Ibpot No. ""TUN

Republic of TunisiaCountry Economic Memorandum: The Road toan Outward-Oriented Economy(In Five Volumes) Volume II: Annex 1Fiscal Aspects of External Debt and Options for Financing and Adjustment

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

FOR OFFICIAL USE ONLY

Document of the World Bank

This documnent has a restricted distribution and may be used by recipientsonly in the perfornance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

- .AL

AE I

FISCAL ASPECTS OF EXTERNAL DEBT AND

OPTIONS FOR FINANCING AND ADJUSTIMET

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

REPUBLIC OF TUNISIA

FISCAL ASPECTS OF EXTERNAL DEBT AND OPTIONSFOR FINANCING AND ADJUSTMENT

TABLE OF CONTENTS

PAGE

I. FISCAL AND OTHER CAUSES OF EXTERNAL DEBTACCUMULATION IN TUNISIA .1.... . . . . . . . . . . . . . . . . . I

External shock hypothesis .1.. . . . . . . . . . . . . . . IGeneral financing requirements . . . . . . . . . . . . . . 4- As determined by aggregate demand . . . . . . . . . . . 4- As expressed in borrowing requirements . . . . . . . . . 6- As reflected in debt levels . . . . . . . . . . . . . . 12Summary . . . . . . . . . . . . . . . . . . . . . . . . . . 14

II. THE FISCAL BURDEN OF EXTERNAL DEBT SERVICING. . . . 14

III. FISCAL CONSEQUENCES OF EXTERNAL DEBT . . . . . . . . . . . . . . 15

Debt-related Macroeconomic Developments . . . . . . . . . . 15- A real devaluation in the exchange rate . . . . . . . . 15- An increase in government domestic borrowing . . . . . . 16- Monetary financing of the deficit and taxation of

financial intermediation . . . . . . . . . . . . . . . 18Effects of institutional arrangements . . . . . . . . . . . 20

IV. FISCAL OPTIONS. . . .......... 21

The sustainable deficit approach . . . . . . . . . . . . . 21The desirable deficit approach . . . . . . . . . . . . . . 23Revenue and expenditure options . . . . . . . . . . . . . . 28

APPENDIXTunisia's Central Government Consolidated Budget 1972-88 . 29

BIBLIOGRAPHY

ANNEX 1

FISCAL ASPECTS OF EXTERNAL DEBT AND OPTIONS FOR FINANCING AND ADJUSTMENT

1. This case study investigates the fiscal aspects of external debtin Tur.isia. These aspects include the fiscal causes of external debtaccumulation; the fiscal burden of external debt ervicing; the fiscalconsequences of debt overhang; and the alternative policy options forfiscal adjustment. As will become clear in what follows, structuraladjustment in the face of heavy external debt typically entails a searchfor alternative sources of financing--in4luding internal debt and moneycreation--and a decision on the size of the overall fiscal deficit.Information on Tunisia has been gathered to permit an empirical estimate ofthe nature and magnitude of these linkages and their implications for thefuture.

I. Fiscal and Other Causes of External Debt Accumulation in Tunisia

2. The evolution of the balance of payments, components of aggregatedemand, and public and private borrowing requirements can be used toidentify the major factors leading to excessive foreign debt accumulationin Tur.isia starting in the mid-1970's. A constant ratio to GDP over timeis taken to imply neutrality; deviations from a constant ratio must beexplained. In the case of the balance of payments, deviations in currentaccount items are used to examine the hypothesis that high levels offoreign borrowing resulted from external shocks such as a deterioration interms of trade or a drop in foreign demand. This hypothesis receiveslittle support. Next, the role of excess domestic demand is investigatedby looking at trends in the components of aggregate demand and in theborrowing requirements of the major economic agents: central government,public enterprises and the private sector. This analysis suggests that anincrease in real consumption, associated with a higher fiscal deficit, waslargely resronsible for the external debt build-up.

The External Shock HvPothesis

3. In order to investigate the external shock hypothesis, the majorbalance of payments items for the period 1972-88 are expressed as a percentof GDP and presented in Table 1. Looking at deviations from trend incurrent account items, the following patterns can be distinguished.

4. Current price exports increased as a share of GDP over the period,from 25 percent of GDP in 1972 to a peak of 42 percent in 1988. Initiallythis was due to a rise in export receipts from oil, of which Tunisia is aminor exporter. Subsequently, increased textiles exports and touristreceipts maintained the momentum, as oil revenues declined. The ratio ofcurrent price imports to GDP also rose--from 27 percent in 1972 to 42percent in 1988, with a peak of 50 percent in 1981. This can be explainedby (i) an overall increase in aggregate demand, as discussed below; (ii) anincrease in exports, and possibly in the import intensity of exports, over

wslpu "q ea^sSS /g

US-M i * Id * Odes.oa: £ * Od

3,t_ 3- g3 *-t t *0 * 0 *-t- aS U1Af3la hf 13 6

Oll sO 30 i*O- 0 J-1- StO Ot- SAWm 103

t- le 0 - e glt *-Ol t *It A - N"° imsi ,o Olt alt lu All 0-t ml /tt@u 1 JJ.

i*36*#It &It IS 059 O lt 95 591 tea1 wfti S3i *3l m5 Al" Oft #33 O-tK tT it t

* o n olo fl so *lOt soft 6*0 g00 *i- 0*. ti- $*OT- 9'S- t6'- L')*- IIUflV ASUE I

031 lO ent Mt out T Mt tat

L*o- 1- 0o- all *o *o, *3- 53- *i- /3UAUSlUeUim S

T*s- 9*t- oo.- v- glo- to- **- .

s*t S'D t's t son got I's *S _ oUu33U M G a

i.e 33 Von 0 5- 55 I' *IN *** 9 O_

lot Ol *t glt -t0 *- t t* -0@*$I U53 Wt t 1 *t *i T lt

0*3r s9 * on LO 0 03 533 33 woo Sm

~~ *I OSel- i*T s- 5* . 3- foll, JgS,MU

4-)

OfiMMUOS ~Y23XI £0 __7V''= AOU>

-3-

part of this period; and (ii1) an increase in the import intensity of bothinvestment and private consumption. The higher import intensities areexplained in part by a more rapid increase in world prices than prices ofdomestically produced goods in the 1970's. Interest payments on foreigndebt rose from 1 percent to 4 percent of GDP, but they have been offset bysimilar increases in workers' remittances and other net current receipts.Direct foreign investment has fluctuated, with important capital flows tothe energy sector following the tuo oil price increases. Otherwise,foreign investment has played a relatively minor role.

5. Excepting 1988,1 constant price data on imports and exports as apercent of GDP show less structural change than suggested by the currentprice ratios. Constant price exports were 36 percent of GDP in both 1972and 1986, with inte-rim fluctuations between 34 and 40 percent. Theimbalance on the external account has arisen primarily from constant priceimports, which exceeded 45 percent of GDP during the 6 years 1979-84. Thehigh real import levels in these years reflect a high level of totalborrowing in the economy, which took place despite a temporary surge inexport receipts due to the second oil price rise.

6. On balance, it is difficult to argue that the accumulation ofexternal debt in Tunisia has been due to a major balance of payments shock.Rather, it appears that Tunisia experienced a variety of favorable andunfavorable balance of payments developments, which nevertheless allowedthe country to become increasingly open. There has been a decline in thematurity structure of external debt since the 1970's; but other aspects oithe external environment have been favorable, including the opportunitiesfor employment of Tunisians abroad and access to the EC market for Tunisianexports.2 The high level of net foreign borrowing between 1976 and 1986appears, rather, to reflect increases in general financing requirements.The domestic determinants of these general financing requirements areinvestigated below.

1/ In 1988, real exports rose to 46 percent of GDP, but the large touristreceipts component may not be sustainable and oil receipts villcontinue to decline.

21 Faini et al (1988) estimate, for 93 countries, the external shockbetween 1976-81 and 1982-86 due to a rise in international realinterest rates and a fall in the terms of trade. The estimate forTunisia shows a slight negative effect due to an increase in realinterest rates, weighted by the debt/GDP ratio in the initial period,and a slight positLve effect due to changes in the terms of trade,weighted by the export and import ratios in the initial period. Bythese calculations there has been, on average, no adverse externalshock.

-4-

General Financina Reauirements

7. As determined by aatre-ate demand. 'ooking first at domesticdemand from a national accounts perspective, Figure 1 shows that totalexpenditures in current prices rose substantially as a proportion of GDP inthe 1970's and only recently declined. Higher demand appears to have comefrom a surge in investment, which rose from 23 percent of GDP in 1972 to 30percent of GDP or more in the late 1970'. and early 1980's. Consumptionappears more stable, apart from a rising share in GDP in the drought years(1973, 1982, and 1986).

8. In real terms, the picture looks somewhat different. Figure 2shows a persistently high share of real investment in GDP until 1985-86,when balance of payments constraints led to import controls and a majordepreciation of the exchange rate. At this point, the level of realinvestment dropped. The problem with investment over the period as a wholeis the decline in its quality, as evidenced by a rise in the 5-year averageincremental capital-output ratio (ICOR) from 4 in the early 1970's to 5 inthe late 1970's and to 7 in the 1980's. The ICOR is a crude measure,masking a variety of factors contributing to real GDP growth on both thesupply and demand sider; but its sustained rise over a 15 year periodthrough 1986 is striking. Of course, the depletion of oil reserves and thefrequent droughts in the 1980's have contributed to this rise, but even thenon-fuel, non-agriculture ICOR has increased from an average of 4.5 in the1970's to an average of 6.0 since 1982. Thie relatively high levelreflects inefficiencies due to a restrictive investment code and traderegime; support of regional and size distribution of income objectives; anduneconomic investment in some sectors, e.g. electricity generation, newirrigation facilities, vehicle production plants, fine chemicals,fertilizer. and the various transport subsectors (especially railways).3 Tothe extent that some of the investments were premature, GDP and exportgrowth have been facilitated in 1987-88; but premature investments, as wellas basically nonviable investments (such as the vehicle production plants),result in lower growth.

9. Ben Bahri, Benzaghou et al look more specifically at therelationship between the effective cost of foreign borrowing and themarginal productivity of capital by sector of destination. They find thatthe former exceeded the latter in both water and transport/communicationsduring the fifth and sixth Plans (1977-86). For manufactures, this periodwas characterized by an increase in the cost of borrowing and a decline inthe marginal productivity of capital, but the relation was stillprofitable. Agriculture, mining and utilities were also characterized bydeteriorating profitability over this period.

10. The more striking trend in Figure 2 is that for real consumption,which increased from a low of 62 percent of GDP in the early 1970's to 80percent of GDP in the 1980's. The index of real consumption has increasedfrom 100 to 253 over this period--a 75 percent rise even after adjustmentfor population growth of about 2.2 percent annually. This trend is

3/ These areas are identified in the World Bank Report, "Adapting PublicExpenditures to Changing Resource Availability", Internal Report No.6604-TUN dated January 1987.

FImr 1

TOTAL EXPUnMERE

02 .

t

as

n 4 Cou Is .a t;i W 2

Fgutre 2

T!OTAL DPENDmRB

I't

a.

82

o-2 .C4 .u 1. 2 . . . .i . . . . .

0 Total Eip.udituur

4 Conumption

a Zuwatasut

-6-

consistent with independent data on trends in the average real wage, theminimum industrial wage (SMIG); and the minimum agricultural wage (SMAG).Indices for these data, plotted in Figure 3, show that the real SMIGincreased by 80 percent between 1972 and 1983, the SMAG by 70 percent, andthle average real wage by 60 percent. These increases have contributed tothe unemployment problem, which has worsened despite the moderate realeconomic growth which Tunisia has continued to enjoy, as well as to excessdemand. Real wages have fallen since 1983, as has the dollar value of thedinar, as shown by the real effective exchange rate (REER).

11. As expressed in borrowing requirements. The analysis above showsthat the macroeconomic explanation for the increasing external debtoverhang can be attributed to a combination of lower than warranted GDPgrowth, given the high rates of investment, and strong expansion in realconsumption. Figure 4 shows total net borrowing by the economy to financeaggregate expenditures. It has ranged between 10 and 20 percent of GDP,with peaks in 1977-78 and 1981-85 that exceeded nominal GDP growth. Figure4 also shows that an increase in the central government net deficit was amajor reason for the peaks and that they were accommodated largely byhigher foreign borrowing. The circumstances leading to the borrowingrequirements of the central government, the non-financial publicenterprises, and the private sector are described below.

12. (a) Central government borrowing.4 Figure 5 shows the trend inthe deficit of the consolidated central government from 1972 to 1988. Thenet deficit as a percent of GDP shows two clear peaks--one in 1977 and onein 1983. Net foreign borrowing remains modest through 1976, after which itappears very clearly to serve as the residual financing item for thechanging deficit. The use of foreign borrowing in this way was consistentwith the Government's policy of limited domestic financing. The grossdeficit, including amortization, shows a continuing upward trend,reflecting an increasing burden of foreign debt amortization. Includingmilitary debt, amortization was less than 1 percent of GDP during much ofthe 1970's but rose to almost 6 percent of GDP in 1986-88.

13. Central government revenues increased steadily as a share of GDP,from 21 percent in 1972 to 34 percent in 1984, after which they moderated.Figure 6 shows that budgetary oil receipts and trade taxes accounted forabout half of the increase. Oil receipts declined in 1977 and 1983,contributing to the increase in the overall net deficit in these years.Other direct taxes remained at 4 percent of GDP over most of the period,and have recently declined despite the increase in per capita real income.Other indirect taxes and non-tax revenues, such as Central Bank profitsaccount for the balance.

14. Central government expenditures have risen even more rapidly thanrevenues, rising from 23 percent of GDP in 1972 to a peak of 41 percent ofGDP in 1984. As snown in Figure 7, the bulk of this increase has come fromtransfers and subsidies which rose from 6 percent of GDP in 1972 to 15percent of GDP in 1984. Interest payments have remained manageable at lessthan 3 percent of GDP, despite the increasing indebtedness--partly because

4/ Details on the budgetary series which has been developed for thisanalysis are provided in Annex A.

co~~~~~~c

co ~ ~ ~

-~~~~~~~8

Figurs 4

TOTAL NEr BORROWING

2 ~ ~ ~ ~ ~~~2

IM Total Not Borroving

Foreign Not Borrowins

_Central Government Not Borrowing

Figure 5

CENTRAiL GOVERNMENT DEFCfT

1 n-tm

12

to

1972 174 197i 4Sn 1D t h t9Y 1g@

a Gros Deficit

1 Not Do fii t (oxcluo ing onrtization pay cto)

Not Foreign Borrowing

-9-

Fiture S

CENTRAL GOVERIMENT REVENUES

It~t

10-

j , ~~~~~'o

1it ~ ~ Ii ts t *70 IS It" lt lm

a~~~~~~~i

0 Total Revenues

o4 i1 coupany revenues plus trade taes

+ Oi1 Couspny Receipts

Figure 7

CENTRAL GOVERNMENr EXPENDITURES1 tnU

112 174 tIl 11731*t 1* 11 1* te

O toael Ezpeudlture 4 Wayem + Goods/seewces

+ Waces + Good/setrvices + Interest + Invest_mt V Wyes

. Was" + Goodaeewee + Interest

-10-

of the concessional rates received by the government on foreign debt andpartly because of the less than market interest paid on domestic debt.Wages and salaries have remained stable in relative terms, but expenditureson goods and services--including military interest and nationaldefense--increased in the early 1980's. Central government directinvestment remained relatively stable at 5 to 6 percent of GDP throughout1986 and has since dropped slightly.

15. (b) Public enterprise borrowing. Table 2 presents historicalsources and uses of funds analysis for public enterprises and the privatesector as a way of understanding their borrowing requirements. Fixedinvestment and changes in stocks are the "uses" of funds whose financing isto be explained by the "sources".5 The sources include net direct foreigninvestment as well as net domestic and foreign borrowing. