to its promotionalrole, this Committee will be fully independent from API's Board of Directorswith the latter focusing exclusively on supervising and guiding the agency'spromotional activities.

91. To avoid duplicating efforts in export promotion and to save foreignexchange, the MITAP calls for merging the promotional work of OCT with CEPEX.The former is concerned with a large number of activities ranging fromimporting for the Government, to the controlling of exports of subsidized

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products, but accessorily, it also organizes trade fairs and exhibitionsabroad. These latter functions will be taken over by CEPEX which has focusedits activities on promoting exports and on assisting exporters by conductingmarket surveys, providing advice and disseminating commercial information, aswell as participating in trade fairs. The merger will considerably strengthenCEPEX promotional efforts. So as to further reduce costs of export promotionand streamline public efforts in this important field, Government is alsostudying the possibi'ity of more closely integrating the commercial attachesstationed abroad into the enlarged CEPEX.

92. The adjustment program will undoubtedly increase the need fortechnical assistance at the production level, particularly to SSIs wherelimited resources may not allow them to identify and adopt measures to improveproductivity entirely on their own. To this end, the activities of theexisting technical centers which provide valued services to entrepreneurs,must be increasingly geared toward the needs of SSIs. Moreover, in line withthe financial constraints faced by the Government, these centers must be madeincreasingly financially independent from the Government budget. Some ofthem, such as the Center for Electrical and Mechanical Industries (CETIME),already have less than half of their operating costs financed by theGovernment and have indicated the willingness to decrease this proportionfurther through imposing user and/or membership fees. This increasingfinancial independence has to be accompanied by an increased participation ofthe private sector in the management of these centers. At the moment, theirboards normally include only one metber from UTICA but three from theGovernment, usually from the Ministries of Industry and Commerce, Planning andFinance and Social Affairs.

93. The three existing technical centers are operating in separate fieldsand there is little experience or knowledge to be shared among them; hence,there would be little advantage in consolidating them into one organization.However, as other sectors develop, the need for assistance in other fieldswould undoubtedly rise. The MITAP calls for the Government to consult withthe enterprises concerned and with the existing centers so that the necessaryadditional activities can be taken up by one of the existing centers, ratherthan creating a new one. The Government has also decided to work towardsimproved coordination among the centers and between them and otherinstitutions in training and in establishing a data base. In this connection,efforts by UTICA to assist SSIs will also be strengthened.

94. The improved efficiency of public institutions has to be matched bymore active private sector representation. Until now, the Chambers ofCommerce have played a marginal role in Tunisia. Under M!lTAP, they will bereactivated and will take over greater responsibility in representing theprivate sector point of view, i.e. identifying the needs of industry, andacting as an intermediary between the Government and the private sector.Considering the need for extensive consultations and cooperation with thepriv&te sector, as well as with the regional authorities on the most efficientway to reactivate these institutions, delineate their attributions, decide ontheir staffing and agree ou their financing, elaboration of a concreteproposal will take time. Government has agreed to discuss such a proposalwith the Bank before the end of 1987.

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3. Export Promotion

95. In line with the focus of the adjustment program on increasing tradeand manufactured exports, the Government has made recently vigorous efforts toeliminate administrative obstacles facing traders and exporters (para. 24),many of which were identified in the Bank's Industrial Policy Report. TheGovernment quickly moved to implement most of the Report's recommendations.Prominent smong the measures promoted was the establishement of export tradingcompanies (para. 24). In consequence, the program is well advanced;nevertheless, a number of additional improvements were agreed upon as part ofMITAP.

96. Firstly, agricultural exports are, since the beginning of 1986,exonerated from taxes, and so are export-related profits. Also, the tax onfish exports has been reduced from 6 to 3 percent, and for other exports to1.5 percent. Secondly, export licenses have been abolished, except forsubsidized goods. Thirdly, the customs and indirect taxation regimes,including temporary admission and warehousing, have been reformed to benefitexporters, notably by the following measures:

(1) Reducing the number of customs forms required for exports fromseveral into one, and in general, simplifying and computerizingprocedures.

(ii) Ratifying the treaty on international road transport (TIR) customsprocedures which integrates Tunisian road transport into the EECtransport system.

(iii) Reducing the bank guarantee to be provided for goods imported to beused in exports from 100 percent to 5 percent, and abolishing theguarantee in cases of permanent or intermittent customs supervisionof operations.

(iv) Occasional exporters have been allowed to supply themselves fromresident companies without payment of the domestic sales tax, insteadof having to await reimbursement of this tax after exports.

(v) The import licensing document, titre de commerce ext6rieur, has beenabolished for imports under the temporary admission regime, includingimports of packaging materials for exports; this effectively cutsdown on red tape.

Finally, a number of other measures have been implemented through an amendmentto the Customs Code; chief among them is the improvement of the reimbursementof taxes on imported goods used for exports. The measures remaining to betaken relate mainly to the objective of further facilitating tradingoperations.

97. In an effort to further improve the import/export trade system, theGovernment intends, during 1987, to (i) complete the computerizatiou ofcustoms services, for the about 15 percent of services not yet covered; (ii)strengthen the computerized handling of operations; (iii) decentralize customs

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offlces; and (iv) in concert with other export-related Government services,unify working hours, regroup services in a single location, integrate computertreatment and in general, try to place a single Government respondentvis-4-vis the exporter. The Government has informed the Bank in detail aboutthis program.

4. Money and Credit

98. Liberalization of banking activities. As mentioned above (para.20), the main features of monetary policy adjustments were agreed upon withthe IRF in the Fall of 1986. The Tunisian authorities have now decided on anumber of measures with regard to the volume of domestic credit, which theCentral Bank will regulate through daily intervention on the money market, nowthe principal source of refinancing for the banks. This orientation towardglobal regulation techniques means, for the banks, a larger margin of autonomytogether with increased accountability. In particular, they are regainingcontrol, with some reservations, over interest rates both for lending andborrowing. This represents a major and quite sudden evolution since up to nowouly long-term rates were free, while all other bank lending terms (includingmargins and commissions) were set by the Central Bank.

99. The move toward liberalizing banking activities is furtherstrengthened -as part of MITAP-- by the decision to mitigate two constraintsthat have considerably limited the autonomy of the deposit banks: (i) therequirement to obtain prior authorization from the Central Bank for any loanin excess of a certain minimum, and (ii) the arbitrary earmarking of a largeportion of their deposits to medium- and long-term lending. The annualsubmission to the Central Bank of a complete dossier on any enterpriseapplying for credit above a certain amount was a requirement imposed by theCentral Bank to influence the volume and, above all, the quality andselectivity of credit, through examination, inter alia, of the terms of theloan, the nature of the operations to be financed, the financial structure ofthe borrower, etc. The thresholds of applicability differed according to thenature and duration of the loans, which made the system very complicated. Forshort-term lending, by far the most important type of lending, three differentcategories were distinguished: (i) credits with no need for priorauthorization (export financing); (ii) credits with a high ceiling below whichno prior authorization was required (essentially commercial bills and lendingFor agriculture, mining and manufacturing); and (iii) credits with a lowceiling below which no prior authorization was required (essentially thefinancing of trading transactions). For medium-term lending, similardistinctions were made: (a) authorization-exempt credit (approved newinvestments); (b) pre-authorized credit above a certain ceiling (agriculturalinvestments); and (c) the "other" types of pre-authorized credit, regardlessof the size of the loan.

100. This procedure effectively resulted in the Central Bank substitutingits judgement for that of the commercial banks in the role of risk appraisal.To reduce the Central Bank's role in this respect and to increase theaccountability of the commercial banks, the Central Bank increased in February1985 the short-term credit ceiling, from TD 600,000 to TD 1.000,000 (the lowerlimit remaining unchanged at TD 100,000). A much larger inerease took place

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on January 2, 1987, within the framsework of this Loan'. adjustment program:for short-term commercial bank lending the ceiling above which prior approvalby the Central Bank remains required wan raised uniformly to TD 5 million.Thus the system bas been miade considerably more simple and less burdensome:the TD 5 mdllion ceiling now affects only about 50 enterprises, mostly fromthe public sector, whose situation still requires monitoring. The few privateenterprises still affected by this requirement will no longer be subject to itafter January 1, 1988. Medium-term lending has become completely exempt froma priori authorization from the BCT except for the negligible amount of loansdestined for other than investment purposes. The small amount of long-termlending is also exempt for private borrowers, while the a priori authorimationis maintained for public enterprises regardless of the size of the loan.

101. Starting in 1963, the commercial banks also had to earmark a largeproportion of their deposits (except for foreign accounts) to medium andlong-term lending operations, which accordingly restricted their latitude tomake decisions. This proportion eventually totalled 431: 201 in developmentbonds issued by the State, 51 in bonds of the Caiss Natiuonaled'Eirgne-kogement (CNEL), 181 in medium-term loans (of which 21 was reservedfor small enterprises, crafts and small trades). The objectives of thisschee were to get the banks to participate more actively in investmentfinancing.

102. The imposition of a minimum medium- and long-term lending ratio, mayhave been justified at a time when the institutions catering to such lendingwere not sufficiently developed. Now, however, with the creation of severaldevelopment banks in 198182, it is less essential to maintain such a high andundifferentiated lending ratio. Accordingly, it was replaced on September30, 1986 by a lower and more specific ratio, known as the "priority activitiesratio," which applies only to the financing of investments in thecrafts/artisan sector, the SSIs, agriculture and export activities.Initially, the new ratio is fixed at 71 for the deposits of each bank (exceptfor certain categories of accounts): it will rise by one point per semesterto reach its final level of lOS by March 31, 1988. This new measure willenable the banks to freely decide on how to allocate an additional amount ofapproximately TD 160 million in deposits.

103. ExchanRe risk guarantee. Linked to the system of credit distributionis the problem of the exchange risk. Under the Seventh Plan, Tunisia'sdevelopment banks are assigned a major role in investment financing, whichthey cannot perform unless they borrow abroad. With the present monetary andexchange rate instability, this policy is very risky, at least for the shorttern and as it affects each establishment. In the past, when the banks didnot borrow much, the Government generally assumed the risk, regarding this asa normal counterpart to exchange control, taking account of unforeseeable ratefluctuations and the lack of possibilities of risk coverage. Thus, it hassystematically granted its guarantee to borrowings by BDET, whose SSIcustomers have little means of protecting themselves. BNDT has also obtainedGovernment guarantees for its few external borrowings except for one. Up to1981, loans guaranteed in this way were yielding gains to the Government, asthe value of the Dinar appreciated in relation to the foreign exchangeborrowed. In 1981, bowever, the situation was reversed as a result of the

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strong upswing of the U.S. dollar, and has continued in this vein with therecent depreciation of the Dinar.

104. In 1985, the Government took a number of measures to handle -heworsening situation. To offset the heavy losses recorded since 19812. it hasprovided the Exchange Equalization Fund (FPC) --until that time financodsolely out of the gains resulting from exchange rate adjustments-- with oconstant source of income resulting from charges on final borrowers: a 0.5%comuission on overdrafts, a 1% commission on development bank loans and o,thtrcharges included in the Central Bank's re-discount rates. These nowresources, however, will only enable the FPC to repay by the ond. of Lfl8 cheTD 43.3 million in losses sustained on BDET and BNDT borrowings, up t4 tte, end-of 1985. These measures, therefore, remained short-term solutions dicttted bythe circumstances of the moment, and do not present the basis for a long-term'strategy to handle the foreign exchange risk on external borroings. La thelong run, the authorities agree that the exchange risk needs to be borne bythe final borrowers, if because of their size or the nature of their business,they have sufficient means of protecting themselves. Hence, the presentpolicy to grant the banks an undifferentiated guarantee benefiting allcustomers is not justified. Furthermoret it incites the banks to borrow asmuch as possible in stronig currencies, thereby profiting from lower interestrates to increase their profit margins, but at the expense of increasing theforeign exchange risk for the FPC.

105. Within the framework of MITAP, the reformed system, once a detailedstudy has been completed, will be improved along the following lines:

(a) The benefits of the existing FPC system will be reserved for Smalland Medium Enterprises (SME) who do not have the means to protectthemselves effectively; the appropriate definition of an SME will beagreed with the Government once the detailed results of the studyhave become available. Larger enterprises should be sufficientlywell protected by their size (which can allow for diversification ofrisks) or by the nature of their activities (exports in particular)to carry the risk by themselves.

(b) The borrowing banks will pay the FPC a fee equal to the differencebetween their cost of borrowing abroad and a reference rate linked tothe cost of domestic loans of equal duration: thus they will nolonger be tempted to choose systematically the stronger currencies.Moreover, the income of the FPC will thus be linked to the volume andrisk of the operations.

(c) Further corrective measures will be taken should a defki*t in the FPCappear likely, so as to make sure that no budgetary funds need to beused to support the system. To this avail, the Central Bank willreview the situation and outlook of the FPC every six months anddecide on necessary changes in the level of premiums to keep the Furndsolvent.

106. For its part, the Central Bank, which in January 1986 had alreadyextended up to eight months the duration of its forward coverage forcoacrcial operations will undertake a second study focusing on thepossibility of:

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(1) authorizing term coverage of debt service (principal and/or interest)in addition to trade transactions; and

(ii) improving the term coverage of exchange risks affecting foreignborrowing operations.

