Dwunmng ofThe World Bank

FOR OFFlCIAL USE ONLY

Report No. P-6066-ET

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED CREDIT OF SDR 176.5 MILLION

TO THE

GOVERNMENT OF ETHIOPIA

FOR A

PROPOSED IDA CREDIT TO SUPPORT STRUCTURAL ADJUSTMENT

IN THE ETHIOPIAN ECONOMY

May 27, 1993

MICROFICHE COPY

Report No.:P- 6066-ET Type: (PR)Title: STRUCTURAL ADJUSTMENT IN THE EAuthor: BHATTASALI, D.Ext. :34031 Room:J10129 Dept. :AF2CO

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CURRENCY EQUIVALEm(as of Aprl 27, 1M)

Cunrecy Unit = BirUS$1 = ErnSDlBkT = US0.2

ERRP Emergency Recovery and Recon ction Program

GDP Gruss Domeic Product

ICB lMernation Compeive Bidding

IFC Intenational Finance Corporation

ODA Oversmas Development Administion (UK

PFP Policy Framework Paper

QR Quantitive Restriction

SAP Structua Adjustment Facility

SPA Special Program of Asstance for Africa

TGE Trsitional Government of Ethiopia

UNDP United Nations Development Programme

FSAL YEAR

July 8 -July 7

FOR OFMFCLL USE ONLY

eC RQL pAim&sN BE Ew3ImII

PRESI1DENTS REPORT1 '

PageCREDff AND PROGRAM SUMMARY ............................... i-i

I. COUNTRY POLICIES AND BANK GROUP ASSISTANCE STRATEGY ........ I

A. Recent Political and Econonic Developmens ............................ IPolitical Developments ........................................ 1Economic Perfomance Under The Previous Government . ................. 2Economic Perfbrmance Since Mid-1991 ............................. 3

B. Medium Tenm Macroeconomic And Structural Policies ....................... 5Rehabilitation .............................................. 6Macroeconomic Stabilization ..................................... 6Structural Reform ........................................... 8Safety Net . ................................................ 9Exteral Resource Needs ...................................... 9

C. Bank Group Assistance Strategy ................................... 11ExistingProgram ........................................... 11Future Assistance Goals And Satg .............................. 11Conditions For The Bank's Enlarged Program Of Support ................. 13Bank Support After The Transitional Period .......................... 13

I. STRUCTURAL ADJUSTMENT PRoGRAm, 1993-94 ................... 14

A. Strategy . ................................................. 14Objectives ............................................... 14Basic Consideradons ........................................ 14

B. KeyIssues AndActions ......................................... 15Macroeconomic Stabilaidon ................................... 16Support For The Private Sector ................................. 20Groundwork For Next Phase of Adjustment .......................... 27

1/ This operation was prepared by a team consisting of Messrs. Deepak Ehattasali (AF2CO,Task Manager); J. Short and T. Burton (ODA, Consultants); M. Ruedin (Switzedand); C.Norrl5f (Sweden); G. Olanrewaju and P. Mwanabutwe (African Development Bank); andAbbay Deshpande and Fayez Omar (AF2ET). Mr. Enzo Grilli (DPG) was the Lead Advisor,and Mr. Kazi Matin (AF4CO) was the peer reviewer. The Country Strategy Statement wasprepared by Mr. Lee Roberts (AF2CO). The maaging Division Chief and DepartmentDirector, respectively, are Mr. Michael F. Carter and Mr. Francis X. Cola9o.

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

MI. TEE PROPOSED CREDff ........... ...................t.. 28

A. SizeAndEAoect.dCofinancu.g 28S. Disbursement 28C. Procurement 29D. Management, Monitoring and Account ................... 29E. CoordinationWithM FAndOther Dono ............................. 30F. Conditionaity.. 30

IV. BENEFIS AND RIMS.31

A. Benefits .31B. SocialImpact .... . 32C. Risks .. 33

V. RECOMM&ENDATION .34

ANNEXES

I. Economic Indicators. 35HI. Letter of Development Policy and Matrix .41M. Supervision Plan .54

EMS[ SuLiAL Al>AlIS CREDff (SAC 1}

CREpl AMI PLQGAHMSt Y

IlqM : Govement of Ehiopia

Amout: SDR 176.5 million ($250 million equivalent)

Wms Standard IDA with 40 years maturity

DSIeUm: SAC I will support the first phase of the economic policy of the TransitionaGover ment of Ethiopia (GE). The TOE's economic objective is to reducepoverty tirough rapid labor-inive growth. This is to be achieved througha fundamental trasfomation of the economy from cetralized planning tomakets, with a dominant role for the private sectr. In the periodimmedialy follow;ng its assumption of power, the TGE cocetaed onrehabilitation and relief to cope with the problems of civil disruPton,exeme poverty and physical devastation caused by prolonged internaconflict. Since late-l99M, when agreement on a PFP was reahed, the focushas shifted to reconstuction and strucora reform. In the first phase, theprogram will consist of two main components: support for ecoAomicstabilizaton, and support for the priae sector. For this, the followingactons are covered by SAC I: adjustments in key economic prices (exchangerate, fiance and wages); improvements in domestic resource mobilization,icluding a reduction in the fiscal imbalance; changes in the boundarybeween public and private economic activity; promotion of price signals andcompetition; introduction of a market-based system for allocating foreignexcuange; trade reftoms; and safety net policies for those affected bystructural adjustment During the SAC I implementation period, the TOEwill also build institutional capaciies and conduct studies to assist indesigning the next phase of the economic reform program.

Economic growth is critical for reducing Edtopia's extreme povert.EcOnOmic stabilization though fiscal reforms and the correction ofdisttioos in key prices will promote domestc resource mobilization,thereby reducing over time Ethiopia's high reliance on foreign assistce.A review of public expenditures wil underpin strucur improvements in thefiscal position, while helping the TOE to carry out efecve programs ofspendig fbr growth. Combining such measures with stronger economicincentives, through trade refrm, the decontrol of prices, and the reductionof public sector monopolies, will help esablish a broader role for marketsignals and greater opporuiies for the private sector. The provision offoreigl exchange to the private secor wil stimulate growth in agriculture,where most of the poor are, and will encourage increased private trade and

g. Moreover, improved pricing of key inputs, combined withhe implementation of a more flexible labor code, will promote the use of

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labor, which Is Etopi's most abundant fictor of production. This wiUhave a direct effect on reducing poveny. Finally, the removal of bottleneckto upots will allow Ethiopian producers to expand production beyond theconfines of the weak domestic market.

Ria: Ihe major risk is political. Democratization, nationality rights and regionaldevolution are at the core of current politcal activities. The continuedmantance of security and reestablisment of the normal processes of civiladministration are essential to support economic activity. The front-loadingof refrm meures, the demouated commitment of the TOE, and theabsence of large social diions minimi the risk of a major derailmentof ihe structural adjusutm program. If the program is implementedsuccessfully, availability of the second tranche of fumding would prevent apotential disruption of external support in the period during which an electedGovernment assumes power in early-1994. However, although the TGE'sperfrmance on the economic front has been impressive, it is important toreogcize that it is, as yet, inewerienced in implementing structral reformsand dealing with markets and the private sector. Technical skills are in shortsupply. Ihereore, the risk of weak implementation canot be discounted.Not all of this risk can be migated. However, selective use of exaltechnical assistance, carefid monitoring, combined with a willingness on thepart of the administration to make mid-course corrWctions, if necessary, wfllminimize this risk.

Economic Rateofltdrn: Not applicable.

EatiaedMhe Credit will be disbursed in two tranches: $150 million equivlent uponeffectveness, and $100 million after a performance review to be held aroudJune 1994.

REPORT AND RECOMMATION OF THE PRESIDENT OF TIEINTERNATIONAL DEVELOP*ENT ASSOCIATION

1TO THIE EXECUTIVE DIRECTORSFOR A PROPOSED IDA CREDIT TO SUPPORT SRUCTURAL ADJUSTMENT

IN THE ETMOPLAN ECONOMY

1. I submit the following report and recommendation for a proposed First StruchtuAdjustment Credit (SAC I) to the Governwet of Ethiopia. The proposed Credit of SDR 176.5million ($250 million equivalent) is to be disbursed in two tranches. It would be on standardIDA term, with a maturity of 40 years.

2. The proposed SAC I wil serve as a program under which early reform measures andprwparations for later phases of adjustment will be undertaken. It will support a program to carryout the initial phase of the economic policy of the Transitiona Government of Ethiopia (rGE).The program, announced soon after it took office, was elaborated in the first-year PolicyFramework Paper (PFP) for 1992/93-1994/95. The Executive Directors of the Bank, meetingas a Committee of the Whole, discussed the PFP on November 19, 1992. The CountryAssistace Staegy for Etiopia was also discussed at that time, during presentation of the RoadRehabilitation Project. The proposed SAC I operation fits within this Strategy. The Credit willcomplement a recovery program supported by the multi-donor Emergency Recovery andReconstfction Program (EI), and the Structural Adjustment Facility (SAF) from the IMFapproved in November 1992. Several external donors also intend to support ihe SAC I reformprogram, both dtrough direct cofinancing as well as parallel financing. They include the AfricanDevelopment Bank, Council of European Communities, Denmark, Germany, The Netherlands,Sweden, Switzerland and the United States.

L COUNTRY POUCIES AND BANK GROUP ASSISTANCE STRATEGY

A. Recent Political and Economic Developments

Polital Deveopments

3. The Government of Mengistu Haile-Mariam came to power in 1974, after deposingEmperor Hafle Selassie. After a iong and devastating civil war, in May 1991 a coalition led bythe Ethiopian People's Revolutionary Democratic Front assumed power in Ethiopia, while theEritrean People's Liberation Front came to power in Eritrea. Following a "National Conferenceon Peace and Demoray" in July 1991, the TGE was formed under a Charter that requiresnational elections to be held at the end of a "transitional period" of approximately two-and-a-halfyears. The stats of Eritrea, reintegrated with Ethiopia under a United Nations' resolution in1950, was determined by an inteonally-supervisedreferendum on Aprfl 23-24, 1993. Votersprovided an overwhelming mandate for independence, which was declared on May 24, 1993.Meanwhile, the TGE has iniaed an etensive program of political and economic devolution toestablish a federal system of govermen, and national elections are ploposed to be held in early-1994.

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Economic Performance Under The Previous Goverment

4. Ethiopia's considerable economic poeal has remained largely unexploited becase ofthe political and economic problems of recent years. With 53 miliion people, it is the secondlargest coutry in population in Sub-Saharan Afica. Uts known naual resources include gold,platinum, taalum, soda ash, potash and atr gas. However, except gold, none of theseresources has been exploited on a large scale. Instead, since 1974 the eoonomy has been basedupon a near-stapant agriculture sector, a narrow group of agricuItural exports, the producdonby parastauJs of all basic wage goods and some raw materias, and a large volume of seevicesprovided almost entirely by the public sector.

5. Since mid-1984, when the previous Government adopted the Ten-Year Perpectve Plan,the following major factors have influenced Ethiopia's economic performance: (a) state planningand adminis ve controls over investment, rroduction and trade displaced market mechanisms;(b) private entrepreneurship was replaced over time by the participation. of governmentdepartme and public entpdses in all major economic activities; (c) there was a diversion ofdomestic (upto 15 percent of GDP annually) and foreign resources from economically-productivesectors toward the maitanc of iternal security and conduct of the civil war; (d) afier sharpimprovement due to the coffee price increases of 1985-86, there was a steady fall in the extenterms of trade (by nearly 35 percent); (e) the country suffered from large variations in weathercoditons, including a severe drought that caused extensive famine in 1984-85; (t) it receivedthe lowest per capita level of development aid in Sub-Saharan Africa; (g) the growth rate ofEthiopia's population rose from 2.7 to 3.4 percent per year, more than double the rate of growthin real income; and (h) economic policies that afected the key economic variables (for example,the real exchange rate, interest rates, effective axation) were often poor, depressing rates ofreurn to exports, savings, investment and production, and were instrumental in creating a largeunderground economy.

6. Although the previous Government began to itroduce some reforms in earny-1990,Ethiopi's economic condition had deteriorated markedly. A tight squeeze on foreign exchangeand contnuing war losses undermined the ability of the Government to manage the economy.By mid-1991, when the TGE assumed power, much of the economic infrastructure was destroyedor in an advanced state of disrepair. As a result, factories and farms lacked raw materials andspare parts. Real output per capita had declined over the previous three years by more an 6percent. By 1991, the gross investment rate had fallen to 10.4 percent of GDP, down from 15.8percent just three years earlier. War, famine, and reductions in social spending had decimatethe human resource base. With a per capita income level of $120 per year and falling, infantmortality rate of 134 per thousand, life expctncy f 47 years, and prmy school enrollmentof 36 percent, its social indicators were among the lowest in the world. Neady 50 percent of'thepopuation was suffering from absolute poverty, with an estmated average per capia daily calorieintake of 1,750-only 80 percent of the level determined to be necessay for a healthy life. Addedto this were the massive social cost of death, injury and dislocation in the wake of the civil war.Recorded eangs from exports had collapsed to $276 million in 1991, compared to $459 millionIn 1980. Debt servicing (accals basis) stoad at 79 percent of exports of goods and non-facrservices in mid-1991, compared to 7 percent in mid-1981, and debt servicing arrears had reached$408 million. In addition, as a result of the effects of ealier fiscal imbalances and acuteshorages during the last months of the civil war, the rate of inlation rose to 45 percent,compared to an average e of 5.6 percent over the previous three years. The budget deficit for

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the fiscal year 1990/91 was 13 percent of GDP (including grants and accrued debt servicing), anddomestic bank fincing of the deficit reached 9.6 percent of GDP. She current account balacof pamen deficit, before official asfers, reached 8.9 percent of GDP for fiscal 1990,91 (3.4percent of GDP including all transfers). Gross official reserves had fallen to about one week'sworth of imports.

conoic Performance Since Mid-1991

7. Given the stuation inherited by thfe TGE, it would be unrealisdc to have exwected a rapidchnge in economic perfrmace without a resolution of Ethiopia's binding foreiga exchageconstaint. Although the shortage of raw materials, intermediate goods, and spare parts haspersisted, this constraint has been eased ptally through the ERRP. Real 'iutput, which fell byover 5 percent duing 1991/92, is esmated to have grown by 6.5 percent in 1992193. Theseestima are subject to more than usua uncertity, given recent disruptions in Ethopiasstatistical base. Nevertheless, several reliable production indicators suggest that a noticeablerevival in growth could be unlerway. Thus, for example, the production of cereals and pulsesrose by over 8 percent, and is estied in 1992f93 to be about 5 percent higher than the record1990 level. The net production oe staple foods is also esdmated at 8 percent higher ta theprevious year. However, both domestic savings and investment, as proportions of GDP, havecontinmed to decline. Ihe former reflects the return of private consumption to historical levelsand lower-t -expected revenue collections. The decline in the investment rate reflects a slowresponse on the part of the private sector, inadequately offset by capital expenditures from theTGE's budget.

8. As assessed by a recent PFP review mission, there are some favorable signs with regardto the aggregate macroeoonomic balances. Despite a sharp fall in government revenues, the dropin militay spending is expected to moderate the budget deficit (excluding grants) for 1991/92 at13.2 percent of GDP, compared to 16.5 percent the previous year. Similarly, for 1992/93, thedeficit b expected to be below the 11.8 percent of GDP assumed in the PFP. Importcompression restrained the cuent account bace of payment deficit to 8 percent of GDPduring fiscal 1991/92, down from 9 percent a year earlier. Again, the expected outcome for1992193 is lower than the 16.2 percent of GDP deficit anticipated at the inception of the PFPstabilization program. By end-March 1993, the year-over-year increase in the general price levelwas only 7 percent, despite the devaluation of the Birr (the first since 1973) from Birr 2.07 toBirr S per US Dollar in October 1992. In addition, gross international reserves now stand atabout 8 weeks of imports, compared to 7.2 weeks targeted in the PFP program. The successfilcompletion of Paris Club negotiaions in December 1992 resulted in a rescheduling, on eancedconcessional terms, of Ethiopia's debt service (mcluding arrears) with a cut-off date of end-1989,a three year framework for the rescheduling, and an initial consolidation period of December 1,1992 to October 31, 1993. Debt relief secured from Paris Club creditors fr the initialconsolidation period is estimated to amount to $207 mhlion.

9. Ethiopia's recent performance suggests that the TGE is beginng to asset control overbasic macroeconomuc management However, the size of economic imbalances remains dauntingard unsustainable. Viewed from a different perspective, resource requirements are especiallylarge. Becase of the emergency recovery program and donor support (ERRP), imports havebegun to recover, some critical imputs have entered the economy, and dormant productioncapacities are being reactivated gradually. In addition, improvements in the policy environent

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for agIcultue, acoompanied by improved distribution of fertilizers, seeds and pesticides, havealready delivered visible gains, both through increased production and exports. Nevertheless,contined macroeconomic stabiizaton and radical strucUra adjustment measures will be nededto transform the economy and create the basis for a more robust and sustainable growthperformance. This will ned to be complemented by large flows of concession resources.

10. There are several potential sources of economic growth. In the near- and medium-term,agriculture will continue to be the mainstay of the economy. It contributes about 45 percent ofGDP and 85 percent of merchandise export eaings (coffee, pulses and hides and skins). Nearlytwo-thirds of exot go to the European market, through well-established market links. Forexample, coffee and hides and skins exporting continued even at the height of the civil war,although at lower volumes due to domestic supply disruptions. Increases in agAcultural exportvolumes by 1995/96 to at Ikast the 1990 levels, combined with improvements in quality, wil havea favorable effect on foreign exchge eangs and the domestic growth rate. However, the sizeof the domestic market, existence of large food impomt imd availability of large cultivable areassuggests that significant potendal also exists in food crop production. Peasant field crop activitysupplies nearly 40 percent of agricultural output, but performance has been disappointing untilrecenty despite the considerable scope for achieving higher yields and incomes. Increases inoutput through agricultural extesification and improved technology and extension, especially inthe livestock sector, are judged to be feasible over the medium-term. In tha near-term, theavaiability of critical inputs, restoration of transport, institution of more liberal distibutionnetworks, improved publik security, and good weather will be the main factors helpin,agricuural production.

11. Nearly 80 percent of the popuation depends directly on agricultural income, and nearlythree quaters of the poor live in rura areas. Impfoved agricultura performnce is, therefore,aWlso the key to increasing effective demand in the economy, generatng a higher level of domesticsavig and invesiAent, and meeting basic needs. This undoubtedly would provide a stronggowth stimulus to the m a sector, which is almost entirely domestic market orientedand largely under state ownership. However, the limited size of the private sector implies thatin the near-term, manufacturing efficiency wiU come mainly from the increased autonomy ofpublic enterprises and, as the availability of foreign exchange increases, from a phasedliberalization of the import regime. Nevertheless, private sector participation in all sectors needsto be encouraged through the rapid removal of barriers to entry, improvements in incentivescombined with a looseing of production and trade controls, and pro-active measures to ease theavailability of inputs and foreign exchange. Because of Ethiopia's low wage costs, there is scopefor considerable growth in labor-intensive exports. These include leather goods, garments, andprocessed agricultural products. In addition, the cost advantage extends to several import-competing industries, such as building materials and wage goods. As effective demand picks up,the potential for labor-intensive domestic production is expected to be realized tough anexpansion of private sector production.

12. Potentially, the mining sub-sector and services are important sources of future growth.The former contributes less than one percent of GDP now. Several studies and geologicalexplorations suggest that, besides gold, other metallic mineral deposits, including other preciousmetals, also exist. Ihe hydroelectric and geothermal sources of power and deposits of naulgas remain largely unharnessed. Installed capacity is only about 1.2 billion Kwh, compared toan estimated potential of 60 billion Kwh. Only 10 percent of the population is connected to

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electric power, and other utilities are developed poorly by African standards. Ibis is true alsofor banking, transport and communication services, which may be expeced to expand as growthrevives In the economy. Here too, the entry of the private sector, both domestic and foreign,would be a critical facbr in providing investible resources and pressure for condual increasesin efficiency and improvements in quality.

B. Medium Term Macroeconomic And Structural Policies

13. The Transitional Government of Ethiopia articlated it's economic goals and strategy intwo basic document. In November 1991, the TGE published a statement entitled "Ethiopia'sEconomic Policy Dhuring The Trnsitionaa Perima' In September 1992, with IDA and the IMP,the Govenment formulated the Policy Framework Paper for the period 1992/93 to 1994/95. Theformer document states explicitly that the TGE would sidestep issues that are likely to becontroversial and concentrates on solutions t urgent economic problems upon which broadconsensus can be reached." In this, it recognizes the potential for disagreements among membersof the existng coalition that rules Ethiopia until general elections are held. Also, it responds toa situation where public administration and the knowledge base may not be adequate, but wherepolicy errors could be cosy or irreversible. So, the TOE has postponed for later considerationsome Important areas of economic reform. Chief among these are ownership (but not user rights)in land, private ownership of financial institutions, and price decontrol of a few selected servicesand goods. Conversely, while the document oudines a policy for the transitional period, "itwould be open to continuity during the post-tansitional period with only minor adjustments."Thus, the TGE does not limit its economic policies merely to the short term. The PFP, whichencompasses a broad range of demand- and supply-side measures covering a three-year period,shows this clearly.

14. Ethiopia's main economic goal is to reduce absolute poverty. This poverty is of twokinds-chronic and transitory. Of the 17 million chronically poor (32 percent of the population),three quarters live in rural areas. Their poverty has the following causes: lack of economicopportunities; little or no access to productive assets and natural resources; and underdevelopedhuman capital-poor health and education, including lack of skills. The population affected bytransitory poverty is heterogeneous, and includes mDre than 490,000 refugees. Vulnerability tothe effects of recurrent droughts accounts for most people in this group. Also, much of the civilpopulation dislocated by the war and military personnel demobilized when it ended in 1991belong to this class. Altogether, about 50 percent of the population lives in absolute poverty.

15. The TGE has adopted a three-fold stae to reduce poverty. First, it intends to reorienteconomic structures and policies to stimulate a rapid growth of incomes and employment. ITiswill enhance the economic opportmities available to all Ethiopians. Second, it intends to buildhuman capital to enable the poor to take advantage of the new income-generatig opportuities.To achieve this, it will improve their access to education and training, health care, and othersocial services. A strategy for human resource development is being prepared by the TGE,including measures to tackle Ethiopia's rapidly growing population. Third, special measures arealso being put hito place to employ large numbers, who cannot obtain work through other lteans,in labor-intensive public works programs to rebuild or expand essential infrastucture.

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16. The implementation of such a strategy Involves four main clusters of aions. These are:(a) the of existing economic and social lnfrastructure, and provision for selectiveexpansions and reguar ma_itenace; (O) maioeconomic slbzation to reduce the largeimbalances that characterize the economy; (c) MCU rform to transform the economicsystem and to provide access to basic social services by the poor; and (d) the estatlishment andmalntenanc of an efficient and transitory eafg to cope with the current social crlsis thataffects half the populaton. We discuss each of these below.

Rebabilitation

17. Early economic rehabilitation actions concentated on the repair and replacement ofesseti economic assets and infrasucture and the provision of key imputs to squeeze out highergrowth from existing facilities. The ERRP, under implemention since May 1992, representsthe core of this effort. This program provides seeds, fertilizers, spare parts, constuctonmaterial, hding and equipment for the rebabilitation of social infrastructure (health andeducation) and portion (for example, trucks and buses, ports, the railway, and civilaviation). Ihere is a special focus on the rehabilitation of transport and road networks. Thedensity of roads in Ethiopia is significantly lower than in most other African countries. Here,actions involve, for example, improvements in the road maintenance capacity of the EtidopianRoads Authority. Rural roads are especially scarce. This has an adverse effect on both theproduction and markeing of crops intended for the domestic and export markets. Therefore, theGovenment intends to complement the initW efforts under FRRP by beginnig a program forsuch roads during 1993, using largely community-based prog..ns. Rehabilitation of the lifelineAddis Ababa-Assab road is also underway. The next phaset of investments and reforms in thearea of physical nfrastructure, while continuing to focu on Immediate reconsuction, willintroduce the additional consideration of selective upgrading and expansions of infrastructure tosupport the mediumterm needs of the economy. These needs are enormous, and must beassigned pnorties within detailed sector programs. Transport and distribution infrastructure willcontine to draw the major part of public infrastructure spending. However, the revival ofgrowth will result in the rapid emergence of shortages in energy supplies. Energy consumptionper capita is less than one-seventh the average level for low-income countries. Furtherdevelopment of hydropower potental and exploitation of natural gas as an altermative energysource, also for potential export, are planned.

Maroeconomic Stabilation

18. Low and stable inflation, appropriate investment and production incentives, andunintrrpted avaiability of foreign exchange are essential supports for encouragir' the privatesector, hence the sustained growth of incomes and opportunities. In the PFP, thtii lovernmenthas moved to design a coherent macroeconomic framework to revive growth, mprove theeffectiveness of public and private investments, and to support the change to a market-basedeconomy. The main elements of this framework are: (a) increased domestic resourcemobilization, through an enhanced government revenue effort and improved incentives for privatesavings; (b) reduction in the fiscal imbalance and inflationary financing of the deficit; (c)correction of price distortions; and (d) reduction of the extern imbalance through appropriateincetives for exports and restructurng of extrna debt servicing.

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19. (a) Today, forelgn savigs (oans and grants) fund all of domestic investment in Ethiopia.Both public ad private savings will need to rise sharply to keep Ethiopia's growth path stableand susainable. Historically gross investment has averaged about 15-16 percent of GDP. Toachieve faster growth In output and employment, Ethiopia requires an increase by the end of thePFP period (19949 to about 24 percent of GDP. In addition, higher growth will require sharpincreases in the efficiency of public investment, and in their effectiveness in complementingprivate economic activity. Raising goverment savings to finance investment is less anexpenditure than a revenue problem. The later has falen from traditional levels of 25-30 percentof GDP to 15 percent this year. Revenue goals consist of convertir- to a market-based systemof assessment and collection, overdue adjustmens In rates and covurage, and Improvements intax coordinton and administration Regarding private savings, increased incomes, improvedtation of income, and stable and low inflation are the main elemants that will provide the rightincentives. The introduction of positive real interest raes will encourage greater savings throughthe financial system.

20. (b) The fiscl deficit (including grants but excluding foreign loans) iS eWpected to riseinitly from the fiscal 1991/92 level of 10 percent of GDP, but then decline by the end of thePFP period to about 8 percent of GDP. The deficit remains large because of the vast resourceneeds for rehabiliaion, reconstuction and resetdement. However, the potential inflationaryeffect of the large deficit will be reduced by foreign concessional financing. All domestic bankfinancing of the deficit will be stopped by the end of the PFP period. Besides the revenuemeasures mentioned above, actions to contain current expenditures-reducing the growth of thewage bill, limiting purchases not required for operations and maintenace in the economic andsocial sectors, and cuttg budgetary subsidies-are also planned. A comprehensive review ofpublic expenditures is needed to direct this effort.

21. (c) Price flexibility will play a significant role in stabilizing the economy by contributingto a supply response. Initally, it can be expected to bring prices rapidly in line with actuademands and supplies, correcting the major distortions that occurred under the previousGovernment. Adjustments in some key prices-official exchange rate, deposit and loan inteestrates, public sector wages-have already occurred, or are underway. These measures will providea better guide to investment and production, especially when supported by product priceliberlization and adjustments in tariffs for selected public services. Although recent pricechanges mav not yet have Improved the domestic terms of trade for agricultur-necessary tolessen food shortages, stabilize prices, and increase the incomes of the poor-incentives fortadeable goods production have improved markedly. The TGE proposes to continue pricedecontrol at both the wholesale and retail levels.

22. (d) Due to Ethiopia's massive import needs, the externa deficit is expected to widen toabout 21 percent at the end of the PFP period. A sharp increase in disbursements of exteraconcessional financing, to an average of about $950 million during 1992/93 to 1994/95, combinedwith total debt relief of about $1.36 billion, are required to finance the deficit and theaccumulation of a prudent level of reserves. Although actions to improve the externa balancecan only be expected to show results over the medium term, a set of coordinated measures isproposed. While providing stronger price incentives for the production of tradeable goods,acdons to reduce the inherited anti-export bias in Ethiopia's economic system will be given a highpriority. The maintenance of a competitive exchange rate is key, to be coordinated withappropriate dcanges in the trade regime. This will be synchronized with the expanded provision

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of foreign exchange to the private sector for external payments. Further, a significantenhancement of the convertibility of the Birr will occur by the end of the PFP period.

Structural Reform

23. The TGE recognizes that the generation of growth to reduce poverty will involve astructural a, rather than mere reforms within the existing system. The challengeis to transform a highly directed centrally planned system to one based on the functioning ofmarkets. In this system, the private sector would play the key role in production, and the publicsector would focus on providing stable and supportive policies, critical infrastructure andiform ation, and support for hum resource development. The TGE's economic policy hasdetailed an extremely ambitious program in this area, perhaps with inadequate attention to thecomplexity of the process. Structural reforms will stretch over several years, and will requirecontuous evauaon and anodification as economic conditons change. The sequencing ofreforms will need to be tailored to implementation capacities. It will also be designed to benefitfrom complementarities, minimize transitional costs, and build support for the program bothdomestically and abroad. Ihey wil build on the steps already underway for generating economicrecovery and stabilization (paras. 18-22 above). This phase, which is the focus of the proposedSAC L will provide the private sector with expanded opportunities. This would be achievedthrough an improved enabling environment, reducing barriers to entry into activities reseved forthe public sector, and greater access to inputs, especially foreign exchange. The following phaseof adjustment will begin the difficult process of reforms in the public sector and financial system.For this, a stronger knowledge base and significantly greater policy making and institutionalcapacites are required.

24. There are several policy and institutional measures for improved efficiency In resourceuse and structura change. Chief among them are those that will ensure increased scope for theprvate sector and competitive markets, closer integration of Ethiopia with the internationaleconomy, and human resource development. Initially, the TGE has atempted to create marketsby freeing some prices and distribution, and by diminishing the monopoly of parastats in a fewsectors. Further, major pieces of legislation have been promulgated or are planned to supportthe establishment and operation of markets. These include revisions of laws governinginvestments, labor, public enterprises, general business, fiancial institutions, and taxes. As theeconomic reform process unfolds, it wiUl be necessary to formulate implementing regulations, alsoto modify existng legislation in the light of experience. Improvements in economic management,including better support for macroeconomic stabilization, are also planned. These includechanges in policies and insfitutions concerning taxation, foreign exchange allocation, money andbanking, and trade. In agriculture, support for an enhanced supply response will focus initiallyon guaranteeing land user rights, maintaining or deepening the liberalization of prices anddistribution, privatzing state farms, and improving the access of farmers to inputs andagricultural support services. For parasuals, reform will begin by hardening the budgetconstraint, strengthening management autonomy, and reducing the size of selected firms. Inaddition, efforts to reduce the monopoly power of parastatas will continue, especially in trade,transport and construction. Later measures will focus primarily on the financial sector, publicenterprises, civil service reform and the security of landholding.

25. As adjustment proceeds, structural measures to realign the budget toward more effectivesocial spending, especially the expansion of access by the poor to health and education, wil

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increasinly become the focus of the reform effort. The enhamced quality of primary educationand health care, combined with a better geographical spread of facilities, will be given priority.Development of a coherent stay and programs for improving access to basic social servicesIs under way, but will take some time.

Safety Net

26. ITe TGE has embraced two differnt, but related, concs of the safety net. Themassive poverty-both chroic and transitory-that affects Ethiopia requires urgent attention. Thegains from structural reforms will be visible only with a lag. The TGE has started to move ftomthe wasteful regulation of prices of essential consumption goods to better targeted interventionsto support the consumption and incomes of the poor. It is considering the use of cash-denominated vouchers for the purchase of food and kerosene in urban areas and production inputsin rural areas, and the introduction of a labor-intensive public works program. Always, theprograms wiUl be targeted narrowly, they will be trsitory, and will be accounted for explicitlyin the budget. The second concept of a safety net relates to mitigating the social costs thatinevitably arise during the expenditure-switching and expenditure-reducing phases of stabilizationand reform programs. Tle October 1992 public sector salary adjustment, intended to compensatepartially for recent price increases, represents one aspect of suck measures. Here too, the TGEintends to focus on a narrow targeting of benefits to groups affected by the adjustment program.In this regard, steps are underway to design appropriate retrenchment schemes for publicemployees made redundant by the early measures to limit parastatal monopoly power andintroduce hard budget constraints. To complement and direct this effort, the I-GE has establisheda National Economic Reform Task Force, under the Prime Minister, which wil monitor theentire reform process.

Extenal Resource Needs

27. Ethiopia's undoubtedly massive resource needs cannot be estimated with great precision,given the complex nature of its reconstruction and development challenge. In addition, under theprevious Government, Ethiopia had accumulated eternal debt servicing arrears. In November1992, arrears on hard currency debt servicing stood at $595 million, while arrears on debt owedto the former Soviet Union stood at Rubles 795 million. In March 1993, becuse of the ParisClub rescheduling, and assuming comparable terms on a flow basis from non-Paris Club creditors(but excluding Ruble-denominated obligations), it is estimated that Ethiopia may receive debtrelief equivent to $723 million for 1992/93, $162 million for 1993/94, and $143 million for1994/95. This would enable it to bring down the projected debt sericing ratio (for scheduledpayments) fiom 38 percent and 30 percent in 1993/94 and 1994/95, respectively, to 20 percentand 18 percent for the same years. The TGE has contacted all official creditors to rescheduleEthiopia's debt service and ousanding arrears in line with the terms detmined by the ParisClub. If the Rubledenominated debt is taken into account, non-Paris Club creditors would needJo provide more concessional debt relief than in the Paris Club agreement if the financing gap isto be closed. A recendy concluded bilateral agreement has indeed provided significantly betterterms. Discussions are exected soon with the Govermment of Russia on the outstanding Ruble-denominated debt.

28. Inplemeon of the stabilization and structural reform measures described above shouldtrengten the balance of paymens, but only gra y. Export eags now cover bary one-

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fifth of total import needs. In recet years, earing from non-factor senrices-reflectingincreased earnings by Ethiapian Airlines and Ethiopian Shipping Lines-reached nearly 50 percentof export earnings. In addition, with the introduction of h am (own resources) Importsby the private sector in the lat-1980s and inflows for relief operations in the aftermath of the1984 drought, private transfe grew rapidly, averagig 40 percent of export earnings. Bothsources of foreign exchange cushioned the effect of the large trade deficit. In 1991 and 1992,import volumes fell dratically, reflectng mainly the sharp reduction in military and othergovernment outlays as well as a decline in general imports for production. However, as growthrevives and imports are restored to their historical levels, the importance of increased exports willbe heightened. For the PFP period 1992/93 to 1994/95, import volumes are projected to rise atan average rate of 9 percent per year. An etern reserves target of roughly three months ofimports is considered appropriate, which would imply an annual increae of about $130 million.The availability of inputs, improved domestic security and transport, and recen actions toimprove exchange rate incentives will have a favorable effect on exports. Even so, it is expectedthat the volume of traditional exports in 1994/95 will remain below the levels reached in 1988and 1989.

29. As shown in Annex I, the projected level of imports of goods and non-factor services is$ 1.8 biXlion in 1993/94; in 1991/92 they were $1.3 billion. After accouitng for the recent debtrelief obied through the Paris Club and comparable terms from other official creditors,scheduled iterest and amordzation payments for 1993194 are estiatd at $327 million; for1994/95 they are estimated at $312 million. The total foreign exchange requirement for 1993/94,consistng of imports of goods and services, amortization payments, and an increase in grossofficial reserves, is $2.3 billion, while foreip exchange eangs are expected to provide about$1.2 biUlion. Of the difference, $598 million is expected to be funded through disbursefrom exist commitments, leaving a fimancing gap of $492 million. For 1994/95, this gap isprojected at $522 million. These gaps will need to be covered by disbursements from theproposed SAC I and associated cofinancing, as well as by yet-to-be-identified sources. Thesccessfid completion of the current debt reschedling discussions with non-Paris Club creditorswill offer additional relief.

30. Total disbursements from SAC I for 1993/94 are estiated to reach $130 million.Provided early progress is made by the TGE in establishing a trade verification mechanism forprocurement under the Credit, as much as $20 million of the first tranche of $150 milion isexpected to cover the retroactive financing of imports undertaken during the last two months ofthe 1992/93 fiscal year. In addition, disbumn from cofnanciers are projected at $175million, leaving a residual gap of $25 million to be funded by disbursements from newcommitments. For 1994/95, SAC I disbursements would consist entirely of the second trancheof $100 million. Cofinancing amounts are estima at $27 million, leaving a residual gap of$252 million. Clearly, for both 1993/94 and 1994/95 there is need for additional debt relief andproject and quick-disbursing funds to cover Ethiopiaes projected balance of payments deficits.

C. Bank G6op Assitace Strategy

Eisting Progra

31. Before May 1991, the Bank Group restricted its actvities in Ethiopia to a core IDAlendig progam, and one active IFC operation. The failure of the previous Govenment toproduce a coordinated reform progrm and the continued state of civil disruption limited the sizeand nate of the 1DA portfolio. Ite 16 operations from ths period that are now in the portfoliorepreented a total commitment of $729 million. Ihey responded to high priority needs for socialsupport, as well as the need to ensure that infrastructure woud be in place to support a programof development once agreement was reached on policy reforms. However, implementation ofmany of these projects slowed because of the adverse policy environment, insutional constaintsrestilug from rigid monopoly arrangement in the implementing agencies, and contuingisci as the war escalated. IFC limited its activities due to the severe restrictions imposedby the Government on the private sector. The only IFC operation was a largely undisbutsed1989 equity investment of $7.8 million in petroleum and nat gas development in the Red Sea,recently canceled.

32. In 1992, the Bank coordinated a consortium of donors to support the TOE's efforts toreoonstruct its war-tom infucure, jump-sart economic production, provide essentialmedicines, and launch a pilot social fund to provide support for community-led efort to rebuilddestroyed local facilities. The multi-donor ERRP (see para. 17) has succeeded in mobilizingabout $600 million in total etal support for Ethiopia's immediate needs. The sum includesa new IDA commitment of $150 million and $80 million restuctured from the exsti portfolio.TMe undisbursed portion of IDA's current portfolio in Ethiopia is large-$645 milion out of $975million in exist commitments (icluding ERRP and the Road Rehabilitation Project)-reflectingmainly the unsettled condiions of recent years. However, disbursement of the IDA-supportedportion of the emergency program is better than the average for both Ethiopia and Sub-SaharanAfrica. Ii November I992, the TGE indicated that it had established several groups to reviewall projects to restrucure them as appropriate and speed up disbursements.

Futue Assisbnce Goal And Sttegy

33. While no investments are planned, given the improved policy environment IFC intendsto become more active in Ethiopia if the TOE can maintain peacefud conditions and deepenmeasures to stimulate private investment. Investment priorities would focus initialy onsupporting the privatization of selected industrial public enterprises; financing the rehabilitationand expansion of these enterprises; and helping writh financial sector reforms that establish privatesector instutions and mechaisms to mobilize funds for private investment.

34. Ethiopia has been a full member of MIGA since July 1991. To date MIGA has notinsured any investments in Ethiopia, and has registred only one expression of inerest forinvestment in the transport sector. Ihe policy advisory and foreign investment advisory serviceshave not yet been active in Ethiopia, although contacts have been made recendy by a FIAS teamwith the TGE's investment office.

35. The aim of the Bank's assistance program will be to support the Government's efforts toreduce poverty. There are three main strands to this support. Ihe first consists of measures that

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will result in employment generating and enrometally sustainable growth, the most efectiveand sustainable basis for eradicating poverty. The second consists of measures that will rapidlyimprowve the quality and distribution of essential soci services, and build the base for longerterm human resource development, with a special focus on improvig the economic participationof women The hid strand consists of providing general, but non-lending, support to establishsafety-nets to protect the most vulnerable from the transitory negative effects of adjustment. TheTOE has accepted the responsiility for making its own budgetary provisions for these measures,but its capacity to do so will depend in part on the local counterpart of quick-disbursing balanceof payments support that will come from the Bank and other donors.

36. The Bank has set four specific &oa8 in griot areas for the remainder of the transitionapVjo4. So long as there Is adequate progress toward adjustment goals, we will provide anincreased level of support oompared to the previous core program.

37. Th' Bank's participation in the TGE's program to revive investment and productionwill be supported initially by the proposed SAC I. IDA also will support selected initiatives thatcomplement direct measures for economic growth and employment. These include a NationalSeeds Project to improve the quality and distribution of improved seeds, and a Fertilizer Projectto improve the distribution and widen the use of feriizer in the peasant sector. In addition, thereconstruction of economic infrasucture will be supported by the Road Rehabilitation Project(approved by the Board on November 19, 1992), and a Public Works Project which will uselabor-intensive methods to contime actions strted under the ERRP to rehabilitate key roads,water supply and other priority fcilities, and to support conservation efforts. Finally, the CalubGas Project represents the first exploitation of Ethiopia's large gas reserves. It wiU provide animportant alternative to reliance on traditional energy sources, will contribute to environmentalconservation, help the development of the disadvantaged Ethiopian-Somali region, and providealternative employment to women fuelwood carriers. Because of the proximity of the project siteto the border with Somalia, adequate secuity wiUl need to be ensured.

38. Five Bank initiatives are proposed for Improving the access of the poor to basceducedion and health services. Initially, the existing Family Health Project ($33 million, ofwbich nearly 85 percent remains undisbursed) will be restructured to support the urgentrehabilitation of health facilities and improve health sector management. This will be followedby an operation to improve matal healt, id care and family planning, probably through theprovision of essential supplies. ThWd, the existing Seventh Education Project will be restructuredto strengthen the focus on basic education. The fourth activity will be the monitoring of theERRP's pilot social fimd, to lay the basis for broadening the pilot both in scope and to other partsof the country. Finally, during the traisitional period, with other donors the Bank wiUl launcha major human resource development study to support the TGE's planning efforts for this crucialsector, to develop a strateg for the dhange from relief to development aid, and to lay the basefor famre Bank and donor operations in this area.

39. The third specific goal for the transitional period wil be to contribute to thedevelopment of a sound analytical base for investment in several sectors. Besides humanresources development, discussed above, the other major studies proposed are: (a) agriculturalsector memorandum (including a review of small-scale irrigation schemes); (b) rural roads study;(c) a national environmental action plan to follow the soon-to-be completed forestry actionprogram; (d) updates of previous studies on the financial and industrial sectors; (e) energy sector

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review; (f) a review of public expenditures; and (g) additional work on poverty assessment (toeted the assssment prepared in 1992 as an input for the PFP). Also, the Bank will arngecooperative work plans with UNDP to strengthen economic policy analysis and sector planning.

40. Finally, the Bank will support the TGE's efforts to set up an effecve donorcoordination medcani, and to help mobilize donor support for its programs. With itsagreement to enter a program of adjustment, Etiopia is now eligible to participate in the SpecialProgram of Assistance for Africa (SPA). A successfil Consultadve Group meeting took placeduring November 23-24, 1992, at which donors pledged to Ethiopia over $1.2 billion for theperiod up to mid-1994.

Conditions For The Bankl's Enlarged Program Of Support

41. For FY93 and FY94, the Bank plan to provide an enlarged program of support totallingabout $800 million. This level of support is contingent on three factors, besides maintenance ofthe macroeconomic framework supported by the SAP from the IMF and laid out in the PFP.First, adequate progress in designing and carrying out the first phase of structural reformmeasures. Second, adequate implementation of both the restructured portfolio and newoperations. Third, main ning a reasonable political and security situion. If such a frameworki not in place, IDA lending could drop to a core program of not more than $150 million a year.Such a program would focus on major social investments on which progress is possible withoutneed for a comprehensive policy reform.

Bank Support After The Transitional Period

42. Once the new elected Government assumes office, the Bank will revisit its strategy, levelof support, and program priorities. Assuming policy continuity ater the transitional period, theBank will continue to pursue the central goal of poverty reduction. This will be achieved byexpanding support for the adjustment process, further measures to stimulate producdon andemployment, additional efforts to expnd essential infrastructure, and by carrinyg out a humanresource developmen program. On policy reforms, attenion will focus on a second phase ofmeasures to build the confidence of private investors. This would include liberalizing anddiversifying the financial sector, firther reducing regulatory constraints, and restructuring andprivatizing state enteprises. To support production and employment, help will be given foragricultural research and extension, expansion of the mral roads network, improvements to trunkroads and urban and rural water supply, additional investments in transport, tapping Ethiopia'shydroelectric potential, and improvements in telecommunication to support business expansion.Building on the National Environmental Action Plan, the Bank will design a project for theimplementation of its major findings and priorities. For improving social services, the Bank willtake several initatives, building on the findings of the forthcoming human resources developmentstudy. These will include improvements in the financing and delivery of basic health andnutritional services, family planning, and primary education (including the participation of girls),and support to the Government and regional administrations in efforts to restructure the provisionof social services.

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I. SRUCTURAL ADJUSTNT PROGRAM, 1993-94

A. Strategy

Objectives

43. As descrbed in paras. 23 to 25, the TGE is engaged in a comprehesive progm ofStructural reforms. This program aims to transform the uments of economic managementand ras investment, particularly by the private sector. It also aims to reduce the size and scopeof the public sector, alow market signas the primary role in allocating resources in the economy,mobilize a lager volume of domestic resources, and improve the quality of social services forall Ethiopians, while improving access for the poor. In the first phase, the TOE will carry outonly the most urgent reforms to revive growth in the economy. The proposed First StrucuralAdjustment Credit will provide a resource tansfer to Ethiopia to support three groups ofmeasures: (a) to aid i impleme ithe macroeconomic stabilization framework descrdbed in thePFP; (b) to address initdal constrais to iereased participation by the private sector inemployment creation; and (c) to help identify and design later phases of reform. By focusig onthese three areas, SAC I will create the conditions for stmWating a strong production responsein the Ethiopian economy, thereby generating the impulse for growth in employment and thereduction of poverty.

Basic Considerations

44. 3Ethiopia's extreme poverty, massive rehabilitation and reconstruction needs, andunsusnable macoeconomic imbalances make impiementation of its strucural reform programexceptionally complex. Moreover, its underdeveloped private sector institutions andepreneurship are unable to compensate filly for the limied (ut high calibre) capacity of

public agencies to manage the dhange from a planned to a market economy. To complicatemauers fiurher, a resolution of the political siuation will come only after the successficompletion of general elections which, according to the Transitional Charter, should take placeby January 1994. Under such circmstunc, more thm usual care is needed in designing theambitious program of policy and insttional reforms idenified by the TGE in its econom..policy statement of November 1991, and in the PFP.

45. SAC I wiUl cover a set of structural adjustment measures that conforms to five basicconsiderations. *st, the measures should support and be consistent with the macroeconomicstabilization framework identified in the PFP, vital for the revival of growth. Second, the privatesector should participate more actively in the generaton of growth and employmenL Initially,this would consist of a set of measures to improve the enabling environment, including increasithe availability of foreign exchange for its operation and expansion. Foreign exchangeavailability will be especially helpful for agriculture, where reforms have proceeded rapidly butshortages of inputs and some institutional bottlenecks continue to hamper production and sales(both domestic and foreign). As most of Ethiopia's poor live in rural areas, actions in theagriculture sector wiUl have both a direct and indirect effect on reducing poverty. Third, thetiming and scope of reform measures should be tailored chiefly to the mandate and tenure of theTransitional Government, to ensure the fill ownership and political feasibility of the program.However, it should include elements that would favor continuity in the basic thrust of official

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policies beyond the transitional period. Fourth, there is a need to focus on critical elements ofc rapy and knowledge building to help desig and implement later, and possibly more"difficult', pbases of the structual adjustment program. Finally, there will be some losers fromthis first phase of reform, chiefly in unofitable parastals exposed to market competition andhard budget constrain. There is a need even at thbis early stage to ensure that an adequate safetynet exists to provide support for affected public sector employees.

46. SAC I contains mnay up-front actions, some of which have been taken already sinceagreement on a PFP was reached in September 1992. Structural measures that, to be effective,would require improved macroeconomic conditions, complex preparation, or which fall outsidethe mandate of the TGE, wil be crred out at a later stage of the adjustment program. Suchmeasures include, for example, the major part of civil service reform, public enterpriserestructing and privadzation, land policy and financi sector development. However, asidentified below, some initial and preparatory measures in each of these areas will be carried outduring the SAC I implementation period. In addition, a set of actions to be taken by early-to-nid1994 (hat is, before release of the Second Tranche) are included in the program. Although theyare integral component of the first phase of the reform effort, additional time is required fartheir Implementtio. These conditions are also itended to mainn policy continuity and toavoid a possible hiaus in the flow of etnal resources while the elected Government assumesoffice. Morewver, while monitoring implementation of the PFP and thie SAP will provide IDAand the IMF with periodic assessments of the maceconomic situation, the Second Trancheconditions will offer additional checkpoints to evaluate the implementation of struchtral reforms.

47. The imortance of agricultural growth in the overall strategy is undeniable. The potentalexist for raising productvity on existing lands, also for opening new lands for development.The need to stem resource degradation is also apparent. Finally, many opportnities for thediversification of agricultural products have been identified already. More than elsewhere in theeonomy, raising growth in agricultre wUi have the quickest payoff for labor absorption, povertyreduedon and foreign exchange enings. To achieve this, there is need for better incenive,security of landholding and competition policies, for investments in supportive infastructure, andfor easy access by the private sector to production inputs. The TGE has deepened some priceand market liberalization measures iniiated by the previous Government in 1990. This is seen,for example, in the liberalization of grain marketing, the abolition of mandatory grain deliveryquotas, the legal guarantee of peasnt' land use rights, and in the freedom to set up large privatecommercial faums and use hired farm labor. The issue of property rights in land is underconsiderable debate; however, it is not expected to be resolved during the transitional period.Instead, SAC I will support faster growth in agriculture through three sets of measures: providingthe private sector access to foreign exchange for imports; completion of market liberalization sofarmers' incentives do not get squeezed by inefficient parastatal intermediaries; and maintenanceof a competitive exchange rate to stimulate agricultural exports.

B. Key kssues And Actions

48. The key issues to be addressed under SAC I are discussed below, with a description ofthe specific actions that will be carried out. Ihese are reflected in the reform program policymatrix attached to the TGE's Letter of Development Policy, shown as Annex II. They fall into

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ree areas: macroecnomic stabilization, support for the private sector, and groundwork for thenext phase of adjustment.

Maereeconomlc Stabilization

49. The size and nature of macroeconomic imbalanc in Ethiopia were described earlier(paras. 18-22). The second-year review of the PFP for 1992/93 to 1994/95 will be completedby end-June 1993. Based on a preliminary evaluation, the TGE's performance onmacroeconomic stabilization has been exremely good. Tbis is true especially for fiscal controland reductions in the rate of inflation, where targets have been met or exceeded. As the SACI measures are fully consistent with the PFP, the current success on the stabilization front maybe attributed pardy to early intiatives in carrying out this reform program. The main actionsunder SAC I in support of macroeconomic stabilization are: (a) correction of distortions In keyprices; and (b) strucural improvements in the fiscal position.

50. (a) Distortions In Key Prices. Rigid prices, with their attendant adverse effects onresource mobilization and allocation, have been an unfortnate feature of the Ethiopian economyin the past. For example, since February 1973 the Birr was peged to the US Dollar at a rateof 2.07. However, the real exchange rate has flucuated, reflecting movements in the Dollar andin relative prices between Ethiopia and its trading partners. In real terms the Birr appreciatedby 83 percent untRi mid-1985, depreciated by 39 percent between mid-1985 and mid-1988, andaeciated again by more than 10 percent between mid-1988 and mid-1991. The slow growthof tradeable goods production, especially exports, and the deterioration in the structural tradebalance may be attributed pardy to the distorting effects of the real exchange rate. Moreover,until recendy, a significat part of Ethiopia's traditional exports was sold abroad tough llegalchannels, where producers' earnings reflected the higher paralel market exchange rate.

51. Simily, efficiency in resource allocation has been impaired through distrtions in otherkey prices. The controlled interest rates for savings, which ranged between 1 and 7.5 percentper year, were mosty negative in real terms after 1986. Lending rates, which ranged between2.5 and 10 percent, were also negative in real terms for most classes of borrowers. Moreover,differential rates and other restrictions applied to different classes of borrowers (with strongdiscrimination against the private sector), thus segmenting the credit mark"t. Che price of laborservices was also relatively inflexible. In the public sector, wages for thos% 1 the lower bracketswere adjusted either annuly or every two years. For senior personnel, they were either ftozenfor long periods or a general maximum was specified. All employment was channelled throughlabor exchanges or though intra-Government transfers of personnel. Reguatory controlsseverely impair labor mobility. As described in previous Bank reports, cumulatively thestructure of prices, wages, interest rates and the exchange rate resulted in a strong anti-exportbias, promoted an underground economy, misallocated financial savings, and led to serious factormarket rigidities, therefore lowering aggregate efficiency in the economy.

52. The SAC I program includes several measures to correct distortions in the price offoreign exchange, financial capital, and labor. Ihe TGE has ompIeted the following measures:

(1) A dvuation of the curreacy from Birr 2.07 go 5 per US Dollar, or 58.6 rcent inDllar tm.

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(ii) Upward ajustm in dps and Iaon tet And the eliminatio of distinctsqxkniS=aWubU ta =Lbtwem. As of October 1992, savings depst rateshave been raised from 2 to 6 percent per year to 10 percent, while time deposit rateshave rin fom 1 to 7.5 perce a year to 10.5 to 1I percent. Although there are somedifferences in borrowing rates by line of economic activity, loans for productive purposesand trade in agricultural inputs range between 11 and 15 percent per year. Given theTOE's success in lowering the inflation rate to single digits, the current structure ofinterest rates offers strong real incentives for increased deposit mobilizaion and improvedefficiency in the use of credit.

(iii) Public SeI= salary crases of 5 to 110 percent. to imro-ve real wage incentves.The increases in public sector wages, which affected nearly 210,000 employees at anestimated total cost of Birr 127.3 million (or 4 percent of budgeted current expendituresfor 1992/93), partially compes for increases in the cost of living and narrow the wagedifferential between the public and private sectrs.

(iv) Reovg of restrions a th myent of labor. The TOE .3act a new LaborCode in Jamnary 1993 (Proclamation No. 42/1993). Ihe Code provides employers withadequate flexibility in the use of labor while providing workers with the protection ofadequate notice of layoffs and due process procedures. The latter are transparent, andtheir costs predictable. Wage determination is largely free of government interventon.Gender-based provisions are designed in a manner tbat should not discourage theemployment of women. In general, the new Code will allow Ethiopia's labor costs tobe modest, making it very competitive within Africa.

53. The following additional actions are proposed under SAC I:

i.) anemeu Qf the exager restore pa maintan opis extenCinm i mgan minin smu ing.

(H) OterlY reviews n a adjusments of deposit and Ian rates to maintin them atpsrea levgls.

54. (b) Structural imravements l[n Tle Fical Positio. A major objective of the TGE'seconomic reform program is to shift the boundary between public and private spheres ofeconomic activity, markedly in favor of the later. This is to be achieved, in the first instance,through a refousing of public expenditures, and then through ihe introducdon of appropriatecompetition and divestiture policies. Due to their complexity, most of the latter will beundertaken once the basic policy and insfitutional preconditions exist.

55. In the short-run, however, te public sector's fiscal role requires examination, not onlyfor balance, but also for the effectiveness and efficiency of expenditures in reactivating growth.As noted in para. 20, Ethiopia's large resource needs imply that the fiscal deficit wil rise beforeit falls. How should this reduction occur over the long tetm, given the choice betweenemphasizing an increased revenue effort and a lower level of expenditures? Sharp cuts in militaryspending and a low implementaton rate of the capital budget have already dropped governmentexpenditures from a peak of 46.5 percent of GDP in 1989/90 to 28.5 percent of GDP in 1991/92.In the 1992/93 Budget, secuty-related current expenditures were cut to about 27 percent of the

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total, from about 59 percent In 1989/90. Nevertheless, to allow for increased public investmentin economic and socia infastructure, there is need for a major effort to curial budgetarysubsidies and contaln the wage biUl, to which the TOE is committed. A hard budget constrainthas been Imposed on all parastatals, under which their operational losses will no longer besupported from the Budget. Although selecive equity and capital contnbutions may be given,no supplemental Budget allocations will be made, cross arrears among parastatas and withgovenment departments will be eliminated, and no government guarantees will be provided fortheir domesdc borrowing. A thorough review of the civil service will be necessary to improveperformance and contain the wage bill. In addition, financial management within the coregovernment agencies needs to be strengthened-including thq; budgeting and accounting of donorsfiuds and the resulting counterpart-and the productivity of public expenditure raised.

56. Restoring revenue collections, which have fallen from 31.4 percent of GDP in 1989/90to a projected 19.9 percent of GDP in 1992/93, is an equally important consideration for thenear-term. A revenue effort equivalemn to 21-22 percent of GDP is considered within reach forthe PFP period. Starting in 1974, the tax (and customs) system was progressively adapted to acentrally planned economy. It requires basic structura changes if revenue is nt to be at risk inthe new economic environment and, in particular, if appropriate incentives are to be given to theprivate sector. A broader range of economic transactions will be conducted by private sectorentiies, as opposed to public agencies. Therefore, the relatve balance between tax and non-taxrevenues as a source of public sector financing will need to change. Besides broadening the base,punitive and disincetive effects from the rate stmcture need to be eliminated. Otherwise, ascentralized controls on the economy are dismantled progressively, tax evasion will becomerampant The entire range of revenue instruments reqiures a fmdmental reappraisal. Theobjective of reforms would be to ensure adequate revenue buoyancy through an improved ratestucure and broader tax base, conversion of the tax regime to be compatible with a market-basedincentive regime, and improvements in collections through building better institutional capacitiesin the core revenue agencies. In addition, the coordination of tax rate and base changes withexchange rate and trade reforms, and widi the regional devolution of fiscal responsibilities, arechallenging high-priority tasks.

57. Under SAC I, the TOE has completed several actions in this area:

(i) Personal income taxes were revised in October 1992 to corMect ta thresolds forinflation, reduce the number of tax bracket frm 17 to 10. and lowe the hi"esmargnal tax rate frm 85 percent go 50 perce

(ii) Except coffee. which contributes 85 percent of export taxes or one percent of totax revenues, all export taxes have been eliminated. In addition, at the time of thedevaluation of the Birr in October 1992, the five percent import levy, used in the pastto subsidize exports, was also abolished.

(il) All exprt subsidies were ended after the devaluation.

(iv) Procedures ha been pu in place for the centlized budging ad accouint ofe ants and cunterart funds. In the past, many exte donors placed grantfunds with individual Ministries. Accounting and control of such finds, and the resultingcounterpart has proved to be difficult, and expenditures In some cases did not fully reflect

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national priorities. The changes introduced by the authorities are expected to strengthenbudgety processes as well as to improve the effectiveness of expenditures out ofextenal grants.

(v) To the exten pOs. l tal gram= are nOW channeled through the Buderfth than trough individual Ministry accounts. as in the ast. However, even thosewhich continue to go through Individual accounts (refleci prior agreements withexternal donors) are accounted for in the government budget, and audited in the samemanner as the budgetary acount,

(vi) Tether with IDA. a ic expenditure review for the cental and regionalGovm s was iiated in Apl 1993. The review will be conducted in two phases,the first of which assesses the TGE's strategies in key economic and social sectors andexamines the broad alocations in the forthcoming Budget for 1993/94. Based on morecomprehensive analysis, the second phase of the public expenditure review, expecte toinvolve several externa donors, will have broader coverage (see para. 58-iii below).

(vii) AUreement a b reahed that. bgi in 199I/94, rental income will beincluded in the dnt of im fr oses. ITis is required to broaden therevenue base, especially as the TGE proposes to transfer state-owned housing to theprivate sector, which will activate the property market. Ind-ivduals as well as businessenteprises be liable for such taxes at a rate lower than the marginal personal incometax rate, after a 'tax holiday' period of three or five years, depending on the size of theProperty.

(*viii) TraW=n, admsld kdDinishave bRDeen inidiatefd in thie nlad Ro eveuand theQcustoms UaitmU =. Besides the TOE's own initiatives since the begining of1992, IMF assistance has been sought to introduce a program of capacity-building thatincludes designing training courses, preparing work manuals, and establishing units formonitoring tax fraud and conducting criminal investigations. A study recommendingchages in the orgaizationa structure of both departments was submitted recendy to theCouncil of Ministers for approval.

58. To promote struc improvement in the fiscal position and raise the efficiency andeffectiveness of public expendi, the TOE will carry out the following actions before SecondTiche Re :

Oi By December 1993 it will comlete a review of the civil servic. This would includecivil service cemuses, and an examination of civil service functions and wage andpersomnel policies. It is intended to assess the quality of staff, identify redundancies andthe need for retenchment, and to design appropriate structures to strengthen regionaladministration. The ultimate objective of the review is to assist in designing andsupporting a structure in which most eivil service fkmctions and personnel devolve to theregions.

(ii) On revenues. corrate and nn-corporate grofits taxes wil be djuste. They wiUlbe lowered to a rate below the personal income tax rate. This would conform to thewidespread international practice of broadening the base while lowering rates so as not

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to unduly distort Incentives. The new tax rate would assist Ethiopian firms in becomingmore competitive with fim in neighboring countries. To broaden the base, capital gainswould be included. The TGE will unify the marginal rates on corporae and non-corporate businesses, and the number of tax brackets for non-corporate profits tax willbe reduced. Corporate taxes are now levied at a flat 50 percent rate. The last revisionof the non-corporate profits tax occurred in 1989/90, when they were lowered from 89percent to 59 percent. However, the current rate is still considered high, and revisionswill be based on the results of a study that is underway. In addition, the coverae ofsale,s taxes wll be increased by including mQoxble services-all consultancy services.advrznaW . and inmet.

(iii) hM uli exenditure review will be omleted. Based on the review. a actionplan will he agreed with IDA to implement its findings in the Budget of 1994/95 andbeyond, and to introduce a rolling public investent progra. Consequently, the reviewwill cover all non-defense budgetary spending by the central and regional governments,it will review budgetary and related planning processes, and it will examine the role ofgovernment spending in the economy, including the coordination of public and privatespending.

Support For The Private Sector

59. Almost two decades of discrimination against the private sector have stifled itsdevelopment. Peace, combined with the TGE's progress in deregulating the economy, hasprovided the private sector with increased opportnties. As dereguation proceeds, positivemeasures are needed to enable it to take advantage of the new opportunities. For this too, thereis a vast agenda. SAC I will support the initial critical phase, which consists of actions in thefollowing areas: (a) increased availability of foreign exchange for use by the private sector; (b)price decontrol and creation of competitive conditions; (c) improvenents in the trade regime; and(d) reducing state ownership and operation of assets.

60. IDA staff have provided for the TGE's consideration several recommendations to improvethe a n of investment reguations, including rn at an appropriate dme ofthe recently approved investment code (May 1992). The code is insufficiently clear in somerespects and contains fiscal and other incentives that have not proved very successful in othercountries. It is unlikely that the code will constrain domestic investment in the near fiture, if itis inrpreted liberally. However, over the medium term, potential barriers to the enty of largefims and foreign investors, and the over-reguation of investment, will need to be addressed.Concurrently, the TGE will need to address problems associated with the repatriation ofdividends, a exernal payments for royalies and technological services. IDA has recommendedthat the code be reviewed in the light of experience, and either eliminated or modified to redressthe potential problem of excessive bureaucratic discretion in its application.

61. (a) Eorng exchange f the rivt se . Within Ethiopia's acute global shortage offoreign exchange, the private sector has been especially deprived. In the past, because oflimitatiens on private investment and production, most fanaiah (own foreign exchange)imports of the private sector consisted of durable consumer goods (about 10 percent of totalmerchandise imports). Increased private ecowmic activity is bound to raise foreign exchangeneeds as well as to change the structure of private sector imports. In partial response to such

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demands, siace October 1992 the TOE has released more than BlrT 205 million ($41 million) forprivate sector imports. Also, nearly Birr 615 mfllion ($123 million) is earmarked for privatesector imports during the 30-month implemeion period of the ERRP. The revival of growthin agriculture, critical for both food security and the sector's direct and indire effect on poverty,depends on the availability of inputs and equipme, and on the construction or rehabilitation ofon-fam investment. In addition, private participation in manufactring and services will raisethe demand for inputs and new imvestment, much of it consisting of imports. Therefore,providing the private sector with efficient access to foreign exchange for such purchases is acentral feature of SAC 1, and will be an important instrument for rapidly transforming theproductive structure of the Ethiopian economy. In addition, foreign exchange should be pricedto reflect market demand. Despite the recent devaluation of the Birr by 58.6 percent in Dollarterms, the parallel market rate for the Dollar has averaged at least 30-35 percent higher sinceOctober 1992. High tariffs, combined with severe foreign exchange controls, imply that theofficial rate of the Birr continues to be overvalued. Once market-based pricing of foreignexchange is itroduced, allocative efficiency requires that this rate be applied broadly to a widerange of transactions. Thus, continued favorable treatment of public enterprises, which will needevenally wo compete on an equal footing with the private sector, also would need to be ended.

62. Under SAC I, the TGE announced fn eane aucti, effective May 1, 1993.The auction will be conducted openly every two weeks by the National Bank of Ethiopia (NBE),i the presence of prospective bidders. Except for imports of pharmaceuticals, fertlizers andpetroleum, official contributionsto international organizations, and official debt servicepayments,foreign exchange from the NBE will be provided at the auction rate. Initialy, access to foreignexchange through this system will be limted principally to imports regulated by a negative list.The composition of this list is intended to restrict non-productve use of the county's scarceofficial foreign exchange resources, but also to protect some categories of domestic manufacture.The negative list will be modified before Second Tranche Release to liberalize imports further.Snefically.. at kast the fbllowing items will be removed from the list: items number 245(uelwood. wood charcoal): 246 (wood in the rough): 247 (other wood in the rough): 248 (woodshaned or simuljy worked): 634 (veeer. plywoo boards) 635 (wood manufactures. n.e.s.):663 (mineral manuftures n.e.s.): 693 (wire products and fencing gills'): 699 (Wanufatures afmetal): and 893 (articles of Wlascs). The fanc ya& system of financing imports will continueto operae. A tetable for unification of the official and auction rAtes of exchange was agreedduring preparation of the PFP.

63. (b) Price decontrol and competitive conditions. Price controls have existed for a longtime in Ethiopia. The output prices of industrial parsstatals, deemined chiefly from a 'cost-plus fonmda, remain subject to control at the ex-factory level, while retail outlets operate at freemarket prices. Coneqeny, in an economy chacized by shortages, large profits can bemade by distributors, while firm-level production disinentives and inefficiencies could persist.Many manuactured goods (for example, pharmaceuticals, building materials) and most stateservices-including housing, utilities-are supplied below market prices. There are markedweaknesses in the quality of goods and services and the product market ualy has beenchar ized by conditions of excess demand, a legacy of the centrally contolled economy.

64. Usually, there is only one parastatal supplier of services and industial products. TheGovernment has acted to remove public enterprise monopolies in freight transport and hasliberalized road freigir tariffs. This is a strongly positive measre given the critical role of road

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trasport in Ethiopia. However, several parastatals have dominated large segments of commercialactivity, which reduced private entry and was also instrumeal in raising the costs of distribution.The down-sizing or ending of state involvement in the distributive trades is desirable, and willbe phased. Ihe abolition of monopoly power in the produedon of tradeable goods is especiWlydesirable, sad a frt step In this direction has been taken through passage of the investmentregulations in 1992. Under SAC I, the TOE has completed the following action: frzmalelimsin of the monopoly nower of Agricultr Marketing Corporation. ad sbseentdifimaning of thie Domestic ]Distribution CoxpoSaion and thie hnpo=tE=rt_CXrain

65. The TGE has moved cautiously in the area of price decontrol, seeking to avoid the large"price spikes and inflationary experience of other economies Involved in the tramition fromcentra planning to markets. Recognizing the importance of agriculture, the TGE continued withthe price liberaizadon measures introduced by the previous Government in 1990 and 1991.Many agricultural products and privately-imported goods are in practice sold at decontrolledprices. However, it has condnued to provide direct ex-factory price gaidelines to industriparastatals. Under SAC I the TGE has decotolled all manufactured product prices. except ninetradeable goods produced by paras -scement corrunated roofln- materials, mails.reinforcement bar for construction, four tyes of textIelamns (khaki. nylon, traditionAalkbujaditL cotton yarn. and sugar. Directives have been issued to the managers of all parastatals

informing them of the decontrol, also instructing them to assume fiJl autonomy in pricesetting.These goods will continue to be made available at fixed prices through public retail distributionchannels. The ex-ficty prices of all nine products will be adjusted to import parities plus anmount up to the prevailing (and declining, see paragraph 72) import duty. Because of thismeasure, and despite the continued price control of three critical imported goods-petroleum,fertilizer and phmaceuticas-Ethiopia has moved further in the area of price liberalization thnmost of its neighboring countries. Combined with gradual liberaization of the trade regime, itis expected that increased competitive pressures will raise efficiency in the economy.

66. Coffee plays a significant role in the Etiopian economy. Nearly 10 million peopledirecdy and indirectly depend on coffee cultivation and processing for a living. It has thepotential to contribute more than half of Ethiopia's export earnings in the next three years. Thecurrent structure of the coffee sector may not, however, be conducive to exploiting this potenalfully, given strong govermment involvement in the domestic and export marketing chain, as wellas in coffee processing. The Ethiopian Coffee Marketing Corporation-a parastatal-processesmore than half the sun-dried coffee in Ethiopia, while service cooperatives process an additional40 percent. Not only does the private sector, therefore, have only a 10 percent share ofprocessing, it is restricted to a 20 percent share of exports. On the basis of past assessmentsconducted by IDA, farmgate prices as well as export earnings may have been affected adverselyby such restictions. The TGE intends to decontrol the coffee sector in stages. Towards thisend, by Second Tranche Release a study for the phased liberalization of the coffee sector will beconmleted. Is findings will be reviewed jointly with IDA. and an action plan will be agreed withMDA t implement its recoendtions.

67. (c) Trade reform: Trade policy in Ethiopia has been carried ou through foreigexchange controls, tariffs and discriminatory domestic taxes on imports, quantitative restricions(QRs) operaing through a long negative list and administered through trade licensing, and exportprohibitions, taxes and subsidies. This system, with the associated indirect tax regime, resultsin variable and non-transparent protection, low revenue buoyancy, an anti-eport bias, and

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difficult administration. Foreign exchange controls restrict the level of imports, allowing anovervaluatlon of the real exchange rate compared to a more liberal import stance.

68. Ethiopia's import regime is complex, subject to abuse, and its different elements poorlycoordinated. Taxes and fees on intnational trade are administered in a variety of forms-importduties, sales taxes, excise taxes, import liceme fees, and other Custom's charges. The protectionghven to domestic economic activities through the tariff and indirect tax structure is high, andvaries through time and across activities. For many sectors, although effective protectionestmates are unavailable, nominal protection levels are clearly high because import duties rangefrom zero to as much as 230 percent. There are 25 ad val m duty categories, rising in groupsof 5, 10, 1S or 20 percentage points. There are also specific duties on some 159 product groups.In addition, sales taxes on imports are 12 percentage points higher than on domestic production(24 percent compared to 12 percent). This gives domestic producers additional protection.Specia sales taxes on imports (which are similar to excise taxes) are also 12 percentage pointshigher than on domestic production, except petroleum products. There is a wide range of rates-with domestic production paying between zero and 587 percent-and a proliferation of taxeswithin the same product grouping.

69. The recent devaluation of the Birr increased the local currency price of imports by 142percet, thus raising nominal protection levels further. There is need to offset this increase whilesimplifyig the application of import and idrect taes, makg their mcidence more unform,and coordiatng the different taxes more rationally. An appropriately-valued exchange rate isa critical instument in this regard, and would allow for a lower average nominal tariff for thesame level of protectio Similarly, a lower rate structure combined with improved revenueadministratin could lower the incidence of smuggling, which disprotects several domesticproducers. Further, despite a statutory average nominal tariff rate of 34.4 percent and highindirect taxes of 24 percent, the effective rate of all levies on imports amounts to only 20 percent,a sign of the massive tax base erosion and potental for variable nominal protection built into thesystem. Protection policy can be improved by reducing the many import duty exemptions givento certain classes of importers, also the 588 product groups that have been "zero-rated" forimport duty purposes. In addition, there are several inconsistencies in the duty and indirect taxstructures that need to be resolved. For example, import duties are applied to the c.i.f value ofimports plus one percent. Sales taxes on imports are levied on the same value, and MQ on theduty inclusive value. This reduces the nominal protection given to domestic producers (by theproduct of the sales tax and duty rates). Finally, the easier availability of foreign exchange forprstatal imports, and the itmite injection of foreign exchange from the central bank forprivate sector imports, results in differentdal access to rents for importers of finished goods, anddifferential levels of protection for users of imported inputs.

70. Ethiopia's export potenttal remains largely unrealized. Merchandise exports consistalmostenirely of coffee (68 percet of the total in 1989/90), hides and skins (14 percent), pulses(2 percent) and gold (2 percent), sold mainly in the European market. It is estimated that by1992, the volume of such exports had fallen to roughly half the level achieved in 1988 and 1989.Domestic supply consraint and incentives were largely to blame, many of which are beginningto be taced. For the future, on present price projections and expectations of a return to justbelow the 1988 and 1989 volumes, the value of exports of these traditional products may beexpected to rise by nealy 30 percent annually until 1994/95. This would imply a volumeincrease of nealy 25 percent per year, reflecting the reactivation of domestic production capacity.

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After that, and once earlier levels of production are reached, increases in traditional exports areepected to revert to lower growth rates (4-S percent per year in real terms).

71. For the medium- and long-term, a structural improvement in Ethiopia!s external sectorwill require higher growth and a diversification of foreign exchange earnings. Manufacturedexports are virtually non-existent, despite Ethiopia's competitive advantage of low wage rates,large labor force, and trade quota fiee sus. Areas with good export potent include leatherand leather products, processed food, and texties and garmen. However, manufacturers facea domestic policy environment biased against exports, including inadequate exchange raincentives, high tariffs on imported inputs, and cumbersome government regulations governinginvestment, production and port clearance. There is negligible relief given to export enterprisesto offset the high level of protection offered import-competing industrial enterprises. The existinginport duty drawback system has not provided exporters with adequate access to imported inputsat international prices, and requires modifications to enhance its effectiveness. Finally, foreigninvestment in export industries-found critical in providing capital, technology and market accessfor nascent developing country exporters elsewhere-was restricted in the past by the regulatoryframework.

72. The TGE has recognized there is a clear need for reform of the trade regime, and forclose coordination with tax ard exchange rate reforms. Conversion of the tax system to makeIt compatible with a market economy, protection of the revenue base, transparency and greateruiformity in protection, reduction of anti-export bias, and simplification of trade revenueadministrtion are all on the agenda for reform during the PFP period. The following actionshave been agreed under SAC I, to be implemented through the government budget for 1993194,due to become effective on July 7, 1993:

,3) Classification of iMioted items under the Harmonized System.

fi) Conversion of all specific import duties into ad valorem rates.

CMii) Unification of the sales tax on imports and the general sales tax at 12 percent.

(iv) &plication of a maximum duty rate of 80 percent reduction in the number of zero-tariff uroduct groups from 588 to 77. and reductiorn in the number of ad valorem dutybrackets from 25 to 10.

(v) Review and reduction in the number of classes of importers who receive import dutyexemptions shifting. where possible. as many remaining imports i the "zerq ratedsdule (Schedule 1).

(vi) Streamlininj and broadening me scope of the impot duty drawback system for=fs to accornmodate dabcsof sales taxes piaid on domestic pautcases of !rMutby rter and to speed Dayments.

(vii) Indicating in the Letter of Development Policy a plan for lartely reducing the leveland dispersion of imort duties over an agreed time horizon.

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(viii) Based on a recentyWcompleted review. reducing license fees (incluina the anualrepewal fee) on coffee exporters. nermittinif prvate entry into the marketing and exorof aum arabic (with the intntion of eventualy allowing private production once

^Dgia¢tgtw safe ga i laned elimnad fie threquirement thattraders be members of a Chamber ogf Commerce.

73. The tariff and indirec tax reforms proposed by the TGE will meet the objectve ofintroducing greater aministrative and economic effciency while preserving the Government'sfiscl position. A conservative estimate of the net effect of the proposed changes, based on thecurrent (Birr 5 = $1) exchange rate and the lower levels of imports of 1990/91 and 1991/92,shows that it would be strongly positive. During the first phase of structural adjustment, thetradeff between reenue protection and lower levels of protection has been resolved in favorof the former. It is expc that later phases of the reform program will reduce protection inphases, drawing on a comprehensive review of productive efficiency and existing levels ofeffective protection in the Ethiopian economy.

74. (d) Reduc state ownprshig of assets. In 1989, it was estimated there were 7,684private enterprises in Ethiopia, of which only 7 percent employed 10 or more works, and lessan one percent employed 50 or more workers. The average fixed capital of enterprises was

Birr 30,000. Together, they contributed an estimated 2.4 percent of GDP, largely in paper andprtng, metal working, and chemical (rubber, soap, and plastic), leather and wood products.Although their number may have increased since then, the size distribution has been skewedfiurer in the direction of small enterprises. By contrast, there were 203 state enterprises,employing on average more ta 400 workers, with an average fixed capital of Birr S million,which contnbuted 6.6 percent of GDP. Of this mmaber, 162 firms fell under the Ministry ofIndustry, while 41 oprated under the supervision of other Mmities-for example, State FarmsDevelopment, Construction, Energy. In addition, there were many producer cooperatives.Public enterprises participated in, and were usually monopoly suppliers for, every segment of themarket for commercial goods and services, beyond the monopoly they enjoyed in the provisionof utilities, transport, and infastucture.

75. The debiitating effect of state ownership of productive assets in Ethiopia has beendocumented extensively. The state enterprises were closely controlled and protected fromcompetition, both in the manufactre and sale of goods and in access to inputs. Ihe resultingrigidities and inefficiencies played a significant role in the poor performance of the economy.Although most visible in the m ri sector, where nearly all of value added can beattributed to 15 public industri enterprises, the results have been poorest in agriculture. Theabsence of either ownership or user rights in smallholder agriculture reduced incentives forprivate investment in land. Also, massive resources were poured Into state farms, but withextremely poor rates of retur. Lately, state-owned industrial enterprises have shown levels ofcapacity utilizaton as low as 25 percent, due mainy to shortages of raw materis, spare partsand imported inputs. Losses have been mounting at many firms and, although the fnancialperformance of several state-owned industrial and service monopolies has been good, theeconomic returns often have been low or negative (for example, in shoes, textiles, andbeverages).

76. New legislation governing public enterprises was enacted in 1992 (Proclamation No.25/1992). It is expet that this will enable the authorities to phase-in increased autonomy for

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such firms. By complementing other initiatives-exposing these firms to greater competition,subject them to hard-budget constraints, and down-sizing them as necessary-the eavironmentfor rasn the efficiency of public enterprise is being established gradually in Ethiopia. Someliqions and restru s have also occurred. Several state farms have been dissolved.Further, two major paatatals-Building Construction Authority and Maritime TransportAuthority-were closed, resulting in the retrenchment of 16,600 employees. State ownership ofthe national housing stock, retail outlets, travel and tourism is also widespread, if not complete.The early divestiture of such assets is feasible, both from the point of view of social acceptabilityand relative ease of implemention. However, the main public enterprise restructring anddivestiture actions will occur during the next phase of structural adjustment, afe the principlesand practice of commercial opertion of state enterprses have been established moreffirmly,financial markets are stronger, and an adequate legal and regulatory framework for competitionis in place.

77. The following actions have been taken under SAC I:

(1) Classification of all public ds a irdn tQ their ulime ownship status.This was completed in February 1993. As in the investment code enacted in May 1992,several important areas of economic activity have been retained in the public sector.However, a major part of the public enterprises operting in other lines of activity willbe divested. Over the short term, that is in the next 24 months, the mumber to bedivested in the agriculture sector is 89. The Ic iger term plan is to divest 16 additionalentaprises, and to retain 4 under government control. In the industrial sector, 50 firmsare to be divested fully in the short term, while an addional 23 will be divestedpartially, some in the short term, while others within three years. Over a longer period,the divestiture of an additional industaW 28 firms has been planned. Most of the firmsin this latter category are large monopolies, and their divestitre is expected to becomplex and effective only if an adequate competition framework is in place.

(-i) Development ad issue of directives to all government agencies on a policy and.mehaism for the retrenchment of ublic sector eployees. Changes in the functions

of the public sector, the liquidation and divestiture of public enterprises, and theirexposure to market competition and commercial operation can be expected to result inthe retrenchment of employees. In addition to the 16,600 employees mentioned above,about 3,600 employees in industrial corporations, other parastals, governmentdepartments and the judiciary have also been dismissed. To date, compensation haslargely followed existig regulations, specifically the rcently enacted Labour Law andthe Pensions Law, but has also taken account of collective agreements, which takeprecedence. While payments have been prompt, variations in the application of the lawswere reported in the perod before the new Labor Code was promulgated. Sometimes,retrenchmen packages have been augmented by employment promotion and lendingschemes. The need for uniform and transparent policies has been recognized through theissue of the new directive, and the Governmn intends to protect "due process* inretrenchment decisions in addition to providing at least the minimum severance paymentsrequired by law.

78. Two additional actions have been proposed by the TGE:

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(1) By Decebr 1293 it wHI comIplete a study and issue a Government decision for thesale of state-wne buses to the private stor. A study will be conducted initially toideiy from among the approximately 530,000 units owned by the Government thosehat were constructed before 1974, those buit by *he Housing Agency since 1974, those

that belong to the municipalities, and privat houses that were appropriated by theprevious Government. Based on this, a policy decision will be made, and a phasedprogram introduced for their sale. A task force is currently working on valuation issues,but it is envisaged that technical assistance from IDA or other sources will be requiredto complete the work in a timely fashion.

(ii) Be1fre Second Tranche Release it will pt Mg for sale throgh a public amnouncementall retal shops and at least 29 hotels and restants it owns.

Gromdwork For Next Phase of Adjustment

79. The advsability of sequencing strucur adjustments carefilly has been stressed duringthe preparation of SAC I. An effort has been made to fous on measures to reach the mostimportan economic goals, and to ensure that the means to execute structural reforms exist. Up-front delivery of actions is intended to ensure the success of the program carried out during thetransitional period and immediately after it, but also to provide the latitude to concentrate scarceadministrtive resources on preparing for a deepening of the adjustment process.

80. Later phases of adjustment will require a broader knowledge base and greate technicalsophisicaton. Moreover, the content of the program is expected to change. Whilemaroeconomic stabDization efforts wIll contiue in the contex of PFP agreements, increasedemphasis will need to be given to issues of aliocative and productive efficiency. This has severalimplications. First, efficieacy in the alocton of resources will be achieved by buildingcompetitive markets, and by closer integration with the inteional economy. Second,ieaing the level of output generated by any given level of inputs will be achieved by a markedsif in the boundary between public and private production, and by reducing or eliminatingcosdy controls. Third, increased growth combined with an enlargement of the market economywil likely cause a strucua shift in the demand for skills in the economy, so human resourcepolicies will need to become more flexible and demand determined. Thus, the next phase ofreforms is licely to contain actons on competiton, privaizauon, trade development, financialsector reform, market-responsive education and training policies, and reducing inefficient controlsand disincetives in the productive sectors.

81. To ensure that adequate technical analysis and implementation capacity underpins laterphases of reforms, the TGE has proposed to carry out several studies ad capacity-buildingactions under SAC I. Several studies are underway, and are being conducted independently bytLe authorities. These include: competition policy, privatization and divestiture; civil servicereform; tariffs and efficiency; human resources strategy; and export promotion. Because of theirimportance, the content and quality of these studies require careful review. The following newsudies are also planmed: sector programming and aid coordination; statistical priorities; financialsector strategy; and poverty monitoring. For capacity-building, in addition to the current andproposed inidatives in revenue administration (para. 58), actions will focus on two main areas:computerization of the core economic agencies and staical offices; and strengthening auditngand accounting functions and training. It is expected that partial funding support for the studies

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and capacity-bding measures will be provided by externa donors, chiefly UNDP. Ahas been reached with IDA on terms of reference for hie studies and cpacity-buildine measures

m. THE PROPOSED CREDfT

A. Size And Expected Cofinandng

82. The borrower is the Government of Ethiopia. Me proposed size of the Creiit is $250million in quick-disbursing funds. The Credit amount is about 8 percent of the level ofmerchamdise imports needed to support the projected growth rate of the economy during 1993/94and 1994195. Representatives of several exneal donors participated in the appraisal of SAC Iduring January-February 1993, and will cofinance direcdy or provide parallel financing: AfricanDevelopment Bank, UNDP, Sweden, and Switzerland. In addition, the following donors bavealso indicated their intention to support the program through direct or parallel cofinancing:Commission of European Communities, Denmark, Germany, The Netherlands, and the UnkedStates. In total, the amount to be committed by other donors for cofmancing SAC I is estimatedcurrently at about $280 milion, to be disbursed during 1993/94 and 1994/95.

B. Disbursment

83. The Credit will be disbursed in two tranches. The first tranche of $150 millionequivalent would become available immediately upon effectiveness (July 1993). The secondtanche will be available for disbuement approximately twelve months later, following aperformance review by IDA. The Credit proceeds are intended exclusively to finance the foreignexchange costs of Ethiopia's general imports. The local currency funds generated as acountepart to the foreign exhange proceeds will be available for use in the TGE's budget.

84. Since this is the first quick-disbursing Credit to Ethiopia, IDA staff have mssist the TGEin establishing appte disbursement procedures. Tmis includes the simplification ofdocumentation requirements, which will consist of the final invoice, bill of ladWshippingdocuments, and evidence of payment. To ease disbursements, at least two special accounts(separately for IDA funds and those from cofinmciers) will be established in US Dollars at theNational Bank of Ethiopia, on terms and conditions acceptable to IDA. To facilitate procurementand dibursement, an inial deposit of $30 million will be made in the special account for IDAfunds. Applications for replenishment of the account will be submitted monthly, or whenwithdrawals reach onequarter of the amount advanced. Applications will be fully docmnentedwith respect to payments against contracts of more than $500,000. Reimbursements for paymentsagainst contracts below this threshold will be made on the basis of statements of expenditure, withthe Minstry of Finance designated as the authorized signatory for the submission of withdrawalapplications to IDA. However, the National Bank of Ethiopia will be responsible for scutnizingand retning all required import documentation, and for the preparation of summary sheets fordisbursements.

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C. Procuremet

85. The proposed Credt would finance 100 percent of the c.i.f. costs of general impots,excluding luxuy goods, military equipmen, and environenaly hazardous products definedunder the Standad Inraional Trade Classification, imports bought under contracts of less than$5,000 equivalent, and items finced by other sources. The last Country ProcurementAssessment Report was completed in 1985. I noted that the laws and decrees governing theprocurement procedures of Etwiopia were In broad conformity with the World Bank'sProcurement Guidelines. This was verified in April-May 1992 during preparation of the ERRPopemion, and more recenty during the ppraisa of SAC I.

86. A major component of SAC I is the establishment of an aucton to allocate foreignexchage on as broad a basis as possible (para. 62). Staring May 1, 1993, the auction will bethe only source of official foreign exchange for the facing of all imports except fertilizers,phmancuticals, and peroleum purchased by the Government. It is pected, therefore, thatSAC I fimding will be used mosdy to finance the imports of critical inputs and capital goods bythe private sector and public enterprises.

87. Imports above $1 millon would be procured according to simplified ICB. Public sectorprocurement procedures are based largely upon competition, both open and limited. Fewinstces of direct conract exist; however, they are always undetaken on the basis of vendorlists that are reviewed and updated reguarly. Accordingly, procedures used by the public sectorwould be acceptable for all procurements below the ICB threshold. Private sector procuementfor amounts below $1 million will follow established commercial practies. Access to the foreignexchange auction, through which such imports will be procured, requires the presentation of X

im invoices fom a minimum of two sources, showing clearly a breakdown of f.o.b. andfreight costs. Trade verification mechanisms do not exist in Ethiopia. However, the TGE isexpected to conclude a contract with a trade vcrification frm shortly, and preoshipment inspectionprocedures will be instituted before SAC I fumds are disbursed. Trade verification will apply toall imports funded through SAC I and by direct cofinanciers.

88. Retroactive finacing would be acceptable up to $50 million (20 percent of the Creditamount) for eligible import payments made not more than 90 days before the signing of theCredit. This will allow the Government to maintain an adequate flow of recrent imports duringthe last quartr of 1992193. Financing of petroleum products will be limited to $25 million, andwill continue to be conducted according to IDA's abbreviated bidding procedures established forprocurement under the ERRP. The project management unit established for the ERRP wil assistwith procurement that involves advertsement, bidding, and bid evaluaion procedures. All otherprocurement will be coordinated by the National Bank of Ethiopia, under arrangementssatisfactory to IDA.

D. Man , Monitorig and Accounts

89. The Ministry of Finance will have responsibility for the overall management of thereform progm supported by SAC L A govemment-appointed SAC I coordinating group hasalso been established. It is chaired by the Minister of Finance, and includes the Minister ofPlanning and Economic Development, the Governor of the Natonal Bank of Ethiopia, several

- 30 -

Preidential advisors, and expert staff from the core economic Ministries. The coordiainggroup has worked closely with IDA and IM staff in preaing this refbrm program, and willcontinue to monitor its implemention. As there is a strong "learning-by-doing" element in theimplementation of the reform program, and given the large needs for studies and Insitutonalsupport, MDA staff from headquatters as well as the Resident Mission will need to work closelywith the SAC I coordnatig group.

90. The National Bank of Ethiopia will maintain records of all t actions under the Credit,using sound accounting practices. Audits of all accouns, completed by auditors acceptable toIDA and according to procedures agreed with IDA, will be submitted by the Ministry of Financeno lawer tban si moths after the end of each fiscal year. Due to the massive disruptions of thepast two years, the number of overdue audits of IDA operations in Ethiopia bad reachedunacceptable levels. Technical staff from IDA are working with the TGE to deal with thebacklog as rapidly as possible, and a major part of the backlog had been cleared by end-May,1993.

B. Coordination With IMF And Other Donors

91. Effective donor coordination is an important goal of the Bank's assistance strateg inEhdopia. The TOE, IM and Bank have worked closely in designing the refbrm programdescrbed in tlie PFP. In addition, macroecnomic checkpoints, proposals on fiscal measures,and market-based mecms to allocate foreign exchange have been formulated joiny. At thesuccessful Consultatve Group meeting of November 1992, donors pledged over $1.2 biUlion inassisace to Ethiopia, and have subsequendy discussed a broad range of collaboration to assistin the development of specific sectors. As noted above, several exernal donors have stronglyendorsed the TGE's strucural reform program. Representatives of several donors participatedin the Appraisa. In addition to mobilizimg extemal understanding and support for the adjustmentprocess, the joint appisal has resulted in a harmonization of disbursement and procueentprocedures. In addition, close coordination with the broader community of donors through directcontact with their headqu s pesomel as well as through the Bank's Resident Mission inEthopia has resiuted in an exceptional level of additional funding support for SAC I of about$280 million. Thus IDA's financial contribution in support of the first phase of the TGE'sstructural adjustment program is less than one-half of the total. Coordination with UNDP on thestudies and capacity-building components of the Credit will also ensure that the TGE is able tomonitor technical assistance activities more closely, within the comprehensive framework it hasdeveloped with the former.

F. Conditionlity

92. The Letter of Development Policy and attached policy matrix (Annex U) describe specificmeasures that have been or will be taken during the initial phase of the SAC I program. Duringthe entire period of implementation of SAC I, the TGE will maintain (a) an appropriateframework to promote stabilization; and (b) an appropriate exchange rate to restore Ethiopia'sexernal competitiveness and minimize smuggling.

93. The following actions will be taken before December 31. 1993:

-31 -

(a) The civil service reiew agreed in the PFP will be completed.

(b) A study will be completed and Government decisions issued for a phasedprogram to sell govanment-owned houses to the private sector.

94. The following actions will be completed before release of the Second Tranche:

(a) On revemnes: (i) corporate and non-corporate profit tax rates will be adjusted tohave the same marginal rate of not more than the personal income tax rate, andto broaden their basis to include at least capital gains; and (ii) the coverage of thesales tax will be increased by Including all consultancy services, advertizing andentertainment

(b) The efficiency of public expenditures will be raised by (i) implementing in thegovernmen budget of 1994/95 the recommendations of the public expenditurerview agreed with IDA; and (ii) intoducing a three-year rolling publicinvestm program in its budgetary process.

(c) All statowned retail shops, and at least 29 hotels and restaurants will be put upfor sale through a public announcement.

(d) Ihe size of the negative list for imports will be reduced by eliminating as leastthe following items: number 245 (fuelwood, wood charcoal); 246 (wood in therouh); 247 (other wood in the rough); 248 (wood shaped, or simply worked);634 (veneers, plywood boards); 635 (wood manuctures, n.e.s.); 663 (mineramanufactures, n.e.s.); 693 (wire products and fencing grills); 699 (manufuresof metal); and 893 (articles of plastics).

(e) A study for the phased liberalization of the coffee sector will be completed, itsfinns reviewed with IDA, and an action plan agreed with IDA to implementits reconmnendations.

IV. BENEFITS AND RISKS

A. Bendits

95. Both the economic and social impacts of the SAC I measures and related actions areepecteto be stongly positive. 'he generation of growth, by relieving the foreign exchangebotdteneck, is critical to reduce poverty. The inital effect of the program is already visible inagriciture, where improved incentives and selective decontrol have permitted farmers to respondto the favorable rains by raising the production of cereals to peak levels. Continued progress onthis ront will reduce the food deficit, while generating additional incomes for the vulnerablegroups. Macroeconomic stabilization, combined wfith reforms to correct price distortions and thedecontrol of muturing prces, wil create a favorable envionment for private investment andproduction It will also guard against inappropriate investments, as economic and financial

-32-

profitability are brought closer together by the operadon of freer markets. Improved pricing offoreigp exchange, capital and labor, combined with implementationof a more flexible labor code,will promote the use of labor, which is Etiopia's most abundant factor of production. Ihis willhave a direct effect on reducing povrty. In addition, the rmoval of bottlenecks to exports willallow Ethiopian producs to capitalize on better export prices in local currency and peneae theinterntional market, rather than restrict themselves to the weak domestic market.

96. Fiscal reforms under SAC I are intended to ensure that, aRer an initial periad ofincreasin deficits, the fisca position becomes sustainable. Ihe fiscal and inerest rate reformswiU promote inreased domestic resource mobilization, thereby reducing over time Ethiopia'shigh reliance on foreign assistance. Ihe review of public expenditures proposed to be completedunder SAC I should support improvements i the fiscal position, as it would allow the TGE tore-amine and resructure current expendius and implement effective programs ofdevelopment spending. An important role of the review will be to ensure that public spendingcomplements private investm, rather than crowds it out.

B. Sodal impact

97. It is unlikely that there will be any major social dislocations as a result of implementingSAC I, althoug there will be some public enterprise job losses as a result of imposing a hardbudget constraint and a reduction in the monopoly power of several parastatals. Majorprivatlzation and public sector retrenchment measures will not be attempted under this program.WhUe changes in direct and indirect taxes and the correction of price distortions may be expectedto result in some eUxp iture-switching, the effects are marginal and are expected to be more thanoffset by the general expansion in production and spending that will result from relieving theforeig excnge constraint. Nevertheless, as explained In its Letter of Development Policy, theTOE is strongly committed to mtgating the adverse effects of structural adjustment.

98. AllD - that occrduring the SAC I period wi1 at least be overed by the legalminimum provided under current labor legislation. A recent United Kingdom ODA/IDAasessment of retechment etperience and proposals in Ethiopia concluded that the new LabourLaw (1993) was more favorable for retrenched workers an the 1975 statutes it replaced. TheLaw provides for payment of two months salary, and payment of an additional one-and-one-thirdmontl's salary for every year or part-year worked. In addition, unmsed amnnu leave and pensionrights are fully protected. Ihe TGE is also encouragi Ministries and enterprises to developemployment promotion schemes for retrenchees. While the total scale of retrenchment can onlybe esdmated pardy-that is, only in parasltas for which definite plans exist for liquidation ordownsizing-the TOE expects that as much as 40 percent of public enterprise employees may beafected over the next 24 months, at a tot estimated budgetary cost of at least Birr 290 million(two percent of total projected govemment exenditures during 1993/94 and 1994195).Substatial downsizing of the civil service is unlikely to take place unt completion of the civilservice review, and a clearer defiition of the functions of the Goverment by the electedadministrationthat is expected to assume office in 1994. For those that occur, an adequate levelof severance payments and pension entitlements, expansion of employment opportnies as aresult of the devolution of powers to regional govenments, and labor absorption through highereconomic growth are expected to mitigate the adverse social effects.

-33 -

99. Nevertheless, the generatioi of growth will take time. Meanwhile, the TGE recognizesthe need to improve the consumption levels of tihe poor, and to support their incomes in tiehnrim. Upward adjusments have already been made to the salaries of civil servants followingthe devaluation, and step have also been taken to compensate parastatal employees and cservants who have been laid-off. The authorities are also considering a number of safety netoptions, namely increasing employment oppoftunities of the poor through public and communityworks programs, and by providing direct consumption supports through a food/kerosene voucherand agicultural inputs program. While Birr 517 million were allocated in the 1992/93 Budget,ondy Birr 22 were spent as of end-February 1993. 'Me 1993/94 Budget is being formulated, andthe TGE has indicated that it will include significant amounts for safety net programs. Thechallenge is to ensure that such expenditures are transparent in the budget, transitory, and well-targeted. In addition, the TOE is preparing with MDA a public works and employment projectwith two primary aims: poverty alleviation and the creation/rehabiliaion of infrastructurethrough community-based labor-intensive publhc works schemes. Implementation of the projectis expected to begin in early-1994.

C. Risk

100. The major risk faced by SAC I implementation is political. Actions on the political frontto increase participation and preserve stability are crtical. Nationality rights and regionaldevolution are at the core of current political activities. The contiued maintenmce of securityand re-establishment of the normal processes of civil adminstration are essential to supporteconomic activity. As the transitional period for the resolution of outstanding political issues isset In the Transitona Charter to end by Januay 1994, events in the interim will have asignificant effect on the TGE's ability to sustain the reform program. The front-loading ofreform measures inimizes the risk of a major deralment of SAC I, and successfidimplementation would provide a major impetus for the contmity of policies. If implementedsuccully, the availability of a Second Tranche of funding would prevent a potWe disruptionof external support in the period during which the elected Government takes power after Janumry1994.

101. Although fte TGE's performance on the economic fron has been impressive, it isimportant to recognize at it is, as yet, inexperienced in implemening strucural reforms anddealing with markets. There are remnants of command and control attitudes within some sectionsof the administration, and mutual distrust between the private sector and the bureaucracy.Technical skills are also iF short supply. Therefore, the risk of potenially weak ilencanot be discou -'. No. Jl of this risk can be mitigated. However, selective use of externatechnical assistan, carefil monitoring by IDA staff and other extn dowrs, combined witha willingness on the part of the adinistration to make mid-course corrections, if necessary, willminimize the possibility of weak Implematon.

v34 -

V. RECOMMENDATION

102. 1 am satisfied that the proposed Development Credit would comply with the Articles ofAgreement of the Association. I recommed that the Executive Directors approve the proposedDevelopment Credit.

Lewis T. PrestonPresident

Washingon, D.C.May 27, 1993

Attachments

ANNEX IA- 35- Page I of 3

ETIMOPLIk KEY ECONOMIC INDICATORS

SaUna?. Ppjecto598889 1989/90 1990/91 1991192 1992/93 1993/94 1994195

S2 '% --. %

~~i~s(IJSSM~~~~ p294~ 39i 3 6 ~ 31p3-6 U , ' >406 3 279N,aiN, ( ' k- *,. SM,*.'.................. .- 83.' Q s i...,1

f~~~N' s $ . .N . . .'< - - . 4= .:.< N :- ;-

~~~~~~~~~~~~~~~~~~~~~~~~~~ 9S*,.,,-a...

'~~~~~~~~~~~~~~~~~~~~~~~~~~0Sou.ces: 04% .'wv2'.3%d by10.4% E Nutho; and 1 daff t-2.%

SA%K~~~4 :22%.'0O%~-0~<2A~')% -. 0t

70% K '5.6%. 116% 1.0%. .. 243 kz42de j %a

N . . ~~~~ 11.~~~% 40.0% -8~~~4.0%

~1Sc/Eaotas NN. .

7/~~~~~~~~~~~~~~~~~~~4 `--:].:l Ahb inex

U. Excluding dl OfV "dal Ts. .9/ st.1ndW~4~fl(..'$ 112.* 5§I; of <142.3 ,17rc212s9 115.2 251.7'

Aimlaal CP11(~~ ~.' ..... 9*% 5.1% ~~ 9%'a~< 2t0%~NN '24.2% ~ -a200%.

2/ ~ ~ ~ ~ " Expo a o0soc' 12s$rv ces

3 4 Co .st Nt Nrc aa fo p.j. 4 4

y,.o euraiz a rio

cxotd(by c wc kRptaf d :aep'54% 25% 1w 6.%< 4$ 374/ r(udesallr bPI/ Gnt.'. , 13 1Z .% 71 * .4 91

S/ Excludigg Omft.~~~~~~~~~.,N

& lacluding~~~~ Grants.1% -. 9 ~ 02% 2.3. 1.6 6

91 Ndbmd Bak of EwopiA ta N<, V<,.N: ''"<

ANNEX IA-36- Page 2 of 3

IBALANCE OFP IAYMESMmh. of US DdIaiso

1988/8 1989/90 1990/91 1991/92 1992(93 1993/94 199U/95

11~~~~~~~~~~4 Detdat tb.laatoSs 64 o lsa er. 1e9ddbtsn u ncul d8 ... 896Beg Y9,de sZc xcuds datd Jsu id sao* _76 a 28d 40$f. ~ ~ ~ ~ ~ ~ ~ 0 1ep6? *:.LO FY6O 395 ,t9 .425esdb a noezd

ANNEX IA- 37 - ~~~Page 3 of 3

OMng=. of US Doflun)

1992f93 1993194 I"95(I) REQUOIRMENTS ~4? A6~9

IMOIor Of godsIs0 $

laterl Payztmats Anmotzatton ~1S~Rmnrvs build-upReductlo In Anters50

(2) OWN RESOURCES .

Expoztof goodsExports of Servie.

(3)-1-2 FINANCING GAP ?4 tP

(4) FOREIGN FINANCING FROM

masTFiNG COMAMTMENTS

(5)=3-4 RESIDUAL FINANCING GAP

(6) DEEBT RELIEF . .,

(Th=5-6 REQUIRDDSBREETSM.l

ANNEX IS-38- SehduIoD

PaqulIof 3

STATUS OF BANK GROUP OPERATIONS IN ETIOPIA .1

A. STATEMENT OF BANW LOANS AND IDA CREDITS(as of Marh 30, 1993)

MM ,~R ge

Twelve (12) LoTs and tity tWmee (33) CrediXt fully disbursed. 108.60 538.40

Cr.1404 1983 Ethiopia Second Road Sector 70.00 11.78Cr.L1W9 1985 Ethiopia Sixth Telecommmicatio 40.00 2.60C-.iS20 1915 Ethiopia SixthEducation 70.00 38.04Cr4s51 1985 Ethiopia Agriultul Research 22.00 13.38Cr.1522 1985 Ethopia Tochmical Asistance 4.00 0.41Cr.1704 1986 Ethioia Energy 6L00 29.55Cr.1722 1987 Ethopia FPoraty 45.00 35.18Cr.1765 1987 Ethiopia Smnal Scalk Irigation i COWnL 7.00 4.65Cr.1782 1987 Ethiopia Fourth Livestock 39.00 20.95Cr.1873 1988 Eiopia Educadia VI 70.00 68.11Cr.1913 1988 Ethioia Family H}alth 33.00 21.60Cr.956 1919 Eibopia PADEP I 85.00 9.4SCr.20G2 1989 Eiopia Transport 72.00 67.99Cr.2103 1990 Ethiopia Mmarkt Towns Dcv. 40.20 37.40Cr.2161 1990 Ethiopia Second Addis Urban Dev. 35.00 34.47Cr.2351 1992 Ethiopia Embergency Recovery i Recotrucio Progam 150.00 129.88Cr.2438 h 1993 Ehiopia Road Rehabiitadion 96.0 92.17Cr.2478 1993 Ethiopia Erites Econ. Rec. Rae. 25.00 25.12

Total 108.60 1503.60 642.73of which repaid 101.79 40.32

Tota huld by iank & IDA 6.81 1463.28

Amount sold 6.04of which repaid 6.04

Total Undisbursed 642.73

al No SECALs, SALs and Program Lan.bi Not yet ffctive.

04-13-93

ANNEX IB- 39 -

Schelulo DPgo 2 of 3

B. S-TATEMET QE IFC MESTMENTS IN ETHIOPIA

(As of Match 30, 19)

1965, 1970, Diro Dawa Spnig Weavig and 3.40 1.42 4.82

1973 Fhido

196C EthiopianPulp Mf. of ul PW & Pmo 0.00 2.11 2.11

1968 Motabr SbsarPaFworie8 and 5.52 3.52 9.04

1989 Red Seoa Cmde Pdtoleum and 0.00 7.80 7.80Natural G†8

Taola Grms fomitret 8.92 14.85 23.77

LAw rqynfs, c ,clldmexchge adjs_m,

bko and sob1s 8.92 7.90 1682

Toatl C _miut slow hded bty 1}tC 0.00 6.95 6.95Total udidra 0.00 6.95 6.95Tods O _wwig IPC 0.00 0.00 0.00

We& 3k104-14-93

ANNEX IS-40 -

Schedue DPage 3 of 3

Disbursm Jame

1. Th IDA porlio for Etilopia consist of 18 projects totaling $965 mill, with $643undisbursed. Since PY81 goss dib have avaged $54 million a year, with a peako$77 million In FY89 and FY90. Until about FY89, -mpi ws geaily satfatry.Shne t problem h aisena due to in tprov of c1orpart &nd for rcurrcost; problems in following IIDApu guidles fiu to prae and audit fnancialaccount on tme; and deas due to a lack of construction matedrls.

2. In Agr4icltural Resech (Cr. 1521), ealy Imp ad was sow due to sevedroughts and deas In cl wor consttion Recey proje progress has been seveey setback due to dmes cued by ci war. However, sprogrs has aledy bee madein s eng mor reseah progrms, acheving dloser collboration wih ntationa andRegnl Rsearch Centrs, manpower development and in improvement of research servis.

3. on Educadon VI (Cr. 1520) lag, though more than 70% of ths physicalproject is now comtted for. Implementation delayed, due to problems arising firom shortages ofbuilding matials and of Goverment matching fnds.

4. ImpI of Energy (Cr. 1704) project is prceeig atiactoy. R ofcit proceds was recy undetake as a resut of dicuions with Goverment on the ERRP.

S. In addito the Trasitionl Governm has agreed to import the necesay materials andeumen fom aboad; emphasis is being placed on proper provision of current cost financing asa ontion for noaton; seminars on p em a scheduled; there wi be increasedsuervision missions and county impI n review wHi be sedud8 in the net fiscal year.

6. As there are a f1; projects hat are ei y slow dibursing, and given the TransitionalGovemens nw economc directon, the portfolio is bei carefully a to deteme theneed and scope for project restructung.

ANNEX IIA-41 - Page 1 of 8

Letter of Development Policy

Vt*P lpt C ¶P---. --.

t71 .,s p.St r, .

TRANWIONAL OOVUHUNr OF9 ET VWUOPA Tebs VW r.>x NISTRY OF FINANCWS A " bUI X+ b

-d. 133. f Aidb Abeb. Schkip*

Mr. Lewis T. PrestowPreidentInltemational De veopmen Associtn1818 H Steet NW, Washington D.C. 20433USA

Dear Mr. Preston:

1. Since July 1991, when the Transitional Govemment of Ethiopia CrGE) assumed power,we have introduced a wide-ranging, program of political, social and economic rehabiitaton andreconstruction. In November 1991, we formulated an economic policy for the tanstional period.Subsequently, as you are aware, together with other external donors the Int tonal DevelopmentAssociation (IDA) has supported the first phase of Ethiopia's emergence from nealy two decades of slowgrowth and civil war by funding the Emergency Recovery and Reconstruction Program (ERRP). InSeptember 1992, the TGE, together with IDA and the Intemational Monay Fund (M), formulateda Policy Framewortk Paper (PFP) covering the three-year period, 1992/93 to 1994/95. his was followedquicdly in November 1992 by the OIF's approval of a Structural Adjustment Facility.

2. By this letter, the TGE requests support from IMA for a comprohensive program ofstucwral reforms. This support, in the form of the first Structural Adstment Credit for Ethiopia (SAC1), will enable us to implement the first phase of our adjustment progm.L We recapitulat below thegoals and cont of the program, and identify the specific measures that we intd to carry out duringthe SAC I perlod. In addition, we identiy some of the longpr term meures that the TGE inteds toannounce during the SAC I period.

Enomic Goals

3. Ethiopia is among the poorest counties in the world, although it has vast, unexploitedpotei i termsi of its physical and human resources. Since 1974, when command and conml

echanisms begaa to replace the market in regulating the economy, the prvate sector has been restrictedsystematically. In addito, under the preious Governmet there was a cosdy diversion of resourcesfrom ecoomiay productive sectors towards the maitnce of inal secuity and conduct of aprotacted civil war. Famine and drought have also taken their toil on the Edtopian ecoomy. Bymid-1991, when the TGE assumed power, much of the economic Infrastructure was destroyed, real outper capita had declined over the three premous years by more than 6 percent, investment bad fallensharply, and massive domestic and extenal imbalances had brought the economy to a viru collapse.Ethiopia's social indicators had deteriorated to amng the worst in theworld, and per capita annual income was e_t at $120 per year in 199 1; it continued to declineduring 1992. Presendy, neady 50 percent of the population suffels from absolute poverty, with an

ANNEX IIA- 42- Page 2 of 8

estimated average per capita daily calorie intake that is only 80 percent of the minimum requirement fora healthy life.

4. With such adverse initial conditions, the task of economic development in Ethiopia canbe expected to be long and complex, and will require strong domestic and international commitment. Theprimary goal of economic reform is the attainment of broad based and sustinable economic development.This is to be achieved through rapid employment creation. We are convinced that expanding jobopportunities based on labor-intensive technology and utilization of domestic resources will come onlyfrom a basic transformation from a command to a market economy, with the private rather than publicsector playing the lead role. In addition, to enable all Ethiopians, but especially the poor, to takeadvantage of the increased economic opportunities that will come with growth, a fimdamental reallocationof resources towards the social sectors is necessary. Some of the counterpart finds generated fromexternal assistance in the coming years are expected to provide to some etent a social safety net and thekind of social conditions that will be conducive to supportiDng rapid development in the economy.Moreover, this is in line with our commitment to protect the poor in the period before economic growthgenerates adequate employment.

Sequencing Reforms

S. Soon after its establishment, the TGE sought to obtain external assistance for therehabilitation and reconstruction of the economy, partly for activating under-utilized production capacities.At the same time, we have also embarked on a program of structural reforms. This program should raiseinvestment, particularly by the private sectors, reduce the public sector, allow market signals the primaryrole in allocati resources in the economy, mobilize a larger volume of domestic resources to supportinvestment, production and trade, and improve the quality of social services for all Ethiopians, whileproviding increased access for the poor. Broadly speaking, we perceive the structural adjustmentprogram as achieving the following objectives by the end of the curent PFP program period (1994/95):reaching a growth rate of real income of at least 5.5 percent per year; lowering inflation to below 7percent; conaining the current account deficit (including official transfers) to below 8.6 percent of GDP;and lowering the total external debt service ratio to below 32 percent (after debt relief).

6. In the first phase, we are focusing on macroeconomic stabilization, correcting key pricedistortions while increasing the role of market signals, providing critical inputs for trade and production,initiating improvements in economic environment for private business activty, and public enterprisereform. More complex tasks, and policies that will require a broader consensus, will be taken up duringsubsequent phases. ITus, the main part of civil service reform and privatization of public assets wil takeplace once adequate preparations have been made, although initial steps in this direction have been takenalready. Similarly, financial sector reforms will be tackled during the second phase of the adjusumenteffort, although efforts to reform the legal and regulatory frameworks and the interest rate structure havebeen started. The complex issue of rural land ownership wil be addressed once an elected Governmentassumes power.

7. Agreement has been reached with IDA on the actions to be supported by SAC 1.Understandably, the content of the program is affected by several factors, chief among which are the need

ANNEX IIA-43 - Page 3 of 8

to sequence refom careflly and to pace reforms in line with the implementation capacity of the TGEand the availability of extenal support. It should be noted that the SAC I actions represent a subset ofthe structura measures to be undertaken by the TGE during the first phase of adjustment. Several ofthese actions will have a significant direct effect on the external resource needs of the Ethiopian economy.There are two main components to this program - support for macroeconomic stabilization and privatesector development. In supporting this adjustment program, the groundwork for subsequent phases willbe laid. Further, in these areas, specific actions are proposed as described in the policy matrix attachedto this letter. The remainder of this letter identifies the specific commitnents of the TGE to the contentof the SAC I program and the on-going structural adjustment effort.

Support For Macroecoomic Stabilization

8. Macroeconomic stability is central in the transition from planned to market systems. Asincentives replace command and control in the allocation of resources, low and stable inflation, theuninterrupted availability of foreign exchange, and prices that reflect scarcities become essential supportsto growth. Towards this end, the SAC I program contains basic measures to correct inherited distortionsin key economic prices and the functioning of selected markets. In addition, and recognizing, the keyrole of the fiscal balance in maintaining macroeconomic stability, we propose to undertake severalmeasures to engineer a structural improvement in government revenues and expenditures. Overall, weintend to maintain an appropriate macroeconomic framework, to be agreed annually with the IM andIDA in the context of a PFP. As mentioned earlier, a PFP was completed in September 1992.Checkpoints for evaluating the appropriateness of macroeconomic policies will be offered by the first yearreview, currendy planned for June 1993 (that is, prior to Board Presentation of SAC 1), and thefollowing review prior to release of the Second Tranche.

9. Coting Distortions In Key Economic Prices. The efficiency of resource mobilizationand allocation has been affected adversely by distortions in key economic prices in the Ethiopian economy-the price of labor, capital and foreign exchange. The land ownership question is undoubtedly importantfor economic development. However, this issue will be addressed only after an elected governmentassumes office. The TGE, however, has moved swifdy to correct major distordons in these prices, asa first step in liberalizing all key prices.

10. The devaluation of the Birr by 59 percent in October 1992, after 19 years of a nominalparity of Birr 2.07 to the US Dollar, was the most significant of recent changes. This measure hasimproved incenives for the production of tradeable goods, which is necessary if the Ethiopian economyis to be placed on a sustainable economic growth path. The Govertment will use the exchange rate torestore and maintain Ethiopia's competitiveness and minimize smuggling and has implemented a market-based allocation mechanism in line with an agreement reached wih the IMF. Deposit and lending interestrates in the economy have been negative in real terms for long periods, with adverse effects on domesticresource mobilization and often resulting in a poor allocation of scarce domestic capital. The problemwas aggravated by a severe policy-induced segmentation of the credit market, which discriminatedespecially against private sector borrowers. Since October 1992, a mechanism has been implemented toadjust deposit and loan rates periodically, in order to maiin them at positive real levels.Simultaneously, regulations that discriminated against the private sector were eliminated, and replaced

7

ANNEX IIA- 44 - Page 4 of 8

with ones that promote tthe smooth flow of capital to activities that offer the highest potenial rettur.A public sector salary adjustment was made to partly off-set the rising cost of living, particularly for lowwage earaers. Although a decompression of the salary structure necessary to reward skills in short supplyand to retain qualified staff in public service has not been possible due to resource constaints, it remainsa medium-term objective of the Government. This issue, among others, will be examined in the civilservice review proposed to be completed by December 1993. The TGE has also passed a new LaborCode which promotes both wage and labor flexibility.

11. Fiscal Refo[m Tradidonally, budgetary expenditures have represented a relatively largeproportion of GDP, at times exceeding 40 percent, reflecting massive expenditures on defense andinternal security, a large wage bill and budgetary subsidies and the dominant role of the Government incapital formation. There has been a significant 'peace dividend* since the TGE assumed power, allowingus to trim security-related current expenditures from 17.7 percent of GDP in 1989/90 to about 4.8 percentin the currant fiscal year. Even so, the absence of any significant private sector investment-eitherdomestic or foreign-implies continued and large resource needs in the public sector to rebuild theeconomy. However, declining income and a narrow revenue base have caused a sharp fall in governentrevenues (15.2 percent of GDP in 1991/92). To allow for increased public investment in social andeconomic infatue, the TGE will continue to curtail existg budgetary subsidies and contain thewage bill, strengthen financial management and raise the productivity of public expenditures. It will alsobroaden and improve the revenue base and make it compatible with the needs of a market economy; arevenue effort equivalent to 22 percent of GDP is considered feasible for the PFP period. Nevertheless,the overall fiscal deficit (including, grants but excluding loans), currently estimated at 10 percent of GDP,is expected to remain at about 8 percent of GDP in 1994/95.

12. Increased mobilization of domestic resources is an important objective of the fiscareforms. To increase revenue buoyancy while improving private incentves, the following measures havebeen taken: (a) the personal income tax stucture was revised in October 1992, lowering the highestmarginal rate, reducing the number of tax brackets, and raising the thresholds for taxation to compensatefor inflation; and (b) all export taxes except those on coffee (an important source of revenue) have beenabolished. Under SAC I, the following additional measures will be taken with similar aims in mind: (a)rental income will be taxed, beginning in 1993/94; and (b) before release of the Second Tranche, andfollowing a review, the marginl corporate and non-corporate business income tax rates will be unifiedat a rate below the personal income tax rate, and at least capital gains will be included in the estimationof business income, and the coverage of sales taxes will be expanded to include the following taxableservices: consuting services, advertizing, and entertaiment. Furthermore, we intend to review andchange the tax structure taking into account the recommendations of the IMF and IDA. Changes in taxcoverage and rates will be accompanied by improvements in tax admiistration. Several steps in this areahavt been started to strengthen the program of training and amism ve improvements in the InlandRevenue Authority and the Customs Authority, and initiate studies for further improvements, includingthe following measures: (i) training courses; (ii) preparation of work manuals (Cii) establishment ofseparate department for tax fraud and criminal investigation.

13. In order to reduce budgetary subsidies, the TGE has eliminated all export subsidies andthe domestic wheat subsidy. More, significantly, all parastatals will be subjected to a "hard budgetconstraint for fiscal year 1993/94 and beyond. The TGE would like to reiterate its policy of eliminatingall budgetary support for the operational deficits of parastatals. In addition, the "hard budget" constraint

ANNEX IIA- 45 - Page 5 of 8

involves the ending durng 1993/94 of all cross-arrears among parastatals, and with fiancial institutionsand govenmet departments. It should be noted, however, that the TGE will continue to provide(selectively and on a reduced scale) necessary equity injections and capital expenditure allocations forparastatals, but within fiscal parameters agreed in the context of the PFP. In addition to the abovemeasures, all external grants and counterpart fimds will be accounted for in the central budget, and tothe extent possible all financial grants and counterpart funds will be channeled through it.

14. A public expenditure review has been initiated with IIDA assistance. The TGE isproviding all necessary support and information for a comprehensive review. Upon completion of thereview, but before Second Tranche release, agreement will be reached with IDA on an action plan toimplement its recommendations in the budget of 1994195 and beyond with a view to raising the efficiencyof public expenditures. The action plan will also involve the introduction of a three-year rolling plan ofpublic investments. At the same time, budgetary decisions for 1994195 and beyond are expected tobenefit from completion of the civil service review.

Private Sector Developnent

15. A dynamic and self-sustaining private sector is the cornerstone of a market economy.The TGE intends to promote the private sector through improvements in the "enabling environment".This involves a broad range of actions to increase opporunities for the private sector, eliminatediscrimnatory treatment, reduce regulatory controls, improve production incentives, and provide anadequate level of business support, including smooth access to inputs, infrastructure and other services.The open environment for private investment which has been established will be further strengthened andmaintained. In addition, although expected to take several years, we envisage a reduction in the size of

the public sector and the growth of competitive markets in the economy.

16. Several areas have been identified, and indeed actions taken, to promote competitvemarkets. New Investment, Public Enterprise and Labor codes have been issued. Further, amendmentsto the commercial code, and laws and regulations governing the National Bank of Ethiopia and thebanking sector are expected to be ratified in the presit fiscal year. Ihe TGE is also at g tochange the boundary between the public and private sectors. For this, all parastatals that will be divestedby the Government have been identified, although details regarding timing and methods are yet to beworked out. By December 1993, and based on a review that is currentiy underway, we will issuedirectives for a phased program to sell government-owned houses to the private sector. Before releaseof the Second Tranche, the TGE also intends to put up for sale through public announcement all retailshops it presenty controls and 29 hotels and restaurants.

17. Price liberalization is an important objective of the TGE. At this stage of the economictransition, and given continued shortages of basic goods and the deep poverty of half of the population,price signals to guide resource allocation deserve greater emphasis. However, while price liberalizationis an important objective, we have to give carefil attention to protecing the consumption of the poor andavoiding sharp or potentially destabilizing price increases. Therefore, although all farmgate and retilprices have been decontrolled, the TGE has continued to guide parastaal enterprises in price setting formanufactured products. However, this practice will be discontinued before Board Presentation of SACI, except for nine essential goods: sugar, four varieties of textiles (khaki, nylon, abujadid and a specifictype of cotton yarn), cement, corrugated roofing material, nails, and iron bars for construction. Of these,

7WZ

ANNEX IIA-46 - Page 6 of 8

sevcral will be sold through the public distribution network at controlled prices. In addition, themompoly power of several parastatals is expeced to be eroded through competion from the privaesector. The TGE has formally bolished the monopoly power of the following enterprises ad marketingorganizations: the Ethiopian Domestic Distribution Corporation, the Ethiopian mport Export Corporationand the Agricultural Marketin Corporation. In practice, however, the absence of private sectorcompetitors, and continued limhations on the availability of imports because of foreign exchangeshortages, implies that the monopoly power of several enterprises will persist in the short-to-mediumterm.

18. The importance of coffee production and exports cannot be overstated. However,significant gaps exist in our knowledge of this sector, especially the appropriate pace and conte ofliberalization. Towards this end, we intend to complete a study for the phased liberalization of the coffeesector. The report will be reviewed jointly with IDA and an acdon program agreed before release of theSecond Tranche.

19. Competition from imnports is an important factor increasing efficiency. A central featureof SAC I is the establishment of a mechanism to make foreign exchange for imports available to theprivate sector through official channels. As of May 1, 1993, the TGE has implemented a mechanism toprovide market-priced foreign exchange to private sector producers and parastatal firms on a regularbasis. A negative list is used to determine eligibility for access to this scheme. At the same time, importlicensing procedures have been simplified. As agreed with the IMF, the size of the negative list will bereduced every six months. Before release of the Second Tranche, the negative list will be reduced byeliminating 13 items, including wood and some manufactured items.

20. The recent devaluation of the Birr has raised the local cost of imports by neady 142percent. 'his has increased the already high levels of tarifi that existed in the import duty regime. Iheregime is also characteized by a mixture of specific and ad valorem duties, disparate treatment of similarproducts and a number of exemptions. We have agreed on the content of the first phase of tradeliberalization, which will be implemen trough the 1993/94 budge. Liberizatioconsists of thefollowing measures: (a) reclassification of the import schedules under the Harmonized System; (b)conversion of all but a few specific duties into ad valorem rates; (c) bringing into line the stadard rateof sales tax on imports and domestically-produced goods; (d) conversion of the supra sales taxes inoexcise taxes; (e) conversion of 511 out of 588 "zero" duty rates into appropriate positive rates; (f) areduction in the number of rate categories from the present 25 to 10; (g) a new maximum duty rate of80 percent rather dtan 230 percent; and (0) the elimination of import duty eemptions thatve beengranted in the past to some non-exporters. It should be noted, however, that trade liberalization will beimplemented over several years. The nominal protection afforded by the recent Bir devaluation and theproposed duty schedule will continue to be high durng the first year of the reform. The objective ofsubsequent reforms will be to reduce the tariff substantially over a three-year period such as to encourageimprovements in the efficiency of domestic activities in which Ethiopia ought to be competitive and toselectively promote economic activities in which Ethiopia has the potent to be competitive.Furthermore, the subsequent reform will take due regard of government revenue and the country'sbalance of payments position. In addition, we will continue to eliminate import duty exemptions for non-exporters.

ANNEX IIA- 47 - Page 7 of 8

21. The TGE ines to promote exports at the same time as Improves the import regime.As the level of import duties will remain high in the short-term, despite the SAC I reforms describedabove, for those items not covered by the existing duty drawback scheme they will act as a tax onexports. There is thus a need to streamline and broaden the import duty drawback scheme to Anrtherimprove export incentives. Changes have been made in the 4uty drawback scheme to broaden coverageand to simplify administrative requirements. In addition, a recent review of traditional and non-traditionalexpots identified several constraints which have been rectified. These include, among others, changesin the costs of licensing for coffee exporters, and private sector entry into the marketing of gum arabic.

22. Clearly, structural economic reforms are not cosdess, and some social groups will beaffected adversely by policies intended to promote greater efficiency in production and in the allocationof resources. The TGE Is strongly committed to mitigang the adverse effects of structural adjustment,especily for the poor. It is expected that, under SAC I, public sector employees may be especiallyvulnerable to the removal of parasa monopoly power, the placement of public enterprises oncommercial lines and expenditure-switching and expenditure reduction that may occur as a result of therecent devaluation, price decontrol, and proposed changes in the trade regime. All retrenchments thatoccur during the SAC I period will at least be covered by the legal minimum provided under the currentlabor legislation. In this regard, detailed directives providing guidance to government departmens havebeen issued.

Groundwork For Next Phase of Adjustment

23. The transition to a market economy will ca1l for new and radically different capacitiesfor economic management. Subsequent phases of the structura adjustment program, will require carefuldesign, based on a greatly enhanced base of information and skills. During the SAC I period, and wihassistance from UNDP and other external donors, the TGE intends to complete a number of studies andbuild selective institutional capacities to assist in the design of subsequent phases of the adjustmentprogram and, specifically, for designing a follow-up structual adjusment credit (SAC 11) from IDA.

24. Among the areas of immediate interest are the rationalization and coordinadon of revenuesand expenditures, and restoration and improvement of the statistcal database to assist in the managementof the economy. Further, we intend to open the financial market to competition and increase itsefficiency as a part of the structural reform effort. Finally, to supplement and inform the inivesunderway to deal with the exteme povert found in Ethiopia, we intd to strengthen the monitoring ofpoverty. Terms of reference for the following studies have been developed and agreed with IDA: Sectorprogramming and aid coordination; statistical priorites; financial sector strategy; and poverty monitoring.

25. In addition, action plans wiUl be agreed with IDA for institional strengtheniin thefollowing areas: computezation of the core economic agencies and stcal offices, and thestrengthening of auditing and accounting capabilities. Although many other areas of insionalstrengthening no doubt exist, this focus will enable us to build capacities in priority areas withoutdisrupting the smooth operation of economic management.

ANNEX IIA- 48 - Page 8 of 8

Conclusdon

26. 'he Transitional Government of Ethiopia has embarked on a far-reaching program ofreforms to transform the economy from a command to a market system. The successfil completion ofall conditions for release of the Second Tranche proposed for SAC I will demonstrate the TGE'scommitment to the adjustment program. IDA's financial technical support to the structural adjusentof the Ethiopian economy is critical, and will provide an umbrella for participation of other externaldonors. We request, therefore, your approval of a Structural Adjustment Credit of $250 million, to bedisbursed in two tranches.

Sincerely yours,

t 'f FiL'Minister of Finance

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ANNEX IBPage 1 of S

Structur Adjush et Credit I - Rform Pr em

Reom Objeves And Instrunents And Measures Monioable ActionsAeas E0 Ation A A4y hwilented SAC I Action And Tmint

A. gsut For Magoemoi kSto abjDhm

L. Correct d _trto After completing neotations in (a) Mainain an appropria ContinuousIn key prc to Setmbe 1992 of a Policy macrocomiofamewoktOimo_ e ehlaney t Framework Paper for the period promoe stabilizWon;rese _obflathoa 1992/93 to 1994/95, thoand allocation. Tansn1 a Govement (m) ) Devablation from Birr Compkld

implemented sveral agreed 2.07 to Birr 5 per US Dolar-measure. 59% in Dolar terms;

Autmatic hiring practcs In the (a) Upward adjustment in Competedpublo sector that disto wages interst rates on depoits andand d labor availability in the credits;rest of the conomy have beetpped. In addition, a new Labor (d) Publc soeor saary CompleedCode has bean isued. adjustme to compensate

party for ree rea wagedeclnes.

(e) hoe ecg rate will be Contnuousinained at an appropria

level to resor Ethiopia'sexternal compe s adminimize smugglng.

(f) Itrs rates wi be Continuousrviwed at tduee monhintrvas to matain dem atposuve roa kvea for bothdepositos and borowers;

IL Lowe the sWa The TG has impl nted sevr Revenues:elck and prvide for revenue measur to eiminate or

appropriae means of srml taxes-for exaumplo (a) Revis the personal Completddomestic finadg In agrultund ttax, unowverux, income taX stue, raiseorder to rednee the transactions tx the threshold for taxton,hInea imbeane and reduce the number ofnaintain low and bracets, and lower thostable rates of highest marginl tax wate.Inftionl. Incraserevenue bouyaney (b) xoept for coffee, drop CompletdwhUe relntit al expo tx.towards the needs of amarket economy. (a) Agmeement wM be CompledReduco goverment readhed on the taxation of

- a

I 6

{ i a I i 5 k

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ANNEX U BPage 3 or 5

Wi be mde, p_stats Wi (o) Compete dhe i sewvi December, 1993dLbt sad no eview agred in the' PP.

govanment guntee wm bep- for their domestborrwing.

B.

L. Rede boundary The TG ha tak initil measu Aons ar proposed cabehw_ p_lc and to redace,t d scope of the publi eval fonts:private econoei setor and alow ger eoomic

yopportnt for the piate (a) A udy wil be complted December, 1993sector: and a govanmat deciso

issued for a phased progm(a) Seuriy of had usesip and to sell gonm -

the elmnation of restictions on houses to the private secto.hoad antd lribu-in gabot.

(b) AU pubic e _nt will Completd(b) Enacbsat in May 1Q92 of an be ceorized acoring tou'wemaent code which modifies tir ulmhte o_wMhearle reguatios. statu.

(o) Ranoval of most ricioos (a) Stewnd ral shops, By Second Tanobeon pivate seetor partopation in and at kamt 29 hoteb andtad in nanufaturd items and In raut will be put up fortheprvision of selted sMaes. sale through publio

announcenenL

IL Promote price A larg number of ag _utul 1. Prime decontol will besignals and the poducts and a wide aray of coninued in the folowingoperation of goods impoed by the prvat maner:miable Imcdes. secor arm in pratie sold at

decotofled pie. (a) All mnufacted prdut Completwdpries will be deonroledwith h eepions notedbebw, and the conenedpaaal manager sonotified.

(b) Te monoply power of Compltedparastatats produoingtrdeable goods wll beerded. The prices of ninetradeable goods pduced byde facto mobly supewM be adjused on te bassof imnpot pa* plu anamountupto prv&iin duty.

2. Mh monopoly power of Compleedoffcial distibuton and trdeoorporations-DomesticDitibution, bxpt4nvoort,Agriulura Market-Wlbe limnatd.

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ANNEX II BPage 4 of 5

3. A study for thphasedIienliaton of the coffee By Second Trench.setor will be completd, its

&fnngs viwed with IDA.and agment will bereached on an action pln toimploment itsrwommendatons.

L Improve prive Sin Octobr 992 te National (a) Prvate sector and Completedsedor access to criia Bank of tbhiopia has aLpoatd pa l producers wil beIputs, chiefy foreiun i 132.2 mMion to dIe prvte given access to foreignachange. sectr forthepuhaseof essentl exchange, through a

oonsumr, intermediaeandoapil mechansm stsfactr togoods. An additional Bin 615 IDA.million is also aailable for p*iatsector impots under the EIWprogrm.

IV. RatonaIe the Nono The first phaw of import Completd

inport tariff regbne, rebrms will consist of theIntaly to Incrse foiowing measures:

revenue bouyancy (a) Complete the

while making classification of imported

prtectioransmt items under the HarmonizedSubsequeny, Imprt System.dutes wm be usedmainly for proectie (b) Convet spcific importpurposes. Prnvie duties into ad valorem rates.apwr with speedyacess to Impotd (a) Reiew and implmentInputs at _ _euraona changes in the standard raeprices and reduce of saks tax an imports.marketing andregutoy costs. (d) Implement changes in the

taiff structure by revi gall 'zero tariff, applying amaxium duty rate of 80%and rducing thw nmber ofduty braces to 10.

(e) Reduce the number ofcategories of importrs whocamrtly receive imort dutyexemptions.

(I) Indioae in the Let ofDevlop t Policy a planfor substan y reducing thelevel and disionofimportduties over an agrsee imehorizon

(g) Reduce the size of the By Second Tlchenegive lst to libaalizeimports further by

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ANNEX I BPap So tS

eliminang at lat Ihefo ienms: numbers 245to 248, 634, 635, 663, 693,699 ad 893.

rmoval of oumlubiasesagbat expotb will oCUrtdrougb:

(a) Streamlining and CompleWdbroadening the scope of theimport duty drawbacksystem.

Ob) Identification and removal ComplIdedof speoific maketdng andregulaory constrinb on theexpansion of exports.

V. RebmeC t With help from the World Bank, Develop and issue directives CompletedSaety Nes the TG is designing a transitory to all governnent agencies on

safety net for those most in need. a policy and mechanism forpublic sector employeeretrenchment.

C. GrmundWOlrk FK Next Plase OQ Set Adufa ment

L I.formtio system With assistance from the EMP ad Agreeent on action plans Completedand Institutions other external agencies, die TG for computerizaion of therequired to support has initiated contcts for the core economic agencies andfurther deveopment of upgrading of some statiscal stistical offices, and forthe private sector colkltion efforts. Training strengthening audiing andshoul be upgraded. courses for selected officials accounting capacities.

involved in economicadministrtion have also beenstarted.

11. Develop secora Several studies are being Agreement on terms of Compleedand institutional undatken withi officiairles- refrenc for the followingknowlee to underpin for exampl, fiscl sudies, studi5s: sector programmingthe desg of furter reginal devolution, social safety and aid coordination;stcral adustment nets, school curriculum ss priorities; financialmeasues. develbpment-in areas identifi-d in sector stay; and poverty

the PFP as ortial for economic monitorireform.

- 54 - ,bMM

FItSTRUCTtRAL ADJUSMENr CREDTrr (SAC 1)

iowainPlan

MDA SupwrvisI Input

1. Supwvision of SAC I will involve 30 staff week, distributed equily in FY94 and FY95.Most- actions to be tkn uder the Credit will be completed by Board Psetation. Therefore, thefocus of supvision effots will be: asosSMent Of the macroeconomic famework, monitoring of thesocial impact of reform measue, the private sector's response to adjustment, progress on capacit-buflding and studies, fnCtionig of the foreign edchange auction, donor coordination, and

d m oje c~p9 t/poe W-coon.

Oranization And iming Of Supevison Activitie

2. Ihe responsibility for supevising SAC I will be shared by the Task Manager (PrincipalEnmist) and the Economist in the Resident Mission, who has been involved in the preparation ofthe Credi. Regarding the macroeconomic framework, restoring fiscl balance while improving theeffectivenes of goverment Spnding will be critical for the success of the overall stabilization effort.At the TOE and IDA are jointly preparing a comprehensive review of public expenditures, closemonioring of the macoeconomic framework wil be possible. In addition, close coLaboation willbe mainined with IW staff on montoring macroeconomic developments and assisting in thesequencing of structural measures in the PFP. Contac with the private sector and donors will be theresponsibility of the Resident Mission. The remaining areas of focus for supervision will be the chiefresponsibility of the Task Mnger. The frt suevision mion is planned for September, 1993,and the next appro ly six months later, or following the proposed general election. I is likelythat this mission wM be combined with a performance review, prior to release of the SecondTranche. As this is Ethiopia's first experience with adjustment credits, it is expected that sometroubleshooting assistance on IDA's disbursement/procurement may be required during FY94.Allowance will be made for such assistance, if required.

Brrower's Contribution To Supervion

3. The Ministy of Finance will have overall responsibility for management of the program, andfor monitoring and reporting responsibilities as described in Section M.D. of the President's Report.Administrative arrangements for IDA supervision missions, as well as discussion of the results ofsupervision will be managed by the SAC I cordnatng group established by the TGE duringpreparation of the CrediL However, the socia impact of the adjustent program will be monitoredby the Natinf Economic Reform Task Force Qheaded by the Prime Mins). This arrangementrecogoizes the relative advantage of locally-based supervision in areas where continuous monitoringad strong famiiarity with instutional structures and social settings are necsary.