5. Taxation

107. The Tunisian authorities are vell aware of the importance of creatingan environment conducive for private enterprise, to stimulate production andjob creation: in the past, they used a substantial array of tax incentives toencourage investments, which served for a long time as a model in othercountries. Also, since 1982, Government had been working on a general reformof direct and indirect taxation, with three basic objectives:

(i) for direct taxes: standardization of individual and corporatetaxes and some rate reductions, with the revenue decline beingoffset by more efficient tax administration;

(ii) for indirect taxes: institution of a single, general value-addedtax, to expand the tax base and reduce dependence on imports;and

(iii) overall: streamline and simplify the system that has become verycomplicated over the years.

108. The IMF has expressed full agreement with these objectives afterreview by two special missions in May 1982 and July 1985. The reviewconcluded that there is nothing in the existing regulations to hinder businessefficiency or that should be immediately eliminated, and that perhaps, on thecontrary, there were too many costly incentives. However, the tax system isexcessively complicated and the rates are rather high, although they could bereduced if evasion were less prevalent.

109. As regards form, current legislation consists of a series of lawsthat have been promulgated over the years but never codified comprehensively.The principal texts were promulgated in 1912 (registration duties), 1932(individual government tax-e t personnelle d'Etat), 1945 (taxes onwages and salaries) and 1954 (tax on profits). However, they have often beenamended, and mny additions have further complicated the system, particularlysince the temptation to establish a new general-purpose tax for every newcategory of expenditure has often been too strong to resist. The system thusrequires a general overhaul., with the abolition of many of the minor taxes,and subsequent codification.

110. As regards sWustance, the tax ratio has always been high in Tunisia,but not abnormally so; .t-totaled 26.5% of GNP in 1984 (including socialsecurity contributions, biut excluding oil revenue), i.e. slightly higher thanin Nbrocco and slightly.lower than in Egypt, to take the example of twoneighboring countries. 'wAs is usual in developing countries, indirect taxes(particularly those levied on international trade) account for about twothirds of fiscal revenue. Nevertheless, direct tax rates are kept high as a

I,,

'I

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mans of compensating for the many exemptions and widespread erasion.1" Inaddition, the tax structure is outdated and complicated:

- Individuals pay a combination of schedule taxes (at rates dependingon the source of income) and a progressive personal income taxcalculated on the remaining income. A flat rate tax is applied toowners of small businesses and craftsmen.

- Companies pay a graduated tax on their profits and di-idends. Theprofits tax is proportional, the rate depending on the type ofactivity in question, to which is added a flat rate consisting of 1Xof turnover. Different turnover tax systems are applied tomanufacturing, consumption and services.

111. Since 1982, various cbanges have been made to simplify the system andlighten the tax burden on individuals and companies, and also to establish auniform turnover tax. Two were particularly important:

- the 19B3 Finance Law reduced the flat rate corporate profit tax from46.51 to 441 for commercial activities and from 40.51 to 381 formaufacturing, tourism and transportation; moreover, the securitiestax could be deducted from the tax payable by the holders of thesecurities concerned;

- the 1986 Finance Law reduced the individual profit tax frommanufacturing and conmuercial activities from 25% to 20%, and themaximum rate of the personal income tax from 801 to 68% (with aceiling at 60% of overall income).

In addition:

- The production tax waus extended to cover the construction industry,public works and trausportation (in 1984), together with tourism (in1985) and the tax on services was increased in 1986 to bring it intoline with the production tax.

112. Two more far-reaching reform measures that form part of the agreementwith the IMF, will be iruplemented as part of the overall adjustment program:

- In August 1986, the Government announced that it intends to introducea general value added tax on January 1, 1988. A bill, now underdiscussion, will be submitted to the National Assembly in the firstquarter of 1987.

- The government-also intends to simplify and consolidate the system ofpersonal income and corporate profits taxes during the Seventh Planand perhaps further reduce tax rates.

In its July 1985 report, the IMF estimates losses from tax evasion andavoidance at about 50% of potential direct tax revenue.

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Ioplementation of these two reforms, which are designed to be revenue neutral,will be discussed with the IMF before the end of September 1987, during thesecond review of the program.

6. kEdustuial Emloymnent

113. The creation of productive employment has been a high priority ofTunisia's development strategy over the last decade because, in addition torelatively high unemployment (about 141 of labor force) and underemployment,the labor force was growing at a rapid 3.3 2 annually. Government sought toresolve the employment problem by maintaining a high rate of economic growthand an exceptionally high investment rate. Labor emigration to Europe and tothe Middle East also helped relieve some of the pressure. However, the dropin world oil prices, the decline in Tunisian oil production, and the overallslow-down in ecomomic growth created by it, have necessitated a cut in theinvestment rate, and this combined with the recession in Europe and the oilproducing Middle East countries has led to a further aggravation of theunemployment problem.

114. In 1983, the Tunisian Government and the Bank undertook a joint studyof industrial employment, that identified an action program in six policyareas whose objectives are to reduce unemployment and underemployment as wellas increasing the number of newly created jobs by reducing the cost ofemployment creation. Two of these areas, namely (i) the re-orientation of theoverall development strategy by reforming the system of factor renumeration,and (ii) the reallocation of public investments, are being addressed under themacro-economic program underlying this Loan adn the recently approved ASAL.The third area -the reform of the system of industrial promotion and theIncentives framework in Tunisia- is the centerpiece of this operation. Thefourth policy area deals with the institutional set-up as it relates to (i)technological acquisition, adaptation and dissemination, (ii) the roles ofemployers' and workers' organizations, and (iii) improved coordination betweenthe Government institutions. These, again, are dealt with in this Loan;however, since the study's recommendations cover a long period, only theinitial and immediate measures have been incorporated within the policypackage supported by this operation. The fifth policy area dealt with issuesof education and training reform which should more appropriately be dealt withwithin the framework of education/training operations. Finally, the sixtharea concerns specific wage and employment issues.

115. In addition to the above study, the preparatory work for two lines ofcredit (Loan 2522-TUN for exports and Loan 2554-TUN for electro-mechanicalindustries) as well as for a second SSI project and for the industrial sectorreport, included visits and field surveys of many manufacturing firms, whichcovered among others, issues related to industrial employment and wages.Together with the joint Bank/Government industrial employment study, thesefield visits have formed the basis for some of the specific agreements onemployment and wage policies reached with the Tunisian Government that areincorporated in the sectoral policy package and are discussed in the followingparagraphs .

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116. The proposed Loan supports an adjustment program which incorporates areformed incentives framework favoring labor-intensive policies and a modifiedwage policy that (a) aims to contain any further increases in wages over theshort tern, (b) bases industrial wage adjustments, in the long tern, onchanges in productivity at the level of the industrial enterprise, and(c) aias to prevent any further increase in the high social securitycontribution by employers in the short term and to achieve a gradual declinein the longer term. Thus, the MITAP, in addition to the measures affectingemployment and wages that are a part of the macro-economic framework on whichthis Loan is based, would support the following:

(i) In an effort to prevent any further increases in social securitycharges that help finance six separate programs, some of which areexperiencing deficits while others are in surplus, the Governmentwill study the feasibility of reallocating the total among thevarious programs so as to maintain the longer term equilibrium andvill also review the structure of the various benefits being providedto determine if a balance between resources and expenditures ispossible; if not, the Government has agreed to realign benefits withexpected revenues instead of increasing the burden of social securitycharges on employers.

(ii) Helping enterprises to implement the policy of basing wageadjustments on changes in productivity and to take into account thefinncial condition of an enterprise is a priority task that theGovernment would like to see followed on a wider scale. Thepractical application of such a policy requires the assistance ofexperts to train Tunisians, both staff of the Ministry of SocialAffairs and of selected enterprises, in this area. The Governmenthas requested the Bank's assistance in finAncing the cost of suchconsultants for an initial phase, which is expected to cost aboutUS$200,000.

(iii) As part of the efforts to prepare the Seventh Plan, the Government isundertaking a review of labor and employment legislation to ensurethat it is sufficiently flexible to promote employment, incitesentrepreneurs to hire more staff, and at the same time is not anobstacle to enterprise rehabilitation and restructuring efforts. Theresults of such a review would be discussed with the Bank and atimetable for action agreed upon.

7. Toureism Polcy Study

117. With a share of about 18Z of total foreign exchange receipts. tourismranks with energy and phosphate products as one of Tunisia's major sources offoreign exchange earnings. With energy output declining and phosphate pricesdepressed for the foreseeable future, the optimization of this source iscritical to the sustenance of Tunisia's development. Moreover, the sector isa major source of new employment, not only in the coastal area but wherevertourism can be maintained, thus contributing to the couatry's employment andregional development efforts. In recent years, however, ita growth has beenslow and erratic. Furthermore, domestic value added has remained rather low.

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118. The main causes of slow growth and low domestic value added arefour: firstly, the sector appears to suffer from too-fast an expansion ofhotel capacity and this tendency seems to be continuing. The 301 increase inhotel capacity presently under construction exceeds the foreseeable demandincrease of 13-141 between 1987 and 1991. This will further reduce an alreadylow average occupancy rate. Secondly, the low occupancy rate will furtherweaken the position of the Tunisian hotel industry in its negotiations withtour operattirs and will enable the latter to negotiate even less favorableprices for tunisian hotel owners, thus further reducing the domestic valueadded from tourism. Thirdly, continued reduction in profit margins which arealready depressed will force hotel managers, even more than in the past, toneglect the maintenance and renewal of their facilities and in general, reducefurther the quality of their services. This leads, fourthly, to a furtherdeterioration of the quality of services and becomes a cause forlarger-income, high-spending tourists to turn away from Tunisia.

119. In light of the above, it appears necessary for Tunisia's touristindustry to embark on a program of consolidation. Among other things, thiswould seem to imply that the incentives system should provide moreencouragement to renewal, proper maintenance, and proper management ofexisting investments, rather than to the construction of new hotels. Moreover:

(a) Tunisia would seem to have the potential to branch out and diversifyinto the higher quality segment of the market. So far, Tunisiantourism consists overwhelmingly of low cost, beach-based,charter-flight/package-tour arrangements which generate a ratherlimited value added to the country. Individual tourism is much moreprofitable and should be developed taking advantage of Tunisia's easyaccessibility from Europe;

(b) tourists should be encouraged to spend more during their stay inTunisia on purchases of all kinds; excursions, sports activities andother entertainment. So far, these auxiliary activities are littledeveloped and tourists seem to spend little money over and above theactual costs of the package tour;

(c) attempts should be made to increase the low number of repeatertourists in Tunisia. This will require, most likely, an improvementin the quality of services and in the auxiliary activities.

120. Not enough is known, presently, about the sector to formulate suchpolicies; this will require an in-depth assessment of the sector's problemsand of the various obstacles preventing a more rapid and controllable growth.To this avail, the Tunisian authorities plan shortly to undertake acomprehensive study (see para. 133). Given the high importance of thisendeavour, the Bank was willing to consider a possible participation in thefinancing of this study in the context of this loan; the Government, however,was confident that it had the necessary means to undertake the work withoutoutside assistance. The study would focus particulariy on:

(a) an analysis of the current incentive structure as it affects tourism,with a view to determine whether it is biased in favor of newcapital-investments and against labor-intensive services andmaintenance; this analysis should include an analysis of fiscalincentives and disincentives, the role of Government subsidies, andpricing and import regulations affecting the sector;

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(b) an analysis of the current institutional Bu.Pport structure both athome and abroad, including marketing, linkage with infrastructure,the labor market, as well as the existing specialized schools andtraining institutions; and

(c) an analysis of prices to Tunisia and its competitors from majorEuropean destinations for all-inclusive package tours and individualtourism, versus its major mediterranean competition.

121. The above analysis should result in a set of specific policyrecommendations to Tunisian decision makers on how to:

Ci) coordinate construction of new hotels with foreseeable demand;

(ii) stimulate development of auxiliary services such as sportsfacilities; cultural facilities (i.e. antique monuments,museums, folklore); recreational and shopping facilities(handicraft shops, tax-free shops);

(iii) stimulate better hotel maintenance and renovation;

(iv) improve the quality of hotel and other services; and

Cv) promote individual tourism.

Achieving these objectives will likely require changes in the incentivesstructure, supported by improvements in public services and some publicinvestments, and changes in public laws such as the tax and labor code andimport regulations.

PART V - THE IOAN

A. Origin and Objectives

122. During the 1984 Annual Meetings, the Tunisian Government requestedthe Bank to consider the financiag of a number of sector adjustmentoperations, beginning with two loans, one in industry and the other inagriculture, to help support continued reforms of the economy. In response,the Bank mounted in January 1985,, a missidn to review the industrial sector.The report of this mission was discussed with the Government in September1985. along with a Synopsis Paper that presented the gist of the Bank'sproposals for policy changes within a consistent macro-economic framework.Government, as a result of these discussions, decided to pursue with the Banka broad-based policy dialogue with the objective of establishing an adjustmentprogram that would cover the period of the Seventh Plan (1987-1991) and thatwould be financed in phases starting with an agricultural sector adjustmentloan, followed by this industrial and trade policy adjustment loan. Thisprogram was designed jointly by a Bank team and the staff of the Ministries ofPlaning and Finance, of Comnerce and Industry, and the Central Bank.

l

123. The purpose o0 this Loan is to provide the necessary financial andtechnical support to the Government's program for macro-economic reform,described in Part II, and to the adjustment program in the industrial and

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trade sector described in Part IV. The Covernment's macro-economic andseCtoral adjustment programs have been transmitted to the Bank in two letterssigned by the Minister of Finance and Planning, one covering economicdevelopment (Annex IV) and the other the industrial development policy (AnnexV). The sectoral reform program, including a detailed action program thatcovers the period from mid-1986 to 1988, was appraised by a Bank mission inOctober 1986 and negotiations took place in Washington, D.C. from December 19,1986 to December 24, 19S6; the Tunisian delegation was led by Mr. TaharEnnaifer, Director General of Projects in the Ministry of Planning andFinance. A Loan Suumagry is given at the beginning of this report, and aSupplementary Project Data Sheet appears as Annex III.

B. Acion Proarm Under the Loan

124. The macro-economic and sectoral adjustment programm cover the entirefive-year period of the Seventh Plan (1987-1991), but the action program to besupported by the proposed loan focuses particularly on the first two years ofthis period. While the broad outlines of the five-year program have beendiscussed and agreed between the Government and the Bank, it is theshorter-term two-year slice of this program that has been developed and agreedupon in detail. Thus, a number of policy reform measures have been selectedfor monitoring from among all the measures agreed upon, to gauge the progressof action on policy reform. Monitoring of actions to be taken will be almostcontinuous but a special review would determine whether progress ofimplementation of the macro- and sectoral- reform programs during the periodcovered by the first tranche is satisfactory and on that basis, whether thesecond tranche of the loan should be released (paras. 139-140). Sectoralreform actions in the various policy areas selected as conditions ofeffectiveness or release of the second tranche of the Loan are discussedbelow; they include actions on the new investment code, on the new system ofcovering the exchange risk on foreign borrowings by development banks, as wellas submission to Parliament of the draft law on the VAT.

ahe nMcetves EFramework

125. Assurances were provided during negotiations that the Government willhave submitted the new Investment Code to its National Assembly by the time ofeffectiveness of the Loan and will have adopted the new Code prior to therelease of the second tranche of the Loan (para. 140). The new Code willabolish general investment licensing. It will give special incentives almostexclusively for high priority investments, primarily those exporting part oftheir output or creating jobs in the most underdeveloped areas of thecountry. They will be granted automatically provided specified criteria aremet and will make no distinctions by project size or project type.Additionally, certain incentives will be available to all investments withoutspecific approval as "common law" rights, including those outsidemanufacturing; they will focus on encouraging exports and enterprisecreation. The main incentives to encourage exports, mostly available as"common law" rights, will be tax and duty free import of products to beprocessed into exports, tax free local purchases of similar products, andpartial income tax exemptions for funds invested in, profits generated by, anddividends gained from export operations. The new incentives to encourage the

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creation of jobs in underdeveloped areas will consist primarily of thegovernment bearing the cost of infrastructure on AFI industrial estates; inaddition, they foresee temporary cuts in social security charges on employersand partial income tax exemption for fund: invested in, and dividends fromsuch operations. There will also be minor incentives to facilitate theintroduction of new technologies and Tunisian manufacture of capital goods.Experience with the new code, as well as the need and justification ofmaintaining it, would be reviewed towards the end of the Seventh Plan.

126. For an interim period between the time investment licensing isabolished and imports of capital goods are liberalized on January 2, 1988, atemporary procedure, acceptable to the Bank has been established authorizingImports of such goods for priority projects that do not qualify for specialincentives.

127. During negotiations, assurances were obtained on the followingactions: (a) issuance of a decree separating the Approvals Committeeresponsible for implementing the new Investment Code from API's Board ofDirectors. This is a condition of second tranche release of this Loan (para.l60); (b) merging of CNEI's and AFI's activities and personnel with those ofAPI by January 2, 1988; (c) restructuring API to focus on promotionalactivities by January 2, 1988; (d) merging of OCT's promotional work withCEPEC bY end 1987; (e) a detailed, concrete proposal to reduce financialdependence of technical centers on the budget to 502 by the end of the VIIthPlan (1991); finally, (f) submission of a concrete p,oposal to expand the roleof Chambers of Commerce and of UTICA before the end of 1987.

Mony and Credit

128. Banking: As regards liberalization of ban. .vities, theGovernment has deregulated as of January 2, 1987, all lenuing and borrowingrates, with the following exceptions:

- lending rates on loans to priority activities (i.e. exports,agriculture, small- and medium-sized enterprises, energy saving),which will continue to be set by the Central Bank,

- borrowing rates on special savings accounts and the convertible Dinardeposits of Tunisian nationals resident abroad; these will bedetermined by reference to money market rates.

Banks are now free to determine all other conditions, including spreads andfees. The monetary authorities will intervene solely in order to guaranteepositive real rates for term deposits and to set a ceiling for lending rateswell above the inflation rate so as to prevent usury.

129. The Government also raised the minimum amount for loans by depositbanks that require prior authorization from the Central Bank (BCT) to TD 5million, starting January 2, 1987. This new limit applies to all short-ternloans. Medium-term lending has become almost totally exempt from a prioriautborization from the BCT and so has the very smalt amount of long-termlending, except for loans to public enterprises.

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130. Exchange-Risk Guarantees: In the past, the Government has generallyprovided BDET and, to some extent, BNDT with exchange-risk guarantees on theirexternal borrowings. With the likely increase in borrowings by developmentbanks, Government could face considerable financial risks if these guaranteeswere not limited to small borrowers unable to cover the risks themselves, andif the banks were to continue to borrow in low interest-rate currencies thatare highly likely to appreciate. In consequence, the Government has agreed tointroduce, after a study has determined the most appropriate ways of doing so,the following changes to the system (para. 140):

(a) Exchange-risk guarantees granted to a banking establishment borrowingabroad should cover only loans to SMEs (see para. 105);

(b) Financing arrangements for the Exchange Equalization Fund (FPC) willbe changed to ensure that the FPC would remain financiallyself-sufficient without any need for government subsidies. Inparticular, whenever there is a drawing on a new foreign loan, theborrowing banks would pay the FPC a commission equal to thedifference between the cost of the loan and a reference rate which isthe long-term domestic lending rate, minus an allowance foradministrative costs.

(c) To further avoid the need for government subsidies, additionalmeasures designed to increase the revenues of the FPC will be adoptedany time that there is a foreseeable risk of a lasting deficit in theFund.

Prior to effectiveness of the proposed Loan, the Government will agree withthe Bank on the terms of reference of the above-mentioned study; discussion ofthe findings of this study and the implementation of a mutually agreed uponsystem will be a condition of second tranche release (para. 140). Also priorto the effectiveness of the proposed Loan, the Government will agree with theBank on the terms of reference of a second study to be undertaken by theCentral Bank on forward coverage of exchange risks in the context of theforeign borrowing policy (para. 140); the results of this study will bediscussed and a mutually agreed upon system will be implemented by January 1,1988.

Taxatien

131. There is nothing in the existing tax regulations to seriously hinderbusiness efficiency that should be immediately eliminated. However, the taxsystem is excessively complicated in all categories, and rates are relativelyhigh; they could be reduced if the regulations were more strictly applied.The Government has decided:

(a) as a first step, to introduce a general VAT system on January 1,1988. The submission of a draft law to the National Assembly would -

be a condition of second tranche release under this Loan (para. 140).

(b) to standardize direct taxes on individuals and corporations, withsome reduction in rates before the end of the Seventh Plan.

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Government will discuss implementation of these two fiscal reforms, which areplanned to be income neutral, during the second review of the program withthe IMF before the end of September 1987.

kldsrial Emuomen and Was

132. During negotiations, assurances were obtained that the Governmentwill undertake the following actions as conditions of second tranche releaseunder this Loan:

(1) Social Security contributions by employers will be prevented fromincreasing further in the short term and will be reduced gradually inthe longer term without undermining the financial integrity of theexisting social security system. To this avail, Government will.study the feasibility of reallocating employers' contributions amongthe six programs covered by the social security system and willidentify the actions needed to realign future benefits with theforeseeable resources of these programs. An exchange of views on themeasures to be taken and on a timetable for implementation will be acondition of second tranche release (para. 140);

(ii) The policy of selective wage adjustment based upon changes inproductivity and upon the financial condition of each enterprise willbe pursued with the help of technical experts to be financed underthe project. The focus of such assistance is to help in thepractical application of this policy and to train Tunisian staff insuch tasks (para. 116 (ii)). Employment of consultants to undertakethis task will be a condition of second tranche release; and

(iii) The Government will review the existing labor and employmentlegislation so as to make sure that it is sufficiently adaptable andflexible to promote employment and does not constitute an obstacle toefforts to restructure industrial enterprises. The proposed changesresulting from this review will be discussed with the Bank before thesecond tranche release to determine the scope of key changes and atimetable for implementation will be agreed upon.

Tourism

133. During negotiations assurances were obtained that the Government willundertake a comprehensive study on future policies necessary to increasedomestic resources from tourism. Agreement between the Bank and theGovernment on the terms of reference of this study will be a condition ofeffectiveness (para. 140), and the study's conclusions and recommendationswould be discussed with the Bank before end 1987.

C. Loan Adinistration

134. Eligible Expenditures. The proposed Loan of US$150 million wouldfinance (a) the foreign exchange cost of imported goods up to about US$149.8million, using a negative list. The items not to be financed include goodsfinanced by other sources and a specific list of excluded items, such as

- 46 -

military or para-military items and luxury goods such as tobacco, preciousstOnes, jewelry, gold and nuclear reactors and parts; and (b) the foreignexchange cost of the technical assistance program that would help Governmentto implement its new salary policies in manufacturing enterprises, up to aboutUS$200,000.

135. Procurement. Procurement of imports by the private sector (includingpublic manufacturing enterprises) would be made following regular commercialpractices using not less than three quotations from suppliers or manufacturerswhenever possible, except when any one contract is US$5.0 million or more, inwhich case international competitive bidding (ICB) in accordance with Worldbank Guidelines would be used. Procurement of imports by the public sectorwould be done by ICB, except in the case of contracts costing less thanUS$2.0 million each, up to an aggregate of US$15.0 million, which would, beawarded on the basis of standard procedures for public sector procurementwhich are acceptable to the Bank. Procurement would be grouped wheneverpossible into packages suitable for ICB. Items which the Bank considers of aproprietary nature, expected to total no more than US$5 million, would beprocured by negotiated contract, following procedures satisfactory to theBank. Consultants helping to implement the Government's new salary policies(para. 116) would be employed in accordance with Bank Guidelines. Biddingdocuments, bid evaluation reports and proposed awards of contracts procuredthrough ICE would be subject to the prior approval of the Bank. For otherprocurement, the Borrower would furnish to the Bank, prior to the submissionof the related withdrawal application, such documentation and information asthe Rank may reasonably request to support the withdrawal of funds from theLoan account in respect of such contracts.

136. Disbursement. The Central Bank would have primary responsibility foradministering the proposed loan. Disbursements from the Loan account forimports would be made against 100% of the foreign cost of eligible imports.Disbursements for consultants' services would be made against 100l of foreignexpenditures or 70% of local expenditures. Disbursements for contractsprocured through ICB and for consultants' services would be made against fullydocumented withdrawal applications. Disbursements for other items would bemade on the basis of statements of expenditures (SOE) from the Central Bankdetailing individual transactions in a given period, together with acertification of payment of the amounts involved, and of their eligibilityunder the Loan. Supporting documentation for SOEs would be retained by theCentral Rank, until at least 12 months after the closing of the Loan account,and made available for review to Bank supervision missions. Applications forwithdrawal would be consolidated and submitted in amounts not less than US$1.0million. In order to accelerate disbursements, a revolving fund (specialaccount) with an initial deposit of US$35.0 million (corresponding to fourmonths' payments expected to be made through the revolving fund) would beestablished at the Central Bank. Replenishments would be made either once amonth or when half of the revolving fund has been utilized. The Loan isexpected to be fully disbursed within 18 months of effectiveness. The ClosingDate would be December 31, 1988.

137. Account and Audits. The Central Bank would maintain records of alltransactions under the Loan in accordance with sound accounting practices.Not later than six months after the end of each fiscal year of the Borrower,

- 47 -

all accounts. including the special account (revolving fund), would be auditedby independent auditors acceptable to the Bank. Audit reports would include aseparate opinion with regard to the claim submitted to the Bank on the basisof SODs and would state whether such claim bar been effected in accordancewith the Loan Agreement.

138. Release of Funds and Tranching. The proceeds of the Loan would bemade available for withdrawal in two tranches, the first of US$100.0 millionupon Loan effectiveness, the second of US$SO.O million when the conditions forits release have been met. Disbursement would be made on a 'tfirst-couefirst-served" basis. The conditions for the release of each traeche wouldrelate to the implementation of specific measures which are crucial to theexecution of the overall mero-economic and sectoral adjustment programs.Besides these measures, the Government has already demonstrated its commitmentto the objectives of the macro-economic and sector programs by taking keyactions in recent months; for example, currency adjustment, a first round ofimport and price liberalization, budget cuts, and trade and export pro otionmeasures.

139. The macro-economic reform actions which would be supported andmonitored under the loan are:

(a) as a condition of effectiveness: an approved 1987 budget reflectingthe objectives referred to in Annex I to the Macro-EconomicAdjustment Program, attached to the Letter of Economic DevelopmentPolicy of September 1, 1986 (para. 29);

(b) as a condition of second tranche release: Bank confirmation ofsatisfactory progress in implementation of the overall macro-economicprogram (para. 37).

140. The sector specific actions to be supported and monitored under theloan are:

(a) as a condition of effectiveness:

(i) submission of a new Investment Code to the National Assemblyreflecting the objectives referred to in the Medium-TermIndustrial and Trade Policy Adjustment Program, attached to theLetter on Industrial Development Policy of January 27, 1987(para. 125);

(ii) agreement with the Bank on the terms of reference of thestudies to prepare the concrete features of the improvedexchange risk guarantee scheme and on the forward coverage ofexchange risks in the context of the foreign borrowing policy(para. 130);

(iii) agreement with the Bank on the terms of reference of thetourism policy study (para. 133);

- 48 -

(b) as a condition of second tranche release:

(1) adoption of a new Investment Code acceptable to the Bank (pare.125);

(ii) issuance of a decree establishing an Approvals Comitteeresponsible for implementing the new Investment Code, such acomittee being independent from API's Board of Directors(para. 127);

(iii) adoption of an improved system of exchange risk guarantees(para. 130);

(iv) submission of a draft VAT law to the Tunisian National Assembly(para. 131);

(v) an exchange of views with the Bank on policy changes and on atimetable for implementation of changes aimed at preventingemployers' contributions to the social security system fromincreasing further in the short term, and reducing themgradually in the longer term, without undermining the financialintegrity of the system (para. 132 (i));

(vi) employment of consultants for the technical assistance programaimed at training the staff of the Ministry of Social Affairsand of selected enterprises in the implementation of theGovernment's new salary policy (para. 132 (ii));

(vii) review by the Bank of a program and agreement on a timetable ofchanges in labor and employment legislation aimed at improvingthe adaptability and flexibility of labor laws (para. 132(iii));

(viii) Bank confirmation of satisfactory progress in implementation ofthe overall medium-term industrial and trade policy adjustmentprogram (para. 124).

D. Mament. Coordination and Monitorig

141. Management and coordination of the adjustment program, including bothits macro-economic and sectoral components, would be the responsibility of theMinister of Planning and Finance, with assistance from the Ministry ofIndustry and Commerce, and the Central Bank. Analytical and monitoringsupport would be provided by the Directorate-General of Planning in theMinistry of Planning and Finance. Assurances were obtained at negotiationsthat a semi-annual report on the implementation of the macro- andsector-adjustment programs would be provided to the Bank, followed by anexchange of views on the status between the Government and the Bank.

E. JustWifcation and Risk

142. The package of macro-economic and sectoral adjustment measuresis expected to have a favorable impact on economic growth in general, theallocation and use of economic resources, the balance of payments and the

- 49 -

public finance situation in particular. Its emphasis on decontrol,transparency of policies and avoidance of bureacratic interference in theeconoqy, is expected to result in a distinct improvement of the generalbusiness climate reinforced by the streamlining of the tax system under MITAPand the IMF program and the increased flexibility to be introduced intoindustrial employment polic!.es. Together, this should result in highertrading and exports of goods and services, higher private investments, higheremployment creation, a decline in the ICOR, a gradual decline in the balanceof payments current account deficit, and in the overall budget deficit. Anycomprehensive adjustment program of this size and complexity necessarilyentails some element of risk. The strict limits on domestic demand might notbe maintainable due to social, political and economic pressures .(too rapid anincrease in salaries, too rapid growth in domestic credit and moneycirculation and less rapid than expected reduction in the budget deficit).-The growth of non-oil/non-phosphate exports might be slower than expected forexogenous as well as indigenous reasons (worse than expected world marketconditions, political troubles around the Mediterranean, insufficient exportincentives, excessive domestic demand). Higher than expected domestic demandcombined with lower exports would put heavy pressure on the balance ofpayments, jeopardizing the liberalization program, particularly Qf imports,which is a key element in the overall adjustment process. While these risksare real and unavoidable, they are limited by; (a) the considerable amount ofpolicy measures already taken by Government; (b) the Government's clearcommitment to continue the adjustment program, as expressed in the basicpolicy documents underpinning the preparation of the VIIth Plan and clerrlypresented to the recent congress of the ruling political party; and (c' theproposed gradual approach to change, which permits the economy to adapt to thenew policies steadily, but progressively within a realistic time period.

143. The sector adjustment measures are expected to have a favorableimpact on sector productivity and on both the balance of payments and fiscaldeficits. Some of the benefits will only be realized in the longer term; allof them, however, are vital to the process of adjustment and development. Theabsence of bureaucratic second guessing of investment decisions wouldcontribute to more rational market-driven investment decisions; together withthe streamlining of financial sector supervision and export and tradepromotion actions, this should impact favorably on growth and the balance ofpayments. Institutional and employment related actions should lead to greaterefficiency in the use of economic and budgetary resources. The tourism sectorstudy should lead to reform action which in turn, should benefit the balanceof payments and fiscal situation through optimization of the country'sconsiderable tourism potential.

144. The risks facing the sectoral adjustment program relate to the lengthand difficulty of the process, the unpredictable developments in the externalenvironment and the uncertainties in the response of the private sector to theprogram. While Tunisia's record in implementing reform agreed with the Bankis satisfactory, the magnitude of the adjustments needed and inter-relationships between them create some risk about the pace of implementationand saintaining the integrity of the, reform package. The response on theexport front, specifically contingent on actions by Tunisia's trading partnersand competitors and on how the private sector will respond to the changingenvironment, is difficult to predict with precision.

-50-

145. The design and innsgmunt of the sectoral adjustment program hasbuilt-in feature to minimimoe.the.e risks. First, strong linkages with macro-economic action a itepgr art of the design. Second, the specificactions art -,be taken over a short 12-18 month period for which uncertaintyIs less. Mh1rd, tho phased approach to iWlementing the sector reforminherently peaitii flexibility and adjustments between phases, in light ofsectoral and aicro-econouic developmts.

PART VI - REGOMMEDATON

146. I am satisfied that tb's proposed Loan would comply with the Articlesof Agreement of the Bank and I recomund that the Executive Directors approvethe proposed Loan.

Barber B. ConablePresident

Janur 28, 1987Washington. D.C.

Annexes

e8~~~~~~~~~-

i~~~~~~~~~~~~~

' ;'~~~~~'

! :-

-51- ANNEX IPage 1 of 3

IEJ - DUC DOI

Anm.L OQuit, AAmpiaL (~~~~~~at 1960 gdm)

bdlUm 831 kobu Pfl..TaUsugta* at Lint jzia)

1983 IM 115 11 1m 196 195 1966 1817 19 1

Qim .dtic p :t 8i ,272.6 7A 5.5 -05 4.7 5.7 5.7 -LO 4.0 3.4lrim1hum 1,255.8 9.9 6.5 -10.3 2.5 12.9 17 -12S 9.5 3.5Tia__y 2,U84 9.0 6.8 (L1 6.7 3.B LS LU 1.9 3.4

3,510.8 7.7 6.6 2. 3. 5.1 4.9 1.7 3.8 3.4

6,5312 12.7 7.4 3.0 4.9 5.9 3.1 L2 3.3 2.8QG imuam 2198.6 0.9 15.1 -0.7 -2.2 9 -13.0 -15.4 4.3 4.Eqmu of V.ald WES 2,699.9 0.0 3.5 -69 0.9 27 3.3 1S 3.9 4.4tp.t of 1ods ad WS 3,307.1 4.5 13.0 h9 -2.2 5.7 -13.0 -L7 2.6 3.6Q1 rAjuimi :c 8,191.1 7.9 5.7 -0l 4.7 5.3 4.3 -0.9 4.0 3.4Qua :udru 1,609.9 -4.7 0.3 -1Z.9 4.2 3.2 9A -13.A 7.4 6.1

Gm delawr (19D - 280) 10D.0 UL4 13.2 AL.2 151.6 13.8 15.0_tcbm von 2.6 2.0 L69 L473 L2187 LV3 17

(a wcww 2r Co em m DS ge17 17 16 18 16 1 l9n-76 197641 196146 19661

ntme auIgt 1 20 1. 0.0 DO. 30.0 DD0.0 7.1 6.1 3.6 3.4-giculta 19.4 17.8 17 122 13.5 14.0 6.3 L6 4.0 4.3

zy 2 252 32.0 30.5 269 3.5 86 6.9 3.0 3.1smfd= 47.1 44.0 41.8 43. 44.6 413.0 7.1 6.5 3.9 3.4

60.5 77.3 761 79.3 8.7 78.7 8.9 7 4.2 2.7Qu. ifsm. 21.5 30.7 3X.3 2793 2.6 2L3 5.9 6.6 -3.9 4.0fnau of Moab ad WS 24.1 2S.1 414 35.4 29.8 33.9 7.1 8.5 0.8 2.8

-at3f ci ad WS 2L1 37.0 49.8 44.0 3.1 348 11.6 I8 -2.4 1.6Q~ ua i..l PM= 99.6 97 A0.8 IM.2 99.2 99.8 7.0 5.6 3.3 3.5

-b _im -0A -1.3 0.8 L.2 -- 8 -02 8L -1.5 -14.8 . Yimlstinr Lm.1 214 24.6 l2 155 21. -2.3 4.2 -0.2 6.6

~i z Of IW

>es-c .8 32.3 312 32.2 31.2QA= _adku 193 21.5 23.1 24.4 23.8aijpha (I) or dicit C-) 69 7.8 &.I. 7.8 7.5wizl _Aib" 3/ 11.8 15.3 15.1 16.3 15.2

IOAP f mia LO LO 1.7 2.3 3.3

71g-76 1976116am Bmiwa

- 1w PO gm" mo 4.4 3.9 0.9 1.02.7 5.2 10.4 6.3

.r awir =to -0.0 0.1 -42 0.4Wmtelitiait L6 1.8 -0.7 0.5

Gm ~ at umt gm= ad amwmwds at fw-tc cit. umm au-chnpaod PMu iant jgiMPM& .Jm7y 1977 f de dbt _imi

ii,b - mt ciodtl a of nWtaw vtulma.

- 52 -ANNEX IPage 2 of 3

SsIA - CaL IRE

Awal GQuh R eAM= (at 1980 Price.)

(illio U$ IkbAI Prel. PRmctedat current prces)

Indiretor 1985 1910 1981 1912 1983 19Gb 1985 196 1987 1991

Exports of gos 1,729.2 -0.4 4.3 -8.9 3.2 1.2 -1.0 4.6 2.0 4.1Peerolem 723.3 2.2 -7.3 -Z0.9 0.6 -1.0 -3.7 -. 1 -9.0 -It7Agricults 8W.4 -3L1 83.5 -383 -13.4 62.1 -3.2 12.8 4.0 4.0lizqste tacks 40.3 4.2 4LO 27.8 0.6 -12.1 24.6 5.6 5.5 5.5Mfataurizu 885.2 0.0 16.9 8.7 6.9 -1.0 LO 11 8.9 L86

hyoers of gods 2,740.6 4.5 11.7 0.9 -3.4 5.9 -5.2 -1.3 2.4 3.9Food 333.4 -7.0 2.1 -7.7 21.7 2.6 -227 19.7 1.4 0.6Ietwtrle 369.6 7.9 -87 -*6.9 3.0 7.3 3.8 -3.9 4.6 17.1harenndiae g 892.3 11.0 3.9 12.4 -62 9.7 -13.4 LI 3.6 3.6Cqiital os 63.0 -2.2 40.9 15.8 -19.5 9.8 -28.5 -20.0 0.8 3.7Othes Yi2.4 6.3 6.6 6.1 10.8 -3.6 -v.3 -7.8 Ll L5

.~ ~ ~ c _ We

Export prie i 100.0 9L3 87.0 79.2 75.8 73.6 7.0 72.6 9L9kw= prie is 100.0 93.4 84.5 50.0 78.7 787 820 83.4 948Tern of td indet 100.0 105.2 103.0 99.0 96.3 93.4 81.7 P7.0 97.0

Cayotiao of truhdise 7.ni (2) hew A--I Increse (Z)(a an prices) (at c pris )

1971 1976 1981 1983 1966 19 1971-76 29764" 1981-86 18-91

XPorcs of godls IW.O 10.0 100.0 100.0 10 10 5.0 8.1 0.1 0.1Pecrleus 26.9 42.3 53.3 44.7 24.1 8L 3.4 7.4 - 4.9 -20.2Agriuldture IL6 4.5 3.1 4.4 5.5 5.3 4.4 2.4 0.7 4.0FFasphate rocks 9.9 7.7 1.9 2.1 2.6 3.0 2.9 -LO 6.3 5.5m,ufacfring 50.7 45.5 41.7 48S 67.8 83.6 9.2 10.9 4.5 87

hi5ts of goads 100.0 100.0 100.0 100.0 100.0 100.0 14.2 10.4 -3.3 1.6Food 19.6 12.3 11.4 t4.0 13.3 IL0 -1.9 11.6 0.5 0.7ecroleun 3.6 11.1 19.8 11.2 7.1 6.6 30.5 17.6 -6.1 -5.9

Inrtemsliace goods 30.1 28.A 2.1 29.6 37.2 38.9 12.1 10.2 0.4 3.6Cqpitsl gools 27.7 31.9 25.4 25.6 20.8 21.0 18.0 4.9 -10.7 2.9Ochefs 19.0 15.8 15.4 19.6 21.7 21.4 12.1 11.4 0.1 1.3

S9re of Tra vuith Sure of Trade with Sure of TIrae wirh Sare of TruSe winIdustrial Contries (2) Dewl couarius (2) OitL sn (2;) s ly PlWd Caries (Z)19701l975 1980 1984 1970 1975 1980 19__ 1970 1975 1901 V7019731980194

DDVRD2I OF TREExports 70.8 60.1 68.7 76.9 4.9 21.7 25.4 14.5 13.9 11.1 4.8 7.7 9.4 6.1 0.4 0.9Imiorts 85.9 79.5 51.8 80.7 7.1 10.9 7.7 11.8 0.7 6.3 7.5 3.6 6.3 3.1 3.0 3.9

10!15fl,7EN& CPlI-CJimmy 1987-

~ 53 - .iANNEX Itan= - nmM OFse_. Dmours,Mem. a ush Page 3 of 3

SilMm Wat avrns prim

Antu IbL . eed___ _ VW I19II DUb _ 1Q5 1163 164D 111 -IW__

Nt bias of go u -M&. -409 -619.3 790. -65.2 -6.3 -59.3 -t.0 -705. -414.2Equte of *si. 4 e .373 3,92. 3,9465 3,4773 3,317.3 3,13 3,07.5 2,956.2 3,26L9 4,347.3

_atu at ., A mate 293.5L 463222 4,GLa8 4,2687 3.93.S 4,2.7 3,61. 33,779.2 3,*9.7 . .761.5

lbt t_hn 10.3 58.5 -1I82 23.4 11.9 10.9 10.7 11.7 12.5 15.9Qriet ac hwb . -36.6 -351.4 -449.0 -767.4 -43.3 4754 -568. 4 411.4 -93.3 -39L3

Dient prit. iniemmct 50.9 236.0 367.2 4005 223.8 23.0 139.S 17.2 117.6 195.2ewco 50.7 41.5 23.3 19.0 25.3 3L6 3665 4L7 3.3 4K.6

mt Ls C(md @5.7 346.9 332.8 33.8 499.8 329.4 314.2 562.4 713.1 196.9Official 1LO 266 27.l 239.0 25.8 35 216.1 551.0 64.6 407.5ft-inr 32.7 83.3 60.7 84.8 25.0 36.9 98.1 11 164 -210.7

Odur sqaital IL2 138L0 15L9 -18.8 [76.1 -13L8 8L3 0.0 0O0 0.0asw in auen (- -,1 i incn.) -157.5 -72.3 31.7 -54.7 30.5 172.6 1.8 8O. -17.7 -38.4

Iatzin.1 EF lO1 70.8 GZLI 6768 663 473.7 29.0 2A4.0 396.7 631.6hmerumuflat. 2.2 2.0 1.6 1.9 2.0 1.4 1.0 0.7 2.2 1.6

1976 1979 19O 1991 133 19U3 iW1 1985

Officid grts 53.2 50.7 41.5 773 19.0 25.3 28.6 36.5CCc. dimbrmwen of ?LT 36 2U.0 b393 562.2 6461 03 872.B 744.2 750.7Cucsi.n1 109.3 1408 207.6 2S0.4 2672 167.2 159.2 133.7

*ilax-- 100.4 140.0 199.7 234 251.0 150.2 148.6 122.4ML a9 0.2 1.0 LI 1.0 0.0 0.0 0.0

lu lea i l 0 0.6 6.9 4.9 15D 17.0 L6 11.3lurcessinal 13.7 49L5 354.6 405.7 4031 705.6 585.0 617.0

P=i_te 71.6 373 ZZ5.4 231.9 274A 416.4 26L0 3113Oficil qt credits .9 49.6 55.5 6S9 253 93.4 21.9 149.6ID 25.3 55.4 51.1 69.4 818 89.6 88.0 l38OnttPr maktst.ml 2L9 15.2 22.6 3L5 21.6 36.2 13.1 3.1

I Ot tadiq ad Disuand .,l.L4 3.021.0 3,229.6 3,323.8 3.56L4 3,858.2 3.I01.7 4,441.9official 976.0 1,4l.1 2,03.L5 2,175.3 2.3596 2,531.3 2,635.5 3.1165

W127.8 272.0 269.0 319.5 375.6 434.2 480.9 532.2ML 64.1 673 67.9 67.5 67A 67.0 66.2 65.6Odwr 78461 1,554.7 1,701.6 1.783 1,95L4 2,0301 2,13.4 2.514.9

Prine 206.4 1,16.9 1.19L. 1,145.5 1,165.6 1.326.9 1.116.2 1,323.5Ud isbas dbt 1,133.0 1,869.6 2,012.4 2,150.0 21 2,39.4 2.7347 2,E.6

Total derice paense 9L9 316.3 43L4 518.2 481 569.6 653.9 676.9=ame 37.0 162.8 216.1 3,9 199.7 196.7 239.1 241.5

Pajine Z S 6.7 10.1 110 13.1 14.0 17.2 Z1.B 224sjets asZG 2.2 4Z 4 4.9 61 5.9 7.0 8 8.3

Ibrid lm*W! a..E:

Debt _astdi 1.8 7.7 L3 9.6 10.5 113 32.6 I2.1Dis dmas 10.4 8.7 9.1 10.7 12.2 10.3 11. 15.7Debt S&ti 16.6 1.l L5 8.2 10.7 11.2 12.0 13.6

qianet rem af mm ( 5.5 7.2 6.7 L0 7.6 8.3 8L 7.8Official 4.3 5.6 5.7 6.9 6.7 7.1 8.2 6.9Pri'ae 7.9 9.8 9.8 10.3 9.6 9.8 7.9 9.5szqe onturiy of nm l1m (>e r.) 16.3 15.8 173 15.4 16.5 13.5 13.5 15.7

Official 20.5 19.4 19.B m1 19.3 17.2 15.1 18.8Prin 1.4 9.1 10.2 B4 10L. 86 10.4 9.4

Ms Z of De Oatatadizgat Fed of tet Vet

Yawr (1985)

-w S dzk z

dmitic d. within 5 yea 42.1Atizati due witbin 10 yrn 72.6

lant aetnu. of diet _aadig utmu 6. Misot fiRt ye 4.3

1, twatWA6wiatoauwI/ *Bb diq M amP%et lig

Eat 011-C10QU 67

ANNEl IIPage 1 of 2

L Sis -o m uamuc n5 UKNr if

A. waser LOWm AM ai COM c. of s m wo. eus8 illum

lo r &m CN

Cndh clumexu.)ftte Ue naw - a" DR idiahnsd

loru7ffisI ad tau Daly ahaue 519.27 7.15

1mmi zn lpblic af 2lasaa Rodi Nua (Thd 114) 32. 4631675 19 Reptblk of mduie Saud VIta Sesmue 26.5 6.51746 1979 ulic of lisia Scud Fiad 28.5D 9.341796 IY8 qpbiec of Tmua So" IrDgadua 19.50 3.6D1797 1960 Office dbitu ltim am zd bst 42.5 9.61mu1 1960 lqbtlic of Saiuia Youth liSamy 3.50 13 .171164 1980 Swit laimame de

1'BlsCtzit oh dk Sd ni Sa dPipuS 27.0n 3.79135 1980 BEMu 1tm de lhduis Third 4Fi_uiia CQit 30.08 2.47LMS 1V6 bwtlic ci fia raaia 21.08 14.461966 1961 Uht1ic of ludsi malitta .Mo h t 30.0A 15.3

30 1961 EwUlt ctE bisis t.1fl amd SptS 12.S3 93032E2 16 l9Uqlic oE Saua t. Dicih ad Staq 308R 1367210 1 N962 Apblic Of Usiia FitE 1W1 S (tax hua 35.5D 2s2113 192 Bm K aice ad 1ahmie l ga01satris 3.3D 1L392136 06 S SlIdE imb a4 z s0s2157 1962 eWbliq oE lxdmi. Irrgim : he1q t 22.00D 156127 1962 U_i OE labofDia TDiwica_ saim. 4S 2AOzm13 rn msuc fat i aim taipm 25.08 2L.S723 19p3 SpW Eatlia Matia V 27.0 24.12fl 1 iqami of laisia c1mi laded ruigtia 16I50 ILES2s55 30 Nage of aed s..rq m 34.0 31.52 12963 4 q us bi of ade4a Sin Flood kntma2 5.00 18.2230 3L3 S t raBuny zJt(10f y 16.8 7.823W6 1986 lUdc of labia Kifg Mical Aeiatare 140 10.99236 a* uMic at 2M.iiM S 1ww 5ly 50.01 445323 2964 lySlic of sa Scud Vit law. 330 3L2E2s55 D11 3aii lmisim dB

1Sllwtdcid at du m FOR ah 21.70 21.3120 DII S ihqU de of labia NudE tat h g;iilcf l P d 150 1S.02522 19B 5 Uqpse at Theisf m h apr YSstre 5.LO0 5Q.OD2554 195 UqwdIic of binds Swcud Msnril ad V caI 54.ao

2573 m Eq9115e of Undid Trvia S c Iqinfl 22.0 I 22.002605 1965 1_ lie at GE .i, Cabisrd.ga 2D.70 2?.702735 91 1 Nztsdal at laia fl _ a 4.02Z -

2736 196 qlic of uisia at Udatalh paI t 30.2D0 -

M24 196 UaMi of laia &piazlbnl SeC AdM lto 1500 L 1 15.OO0

SDL 162 75.25 73WOf didE ma bee qdd n doa9M8

l saw amteradiq 1,331.fl 64.91- Sold 25.53aF iih l_. b_, rqdd 2.21 5.32

TOa wish byl W* ad 1.326 4/ 66.91Theel lubiraa 735.47

I M sto of d not. l isted ii Part A im dactrid in a saqif ne am all 3*dImI fimed woiein _m,cda Whic is ipqisedt yawly acd cicuated o dm Bdw Di;ae an Al 30 ad 31.

21 mit ye iaJ My 15, 1966.if Efetiw am X 1ba 1 1S66.z rw tOD *-:bm zet Dm *ljb.|.

1061y7IJsy7. 19117

-55- ANNEX IIPage 2 of 2

1. inn U e DM=S 3 =Eam (Waa p rm use

TMG at Animmes Lma it US KilUc

1963 S a wu ttJilas 2.0 L5 3.5

d'ismstima (uw MM Dv. Fi eC. 23 2.3369 CM lands (u NWR) 1kv. Fists W. LO 2.2 - 10.2M973 gsim ibwiua c

*bihisas S Si Thms 1.6 03 1.9an IbtSis Qo Flae iq dar GM"" 0.6 0.615 InciS ticiin at de

bwRqpamC ds SmjuurW uadm 2.5 0.6 3.1BE/IS d SeS 1.1_m;t id l-us [nse t. 3.1 035 3.6195 BaSIS o tEm ds Spr

(Funer 1f (X 0Q3 0.3

IS S Uas at FOists 5.0 3.2 8iZ

t Cs _ _mc 2..2 1.5 3L.7las emmallicuThmwtim. -.a ide 13.4 .8 15.2

MM by C L.a 9.7 18.S

mst u1iuaui LI LA _9.5

Y1 adtis. i - - A SA. al tat Zii in eztaisa 1misis ( sa ,m4 mS spactialy. a ha 23 at iqiar 4. ISM b km t ya u1.

U0W4

- 56 -

ANNEX III

REPUBUC OF TUNSIA

INDUSTRIAL AND TRADE POLICY ADJUSTMENT LOAN

Suplementasry Projeet Data Sheet

Section k Timetable of Kery Events

(a) Time Taken to prepare project: About 12 months

(b) Project preparation responsibility: Government/Bank

(c) Project first identified by Bank: January, 1986

(d) Bank appraisal mission: October, 1986

Ce) Negotiations: December, 1986

(f) Planned date of effectiveness: April, 1987

Section 1[: Speeial Bank plementan Atios

None

Section IM Speeial Conditions

Ca) Conditions of Effectiveness and Release of First Tranche (US$100 million)

[See para. 139 (a) and 140 (a)]

(b) Conditions of Release of Second Trancbe (US$50 million)

[See para. 139 (b) and 140 {b)]

-57-

ANNEX IVPage 1 of 11

Republic of Tunisia

Confidential

The President September 1, 1986World BankWashington D.C.

LETTER OF ECONOMIC DEVELOPMENT POLICY

Dear Mr. President:

Within the framework of preparation of the Agricultural SectorAdjustment Loan and the Industrial and Trade Policy Adjustment Loan, I havethe honor to set forth below Tunisia's principal development policy goals forthe period 1986-91.

After 15 years of rapid economic development, during which mucheconomic and social progress has been made, Tunisia is currently going througha period of adaptation to the post-hydrocarbon era, a transition that isparticularly difficult because of recent events such as the sharp decline inoil prices, difficulties in exporting phosphates and phosphate derivates, therise in the price of sulfur, and the decline in Tunisian workers'remittances.

To cope with this situation, we have, as you know, adopted a strategyoriented toward the rapid growth of non-oil/non-phosphate exports, therecovery of agricultural production, and the containment of domestic demand.In this way we intend to ensure continued growth and the creation of new jobswhile preserving a tolerable and sustainable external balance.

To this end, a number of measures have been implemented over the pastfew years, of which the following are the most significant:

- wages were delinked from the cost-of-living index in 1983 and sincethen the minimum wage has been increased only once by about 10%;

- the Government's investment budget was reduced by close to 1% in realterms in 1985 and by around 22 in 1986;

- a flexible exchange rate system was adopted; together with the 10%change in the exchange rate of the Dinar, announced in mid-August1986, this made it possible to absorb the rise in the value of thedinar in relation to the currencies of partner countries and toimprove competitiveness on the export markets;

- 58 -ANNEX IVPage 2 oE 11

- deposit and lending interest rates were increased and have mostlybecome positive in real terms;.

- the prices of products subsidized by the Caisse GCnerale deCompensation were adjusted, leading to a gradual decrease incompensation costs with a consequent reduction in budgetary subsidies;

- producer prices of agricultural products were increased, inparticular for cereals, livestock products and olive oil, tostimulate and promote production in this priority sector;

- investment approval procedures on small and medium-scale industrialprojects were simplified and decentralized;

- an export credit insurance system was established to provide securityfor exporters and encourage them to explore new markets;

- the export prefinancing mechanism was revised, raising-the ceilingfrom 10 to 202 of the value of the export and extending the terisfrom 90 to 180 days;

- lastly, export incentives were strengthened within the framework bothof the law on export industries and of the law on encouragment ofthe manufacturing industries.

Thanks to these policy changes, accompagnied by a reduction inimports, we have been able to bring about significant improvements in the 1985financial situation. In particular, we have achieved:

- an increase in nou-oil/non-phosphate exports of 4Z at constantprices, against an average of 1.5S over the period 1982-1984;

- a marked reduction in the current balance of payments deficit, whichfell from 10.9% of GDP in 1984 to less than 72 in 1985;

- a reduction in inflation to 7.8X in 1985 against 8.61 in 1984 and13.61 in 1982;

- a limitation of the net consolidated State budget deficit to a level(51 of GDP) virtually in line with the budget.

Preliminary estimates for 1986 indicate a further slow-down in therate of inflation to about 6.61, and a slight decline in the consolidatedbudget deficit to about 3.91 of GDP. However, as a result of the sharpdecline in oil prices, depressed tourism demand because of politicaluncertainties around the Mediterranean, and the serious drought, the currentbalance of payments deficit is likely to worsen in 1986 to about 8.5-9% ofGDP, requiring a higher than expected inflow of foreign resources.

Over the coming years the stabilization effort will be consolidatedand strengthened to enable us to deal successfully with the two major problemsstill facing Tunisia, namely that of balance of payments equilibrium,resulting principally from the foreseeable decline in foreign exchangeearning3, and that of unemployment and underemployment resulting from rapidgrowth in the active population.

We therefore intend to continue our efforts to curb the budgetdeficit and current balance of payments deficit so as to contain the externaldebt within limits compatible with our repayment capacity.

At this level, and although the goals of the VIIth Plan have not yetbeen established, we intend to introduce a development plan for the next five

~ 59 - ANN rvPase 3 of 11

years based on an annual increase in non-oil and non-phosphate exports of 7 to81, at constant prices, and real GDP growth of 3.5 to 41, resulting in agradual decline of the net budgetary deficit and a marked decrease in thecurrent balance of payments deficit (from 10.91 of GDP in 1984 to around 61 in1988 and under 42 in 1991).

To achieve those goals, we intend to vigorously pursue policies aimedat restricting domestic demand and promoting exports. More precisely, weintend to accelerate the policy of gradual liberalization of the economy, inparticular as regards imports, prices and investments, so that by 1991 weshall have abolished most of the administrative controls in those areas. Wealso intend to strengthen domestic competition by bringing down import dutiesand reducing disparities in the effective protection levels.of the variousbranches of economic activity, and to ensure the competitiveness of exportproducts by pursuing a prudent and moderate wage policy and maintaining aflexible exchange rate system.

These various structural adjustment measures, which are listed in theattachment to this letter, together with an implementation schedule, shouldlead to a marked improvement in the general economic enviroment and anincrease in the effectiveness of the sectoral reform measures beingimplemented in the agricultural, industrial and external trade sectors, or inthe course of preparation in other key sectors such as public enterprises,energy, transportation, education, etc.

It goes without saying that the policy, which we bave designed forthe purpose of adapting our economy to the post-hydrocarbon era, will befacilitated if the Bank will give favorable consideration to our request withrespect to the Agricultural Sector Adjustment Loan and the Industrial andTrade Policy Adjustment Loan, and will support our medium-term adjustmentefforts with other sector loans.

We appreciate the discussions we have had with the Rank and hope tocontinue to exchange views in the future.

Very truly yours

Isl Ismail KhelilMinister of Planning and Finance

-60 ANNEX IVPage 4 of 11Attachment

September 1, 1986

THE MACROECONOMIC ADJUSTMENT PROGRAM

1. The basic strategy underlying the Government's macroeconomicadjustment program reflects its objective of maintaining economic growth andspeeding up employment creation by stimulating non-oil/non-phosphate exports,achieving a more efficient utilization of domestic resources and promotingsavings through more rigorous demand management.

2. To achieve these objectives, the Government intends to pursue itscourse of macroeconomic policy adjustment in eight areas: wages and salaries,the exchange rate, the budget, interest rates, credit and monetary policies,and price, investment and import liberalization. The action program in eachof these areas is summarized below.

3. Wages and salaries. Given the decisive role cautious wage andsalary policies play in any effort to control domestic demand, improveinternational competitiveness and ensure more rapid employment creation; theGovernment decided in 1983 to delink wages and salaries from thecost-of-living index; in consequence, the minimum wage has remained unchangedduring 3 1/2 years from January 1983 through July 1986, and average salarieshave declined by nearly 151 in real terms during the same period. TheGovernment will pursue. these wage policies, limiting wage increases toproductivity growth and to the financial situation of each enterprise.

In July 1986, Government raised the minimum wage by 10S but it hasno intention to increase the minimum wage on average by more than theinflation rate during 1986-1987. During the remainder of the VIIth Planperiod, it plans to follow a minimum wage policy which ensures that the growthof the total wage bill will not exceed the growth of GDP at current prices.

4. Government Budget. Recognizing the importance of reduced budgetdeficits in restoring internal and external financial stab*ility, theGovernment introduced a program of reducing budget deficits in 1985 and 1986.It is determined to follow through on this effort so as to reduce theconsolidated budget deficit, net of debt repayment 1/, from 51 of GDP in 1985to 1.51 in 1988 and practically to zero in 1991. In spite of declining oilrevenues, the Government is determined to maintain the budgetary savings rateat around 61 of GDP, while reducing the share of public investments in GDP,particularly by cutting the Government's contributions towards publicenterprise investments. The detailed u"asures envisaged to achieve thesetargets are mentioned in Annex I to this attachment.

11 Including Chapters I and II of the Government's Budget, the SpecialFunds, the Treasury operations, and the non-budgeted operations financingdirect investments by the Government.

-61 -MEXIV

Page 5 of 11

5. Interest rate policy. Thanks to the interest rate increases in 1985and 1986 and the drop in inflation, the Government has ensured that mostinterest rates are now positive in real terms. During the period of the VrItbPlan, the Government will maintain flexible interest rate policies designed toensure positive rates on most deposit and lending operations. The exceptionswill be limited to certain credits for low-income groups, such as parts of theloans granted by FOSDA, FOPROLOS, FONAPAM, FOPRODI and FODERI, and certainforms of high-priority lending such as seasonal credits, export prefinancingand the financing of renewable energy resources.

Furthermore, to improve the efficiency and viability of financialinstitutions, the Government intends to pursue its simplification of theinterest rate structure and relaxation of existing regulations. To this availa detailed program of action will be prepared and discussed with the Bankwithin the framework of preparation of the VIIth Plan, expected by April 30,1987.

6. Monetary and credit policy. The Goverament is firmly committed to amonetary and credit policy that is consistent with declining budget deficitsand investment rationalization; this implies that during 1986-91 the growth ofthe money supply will be kept within a range whose upper limit will not exceedthe growth of GDP in nominal terms.

7. Exchange rate policy. The Tunisian Government is aware of theimportance of this instrument in regulating external trade. Accordingly, itintroduced in 1985 a flexible exchange rate system, which made it possible atfirst, to absorb tbe rise in the value of the dinar in relation tocompetitor-country currencies. The situation improved further in mid-August,1986 when the exchange rate was depreciated by 101 vis-a-vis a basket offoreign currencies. This improved the competitive position of Tunisianproducts by about 282 compared to the situation prevailing at the end of June1985. The Goverment will continue this flexible policy so as to maintain anappropriate level of competitiveness for Tunisian products. It also agreesthat any exchange rate adjustments will be reflected in the administeredproducer prices for agricultural products.

8. Price Controls. The Government has for several years pursued apolicy of gradual decontrol of agricultural producer prices. This policy willcontinue and will be extended to the manufacturing sector. In particular, theGovernment intends, over a period of three years (1986-48), to phase out allprice controls in well-established industries where the number of domesticproducers is sufficiently large to ensure appropriate competition. A detailedtimetable for phasing out price controls is presented in Annex II to thisattachment.

Between 1989 and 1991, the Government intends to abolish pricecontrols in all other industries in close-coordination with the liberalizationof imports, with the exception of a few key staples (such as bread, semolinaand oil) of which the price must remsin regulated for social reasons.

In the event of monopolistic agreements, however, the Governmentwould reserve the right to intervene to reestablish satisfactory competition.

-62- ANN IVPage 6 of 11

9. With respect to those industrial products for which the price willremain regulated over the short or *edii_-ter., the Government intends tointroduce a more flexible price control procedure on January 1, 1987 thatwould allow the enterprise to chane a price unilaterally, by reference toagreed parameters, and to apply the new price folloving a resonable timelapse, provided there is no justified objection on the part of the Government.

To this end, the Government will-with assistance by the WorldBank-devise rapidly the operation formulas to be used by entrepreneurs in thevarious industries. These formulas must be geared to the appropriateutilization Of Lnstalled production capacLties and the adequate control ofproduction costs.

10. Investment liberalization. In the context of a system of gradualdecontrol of the economy, the Government intends to phase out the control (byAPI, APIA and the Tourim Investent Board) of investments not eligible forspecial incentives or benefits, in parallel with the liberalization of pricesand of external trade, within the framework of a nev investment incentivepolicy.

The Government bas decided to abolish by the end of 1986 allcontrols on investments belov DT 200,000 and on replacement investments notrequiring a specific import authorization for capital equipment and not askingfo, special investment incentives; it intends to continue this process in 1987and 1988 with a view to the abolition, in parallel with the overhaul of theincentive system, of the approval requirements for other well-establishedindustries for which the number of domestic producers is sufficiently largeto ensure appropriate competition.

The approval procedure will be maintained for all investmentprojects that are asking for special investment incentives linked to transfersof technology, regional development and exports.

- In early 1989 the Government is to start on a program leading to theabolition, by 1991, of investment controls in all remaining sectors, exceptfor investments asking for special investment incentives.

11. Import liberalization. Cognizant of the importance of importliberalization in improving domestic resource use and allocation and, ingeneral, in helping to achieve the country's development goals over the nextfive years, the Goverment reaffirms its intention of gradually liberalizingimports. It intends to effect this decontrol by two principal means:reduction of quantitative restrictions and rationalization of import duties.

12. (a) Quantitative restrictions. In mid-August 1986 the Governmentabolished all restrictions on imports of raw materials and semi-finishedproducts for companies exporting at least 25% of their turnover as well as ofspare parts for use in industry, farms, hotels, bospitals. and otherservices. It intends to abolish before end-September 1986 all restrictions onimports for newly approved investment projects and for raw materials used inthe manufacture of pharmaceutical products.

Not later than January 2, 1987, Government intends to abolishrestrictions on all other spare parts and raw materials, as well as on

-63- UNICT'Page 7 of 11

semi-finished products for compaies exporting at least 15 of their turnoverand for those that are reaosnbly integrted.

Not later than January 2, 1988, it plans to lift import restrictionson capital goods and semi-finished products, with the exception of a list ofproducts which are used exclusively in poorly-integrated plants to bediscussed with the Bank.

Starting in 1989, the Government will Introduce a program leading tothe abolition, by 1991, of the remaining quantitative restrictions, mainlythose on consumer goods.

13. (b) Import duties. In line with its concern to promote exports,and to ensure greater efficiency of resource allocation, the TunisianGovernment intends to gradually reduce import duties and to leasen thedisparities in the levels of effective protection between the various sectorsof the economy, the goal being to achieve a reasonably uniform effectiveprotection rate of around 251 by 1991.

To this end, it aims to introduce, on January 1, 1987, within theframework of the 1987 Budget Law, the following changes in custom duties:

- a raise in the minima duty to at least i$S;- a reducuction of all import duties to a msxiamu of 50X;- reduction by 6 percentage points in all duties between 26 and 55%

with a minima not falling below 25X; with the possibility ofdeferring some of these reductions by up to one year afterdiscussions with the Bak, in case a Tunisian enterprise suffersserious agmge as a result of exceptionally Large increases in .imports and with the aim to provide that enterprise somewhat-moretime to adapt.

However, the Government reserves the right to introduce additionalconsumption taxes on products of which tho local production or import isregarded as a luxury or a waste of resources. so as to absorb all or part ofthe loss in revenue resulting from the revision of customs duties.

It also agrees to continue this process in 1988, introducing onJanuary 1, 1988 a new import duty reduction of 9 percentage points on dutiesbetween 26 and 50Z, once again with the possibility of offsetting certainlosses in revenue by consumption taxes, and over the long tern to incorporatethe "Taxe sur la FormalitA Douai&re" (TFD) into the actual customs duties,for purposes of simplification.

Lastly, the Government intends to prepare before the end of 1988 aprogram of further gradual tariff reductions so a to achieve the objective of.a 25% effective protection rate by the end of 1991.

14. M;nitorinL and rogess reLurtins. Progress on the iplementationof the program described above will be monitored by the Government andreported to the Bank every six months.

I .-~~~~~~~~~~~~~N

-ae Sof 11

--- -'.'< - , \ > Adjustment Program

V '-GEX' to Macr- e o

(aL) GovrernnintSenu 11al noi lftlss than:. -

ssJ I..lTUt%ge.

30.6S of GDP99 ,.O7 ,................ 29.0S " - " - L988;a . Frk41 -declining to27.OZ " ' "1991.. N. .L,->

(b) LecugYe.-_jtt3,,'enditut '

24.02 of. Pin 87; . --', 23.0: 9§ -'Not. 1988 dec lining to217.02 :t IL. ,9 -. ,,

(c) The _rowt_ i-e not iv:t[ jervants emploxed sh:ll not exceedZZ p.a. during 19 0-91. e<J¢Tx pweraige' (A-Ai,:-ervice wage rate shall riot grow by

24.02 of GDP1*I 19872 t e 6iip 968,adsalnt nr

more than the inflation- rate:.during d 1986-87, and shaLl not increasefaster than private secitr -wages duziiig he period 1988-91.

Cd) The aggreg,at amouat\of 'aft s' idieW included in the Governmentbudget shall decline by at,least 52 .pps. ln nominal terms ever the period1986-91, with the Govenment as.ing e*ry effo-t"to reduce it even maorerapidly, among others-thrc'hltargetgc household subsidies increasingly onthe poorest segment 0o the populsiiioci' On consequence of this policy is thatthe increase in producerSprices for 4ricultural products proposed in themedium-term agricultural setor adjustment prc;ram would be reflected as muchas possible in coneuour prices.

Ce) Amounts included in the Gcvernment&budget for development outla s,net of debt repayment'shall not exceed:.

8.02 of GDP in 1987; -7.5t " " 1983; gradually,declining to6.0% " " " L991.

The Government intends to makea secteral and sub-sectoralallocation of investment .Nrnds within titse &eobal Liuts as part of thepreparation of the VIlth beveLx?pment PlMn. be reaultt-ng investment programvill be assessed and ,d'itrised`wtth tbi Bank at tae tis2 the report of thePublic Expenditure kiSie' -msi.ion will i' daictzse4..

INO,

I . ., . -

;'t, .- . - 4. \ -v i 4.

:' - ' '~~ ~ ~ ~ ~ ~ ~~~~ I . . .

ANNEX IV-65- Page 9 of 11

ANNEX II to Macro-economicAdjustment Program

Price Liberalization Time-table

September 1. 1986

Building materials excluding lime, cement and sanitary appliances

Textiles excluding undergarments and articles made out of jute

EMI

- car parts including batteries- hardware- TV antennas and parts

Canned sardines

Miscellaneous industries

- plastic articles- graphic art- watches- joinery finishings in wood- cork articles- chandeliers- footwear and accessories- tannery products- packing materials of paper and cardboard- printed articles- small-wares

January 2, 1987

EMI-

control wire and meter transmission cableselectrical and telephone cablesrefrigerators and cooking-stovesboilers

Carpentry

Glue

Inks

Liquid detergents

Tires and rubber articles

-66- ANN IVPage 10 of 11

AISEC II to Macro-economicAdjustment Program

July 1. 1987

Soap excluding perfumed soap

Food products

- canned tuna- canned tomatoes- canned barinss- yogurt- cheese, excluding soft cheese- beverages

Furniture

Fertilizer

- phosphoric acid- hyperphosphate- superphosphate, triple superpbosphate- dicalcium phosphate- moao amnium phosphate, diammonium phosphate- complex fertilizer

January 2. 1988

ELI

- sound making equipment and parts- taps and faucets- bicycles and motorcycles- batteries and miscellaneous articles

Ani4al food

Chemical products

- paint, varnish- perfmd soap- detergents- essetial oils- linseed oil- perfumes- insecticides and pesticides

-67 A NN IV (a)Pas 1.1. of 11

ANM= 11 to Macro-economicAdjustment Program

Household articles in inox and aluminium

Copper articles

Joinery finishings in aluminium

Electrical motors and transformers

Tomato paste

Canned vegetables and fruits

-68- AN VPaRegl-of 11

LETTER ON INDUSTRIAL DEVELOPMENT POLICY

January 27, 1987

Mr. Barber B. ConablePresident, The World Bank1818 B Street, N.W.Washington, D.C. 20433U.S.A.

Dear Mr. President:

Further to the exchanges of views that have taken place between theTunisian authorities and the World Bank in the course of preparation of anindustrial and trade policy adjustment loan, our economic discussions and theagreements reached on a macroeconomic adjustment program, I hbae the honor toset out below the broad lines of our industrial development policy.

As you are aware, the manufacturing sector occupies an importantposition in our development strategy for the post-hydrocarbon era. Thisstrategy gives priority to the rapid growth of exports of manufactures. Atpresent, manufacturing accounts for 14 percent of Tunisia's GDP, roughly 20percent of employment, and one-third of the country's exports. Rowever,except for the phosphate processing industry and the clothing industry, whichare largely export oriented, all other manufacturing subsectors are orientedessentially towards the domestic market. This situation did not present muchof a bottleneck to the development of manufacturing during the seventies andearly eighties when the sector was still small, possibilities for importsubstitution were large and domestic demand expanded rapidly, fueled by thesharp rise in oil prices aad substantial wage hikes. Now, however, in the mideighties, this strategy seems to have reached its limits: the manufacturingsector is no longer so restricted, the most obvious import substitutionactivities are all covered and growth of domestic demand has slowedsubstantially, reflecting the drop in oil production and prices.

Rapid growth of manufacturing production does depend crucially on asubstantial increase in exports of manufactured goods as a means of supportingoverall economic growth while at the same time generating new foreign exchangeearnings to offset the expected decline in oil exports. In the circzmstances,exports of manufactures and tourism will be called upon to play a key role,particularly as these are generally labor-intensive activities and so reflectalso the country's priorities in this area.

We have already begun a significant adjustment effort to addressthese issues, and over the past two years we have endeavored to removeadministrative obstacles to exports and to establish the institutionalstructure needed for their more rapid growth. May I refer to the followingexamples:

--- elimination of export licenses, except for subsidized goods;

- -- partial elimination of export taxes;

ANNEX V-69 - Page 2 of 11

- improvements in the system for reimbursing i[port duties and taxes,by including the TFD (Customs Formalities Tax) in the reimbursement, bygranting reimbursement at the time of customs clearance or even after export,and by opening up the possibility of reimbursing the actual exporter (who isnot necessarily the importer); -

- improved customs arrangements for temporary admission andwarehousing;

- increased opportunities for export prefinancing;

- extending the authorized periods for settling export transactionsand repatriating the proceeds;

- expanded opportunities for forward coverage of exchange risks;

- liberalizing the use of accounts in convertible currencies andincreasJl-g the amounts that may be taken out of the country for businesstravel;

- introduction of a system of export credit insurance;

- establishment of a number of export companies, several of which havealready begun operations;

- establishment in 1985 of an export promotion fund to finance avariety of export promotion measures;

- establishment of two export promotion conmittees, one in the CentralBank and the other in the Ministry of Comwerce and Industry, to deal withday-to-day problems at the working level.

In addition, a macroeconomic adjustment program has been adopted andis being implemented. It seeks to reduce existing rigidities and create theenvironment needed for increased exports and optimal resource allocation.This program, as set forth in detail in the letter on economic developmentpolicy nf September 1, 1986, will be supplemented and reinforced by theSectoral Adjustment Program for the manufacturing and external trade sectorsthat is to be pursued under the Seventh Development Plan, as expounded in theattachment to this letter. In this regard, the Sectoral Adjustment Programwill have three precise objectives:

(i) Encourage the growth of manufacturing output by making better use ofexisting facilities and according priority to private investment;

(ii) Encourage exports of manufactured products other than fertilizersand petroleum products;

(iii) Encourage the creation of additional jobs in manufacturing industry.

For the immediate future, the development strategy for themanufacturing sector being pursued by the Tunisian authorities seeks toimprove the cost-effectiveness of existing activities and optimize the use of

{:-; ~~ ~ ~ ~ ~ ~ MC- ~~~~~~~~ANNE V

-70 - Pagse 3 oE 11

existing capacities. In the longer term, it aims at promotig privateinvestment in activities that vill produce a direct economic return, given thegrowing scarcity of funds for investai-eut and of foreign exchange resources.The program of short-term measures already adopted or currently envisaged -namely those designed to maintain an appropriate exchange rate and to developthe role of the market and of prices in order to ensure better allocation ofresources - are entirely consistent with the longer-ternm strategy.

The key measures, to be taken over the next few years, relate to theimplementation of a new investment code reflecting the new priorities, theliberalization of credit policies and reorganization of the institutions forpromotion and support of the manufacturing sector, together with therelaxation of laws and regulations governing labor and employment.

To enable us to meet the objectives of our policies aimed atpreparing the industrial sector for the post-hydrocarbon era, we herebyrequest you to consider granting Tunisia a loan to be disbursed rapidly tomeet the needs of the industrial and trade policy adjustment program.

Very truly yours,

signed: The Minister of Planning and Finance

Ismail Khelil

Attachment

-71- Pae 4 of 11

MEDIUM-TERM INDUSTRIAL POLICY ADJUSTMENT PROGRAM

1. The Government's medium-term objectives for development ofmanufacturing industry are to encourage private investment in the sector, stepup the expansion of exports of manufactured goods, and create a growing numberof new jobs. To this end, the Tunisian authorities have already adopted anadjustment program, focusing largely on the areas of foreign exchange, wagepolicy, interest rates, and progressive deregulation of prices, investment andimports in accordance with the schedule set forth in the Letter of DevelopmentPolicy dated September 1, 1986. This macroeconomic program, severalprovisions of which have already been implemented, will be supplemented andstrengthened by a number of sectoral measures set forth below.

2. These measures fall iuto two broad categories:

(i) Improved incentives to invest, with a view to encourage privateinvestment by relaxing controls, allowing private enterprises greater freedomof action, and creating a more favorable environment. These incentives shouldproaote exports and create new jobs by changing the relative cost of factorsof proiZLsion in favor of labor.

(ii) Search for greater efficiency in the financial sector, notablythrough improved management of the money supply by the Central Bank;elimsination of prior Central Bank authorization of individual creditoperations; a more flexible interest rate policy, and improvements in thesystem of exchange risk coverage for external loans taken out by thedevelopment banks.

3. At the same time, the Tunisian auLhorities intend to continue withimplementation of the program of reforms undertaken in recent years. To thisend:

- administrative measures for export promotion will be strengthenedfurther;

- the powers and responsibilities of the para-public institutionsestablished to support and promote the manufacturing sector will be adapted toencourage private initiative;

- the wage policy that has been pursued since 1983 will be continuedin coming years. The de-linking of wages from the cost of living index willbe maintained, and any salary increase will be linked to productivityimprovements and the finAncial situation of each enterprise. Otherimprovements will be sought by holding down social security costs andintroducing greater flexibility into conditions of employment.

4. The Tunisian authorities also plan to conduct a study of tourism toidentify reforms needed to stimulate the growth of a more diversified andhigher-quality tourism.

ANEX V-72 - Paxe 5 of 11

A. General Liberalization Measures

5. Within the context of the macroecnnomic measures that have beentaken in 1986, the authorities have decided to eliminate price controls overthe period 1986-88 for well-established industries where the number ofdomestic producers is sufficiently large to ensure appropriate competition.This list was sent to the Bank as Annex II to the letter of September 1,1986. Over and above the products shown on that list, the authorities intendto eliminate price controls on all products whose importation is to bederegulated over the period 1987-88 and beyond. This applies to all rawmaterials, spare parts, capital goods and the great majority ofsemimanufactures.

6. Concerning those industrial products for which prices will remainregulated over the short or medium term (mentioned in the attachment to theletter of Economic Development Policy), the Government will take the necessarymeasures, so that by the time these products are decontroled, abrupt priceincreases or decreases can be avoided to the extent possible.

7. During the period 1989-91, the last import restrictions (confinedessentially to consumer goods) will be lifted except for a limited number ofproducts whose importation will continue to be controlled for social andpolitical reasons. The Government intends to decontrol at least one-third ofthese retaining imports by January 2, 1989, at least two-thirds by January 2,1990, and everything by January 2, 1991. The lifting of price controls willproceed in parallel witb the elimination of quantitative restrictions onimports.

As regards infant industries, the Government has the intention tolimit specific protection measures to a maximum duration of three years fromthe date of completion of the project. Except in duly justified cases, thisprotection shall not take the form of quantitative import restrictions; and inno case shall there be a complete import ban of the product.

B. Investment Incentives

8. Within the context of the macroeconomic objectives of the SeventhPlan, the Tunisian authorities intend to modify the procedures for investmentand for the granting of related benefits and incentives. To this end, the newIndustrial Investment Code currently in preparation lifts all Governmentcontrols on industrial investments and confines the granting of incentives tojust those few projects that correspond to the key priorities of the Nation.The new Code introduces five major changes:

(i) It is highly selective, in that special incentives can only begranted to high-priority projects meeting certain clearly specified criteria;

(ii) It eliminates the distinction between new projects and replacementand expansion projects;

(iii) It eliminates prior Government examination and approval ofinvestments not eligible for special incentives;

AM=E V_n -3 _Page 6 of 1l

(iv) It makes the granting of incentives virtually automatic once thenecessary conditions have been met; and

(v) It focuses the incentives available on the basic objectives of theSeventh Plan, notably export promotion and the creation of jobs indisadvantaged regions.

9. Many of these incentives are covered by ordinary law, i.e. aregranted to export enterprises independently of any prior Governmentauthorization or approval. Export enterprises will in particular benefit fromthe suspension of duties and taxes on inputs, whether imported or purchasedlocally, and exemption from profits tax up to the value of export sales.

Other incentives will be specific in nature, i.e. will be tied toinvestment projects meeting certain defined criteria, namely exports, creationof. jobs in disadvantaged areas, acquisition of technology, and integration.These incentives will take the following specific forms:

- Exemption from duties and taxes on capital goods for units gearedexclusively toward exports. All other projects will be required to pay dutieson imported capital goods. The rate of import duty on such goods has beenadjusted in the 1987 Finance Law to a level providing effective protection onthe order of 25X;

- Payment of the social security contribution for a period rangingfrom two to six years and provision of infrastructure in industrial estates at501 to 100l of actual costs, depending on the area;

- Payment of the cost of formal and on-the-job training fortechnicians linked to the introduction and acquisition of new technologies.

10. The Tunisian authorities intend to review at the end of the VIIthPlan the incentives system established by the new investment code in view ofthe macroeconomic situation at that time.

11. The new Investment Code, which has already been the subject of manydiscussions with the Bank, is expected to be submitted to the Chamber ofDeputies by early 1987, and it is anticipated that it will become effective nolater than July 1, 1987.

As an interim measure covering the period between implementation ofthe new Code early in 1987 and the liberalization of capital goods importsscheduled for early 1988, the Tunisian authorities have set up a procedureunder which projects that do not qualify for approval (agr6ment) may requestauthorization from the Investment Commission to freely import the capitalgoods required.

C. Financial Policy and Fiscal Environment

12. In order to adapt the financial system to new demands from theeconomy, the Tunisian authorities will continue to reform the instruments ofmonetary and credit policy by combining adjustment of overall controls

- 74- NEX VPage 7 of 11

exercised by the Central Bank with assigned increased responsibilities toprimary banks. Within the context of this reform, the Central Bank will adaptits xmeans of intervention to the objective of keeping growth of money supplywithin limits compatible to overall economic growth and balance of paymentsequilibrium. At the same time, it will gradually relax the system of priorauthorization and mandatory placement requirements to which the deposit banksare subject. Both borrowing and lending interest rates will be largelyderegulated to encourage savings and promote better resource allocation.Lastly, the exchange risk coverage system for external loans contracted by thebanking sector will be modified to ensure that this risk is borne by theend-user of the credit.

13. As agreed with the International Monetary Fund, the banks will from1987 onward raise the bulk of their funds on the money market, with fixed-raterediscounting to be available only for the priority sectors (exports,agriculture, small and medium-scale enterprises, and energy-saving). Eachbank's fund-raising on the market at the daily rate will be subject toceilings based on its deposits, with excess fund-raising attracting a penaltyrate. To met the performance criteria agreed with the IMF, the Central Bankwill influence the volume of domestic credit by manipulating its interventionrates on the money market and the refinancing ceilings allowed to the banks.

14. To ensure better allocation of financial resources, bank borrowingand lending interest rates will be deregulated as of January 1, 1987, withhowever the following exceptions:

- lending rates for priority sectors, which will continue to beadministered by the Central Bank;

- borrowing rates on special savings accounts and convertible dinardeposits held by Tunisians residing abroad, which will continue to be set bythe Central Bank with reference to money-market rates. All other rates willbe freely determined by the banks in response to market forces. The monetaryauthorities will intervene solely in order to ensure that the rates paid onterm deposits are positive in real terms and to set ceilings on lending ratesto prevent usury.

15. The banks will also have greater freedom in employing their funds.Two restrictions to which they had previously been subject are to be eased:

(i) The requirement that they use 18 percent of their funds formedium-term lending was replaced, effective September 30, 1986, by an initialfigure of 7 percent (later to rise to 10 percent) linked to the financing ofinvestment projects in the artisanal sector, small and medium-scaleenterprises, agriculture and export industries;

(ii) The various ceilings for short-term loans above which the commercialbanks have to obtain prior authorization from the Central Bank has been raisedon January 1, 1987 to a uniform figure of TD 5 million. The system, thus, hasbeen considerably simplified and easier to administer: the TD 5 millionceiling for total annual short-term loans outstanding will in practice applyto only some fifty enterprises, most of them in the public sector, whose

75 ANNE VPage B of 11

situation is deemed to require continued monitoring. Moreover, thisrequirement wiii be lifted on January 1, 1988 for the few private-sectorenterprises still affected by this formality. Medium-term lending for thefinancing of Government approved investments, of investments receiving specialGovernment incentives and of investments for handicrafts, other smallenterprises and small farmers has become exempt completely from a prioriauthorization from the BCT. Mediu-term credit for the financing of all othertypes of investments, would be exempt from BCT authorization after theimplementation of the new industrial investment code. The small vmount oflong-term lending is also exempt for private borrowers, while the a priorisuthorization is maintained for public enterprises regardless of the size ofthe loan.

16. As regards exchange risks, the Tunisian authorities, mindful of thedangers of poorly spread risks or excessively generous guarantees, havealready taken steps to channel resources on a regular basis to the ExchangeRisk Equalization Fund and to confine the guarantees to certain developmentbanks - essentially BDET (Banque de D6veloppement Economique de Tunisie),specializing as it does in the financing of small and medium-scale enterprises- given the inability of borrowers to protect themselves against this type ofrisk.

In order to further improve the efficacy of this system, a number ofmodifications will be introduced as of mid-1987, reflecting the followingthree principles:

- The end-user of the loan will himself bear the exchange risks wherehis operations are on a sufficient scale to enable him to do so;

- Adoption of specific criteria governing access to exchange riskguarantees designed to restrict eligibility solely to smal1 and medium-scaleenterprises;

- Changes in the way in which the Equalization Fund is financeddesigned to ensure its integrity without recourse to government subsidies.Studies are in progress to examine the possibility of financing the Fundthrough variable commissions depending on the currency borrowed, which couldreflect the difference between the cost of borrowing plus the intermediationmargin and the lending rate obtaining on the domestic market.

At the same time, the Central Bank of Tunisia will be conductingstudies to examine possible ways of providing forward coverage of the exchangerisks bearing on different settlement currencies, with a view to limitingtheir impact on the balance of payments.

17. As regards the general business climate, the Tunisian authoritiesare aware of the need for continued improvement in order to promoteinvestment, increase output and create new jobs.

In view of the impact of taxes on the environment for business, tF-1983 Finance Law already introduced two major concessions:

ANNEX V76 Pace 9 of 11

- reduction in the corporation tax (proportional tax) from 46.5percent to 44 percent for commercial activities, and from 40.5 percent to 38percent for industrial, tourism and transportation activities;

- deductibility of income tax on income derived from securities, forthe beneficiaries of such income.

Other changes have been introduced since then, affecting exportcompanies in particular, with profits derived from export operations now beingtax exempt.

For the years ahead, the Tunisian authorities are devoting theirfull attention to ensuring the success of two major reforms:

- introduction of a Value Added Tax on January 1, 1988;

- simplification of direct taxation by introducing, during the periodcovered by the Seventh Plan, a consolidated tax on individual and corporateincomes.

D. Export Promotion

iB. In order to speed up the adjustment process, the Tunisianauthorities have already made sustained efforts to eliminate the obstacles ofan administrative nature against exports of manufactured goods. This programnow having been largely completed, the authorities plan, in the course of1987, to improve the services provided by the Customs Administration. Inconcert with all the government departments involved in exports, measures willbe taken to gradually standardize working hours, combine services in a singlelocation, and integrate data processing operations, so that the exporter willhave to deal with only one office.

E. Institutional Changes

19. The policy of promoting exports and private investment inmanufacturing industry, together with gradual deregulation of the economy,will be accompanied by a transformation of the support infrastructure in themanufacturing sector, including API-', AFI', CEPEX3', CNEI1 ' and thevarious technical centers.

The purpose of these changes will be (i) to strengthen promotion andsupport activities, particularly to firms in the private sector, (ii) toreduce control and approval functions, and (iii) to encourage beneficiaryenterprises to assume responsibility for a greater proportion of the cost ofservices received. The Tunisian authorities have decided to introduce thefollowing specific changes during the period 1987-88:

Ci) The role of API has already changed and will cbange further with theintroduction of the new Investment Code early in 1987. To enable this agencyto play its promotional role to the full and to make maximum use of the many

1/-Industrial Investment Promotion Agency; 2/ Industrial Lend Agency;3/ Export Promotion Center; A1 National Industrial Studies Center.

ANNEX VPage 10 of 11

years of experience gained by CNEI, the authorities have agreed to merge API.AFI and CNEI. The bulk of the combined agency's human and financial resourceswill be assigned to the effort of promoting and assisting businessenterprises, more particularly through project identification and preparationof sectoral studies. In addition, in order to facilitate the granting ofincentives for eligible projects, API will continue to act as secretariat ofthe Approvals Committee (Commission de l'Agrdment) responsible forimplementing the new Investment Code. This Committee will be independent ofAPI's Board of Directors, the latter focussing exclusively on supervising andguiding the agency's promotional activities. ;

(ii) The role of CEPEX will, for its part, be consolidated in order tomake its operations more effective and reduce its expenses incurred in foreignexchange. To this end, the Tunisian authorities propose to merge thepromotional work currently undertaken by OCT1' into CEPEX and to study thepossibility of more closely integrating commercial attaches abroad into theorganization.

(iii) The three existing technical centers which provide valued servicesto private and public entrepreneurs will be reorganized. The measures beingconsidered in this regard involve providing interested enterprises withenhanced representation on the Boards of these centers and have them graduallyassume a.higher share of the cost of the services provided by these centers.

Should need for assistance become evident in additional sectors notyet covered by an existing technical center, the Government will consult withthe enterprises concerned regarding the possibility of assigning this new taskto one of the existing centers rather than increasing the number of suchcenters.

(iv) Lastly, the Chambers of Commerce will be reactivated as part of thepolicy of encouraging the private sector to assume greater responsibility forits own development, and the efforts of UTICAZ- in assisting small andmedium-scale enterprises and promoting exporters will be strengthened.

F. Employment and Wage Policy

20. The Tunisian authorities are pursuing two long-range goals in thisarea closely linked to the adjustment program:

(1) Create the largest possible number of new jobs in manufacturingindustry; and

(2) Improve the competitive position of industry, more particularly ofexport companies.

To this end, they plan to study ways of gradually reducing theburden of social security contributions without undermining the financialintegrity of the social security system. As a first step, attempts will bemade to reallocate contributions among the various funds. In the longer term.9

1/ Tunisian Trading Office.2/ Tunisian Association of Industry, Commerce and Handicrafts.

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-78- AREX VPage 11 of 11

the structure of benefits will be reviewed in order to ensure that areasonable balance exists between costs and payments. In the event thatresources prove inadequate, the authorities agree on the need to alignbenefits on the resources expected to become available rather than adding tothe burden on employers. Any additional benefits (more particularly in thearea of health insurance) would have to be covered by voluntary schemes.

It is understood that, in cases where the Investment Code providesincentives in the form of exemption from, or reductions in, contributions tothe social security funds, these exemptions will be financed out of thegovernment budget in auch a way as to avoid any shortfall in receipts to thesefunds.

21. In the same order of ideas, work is in progress, as part of thedrafting of the Seventh Plan, to review labor legislation to ensure that it issufficiertly adaptable and flexible to promote employment while keeping theenterprise competitive.

The results of this work, expected to be available before the end ofJune 1987, will be the subject of an exchange of views with the Bank.

22. In addition, in order to curb domestic demand and promoteproductivity, the Tunisian authorities plan to continue the policy ofdeindexation of wages that has been in effect since 1983. To this end, anywage increases will be tied to improvements in productivity and in thefinancial situation of each enterprise.

In order to facilitate the practical implementation of this policy,it would be useful to receive assistance in developing methods to measureproductivity within each enterprise. A request for such assistance iscurrently being prepared.

G. Tourism

23. Lastly, the Tunisian authorities plan shortly to undertake acomprehensive study of tourism policies, in light of its importance for-exports and job creation. It will identify inter alia the various obstaclesto expansion of the tourism sector and indicate what action is needed toremedy the situation. The terms of reference of this study will be discussedwith the Bank in March 1987. It will be completed by the end of 1987 and itsconclusions discussed with the Bank.

H. Monitoring of Progress

24. It goes without saying that the Tunisian authorities will carefullymonitor implementation of the progr±mn set forth above; they will submit aprogress report to the Bank every six months.

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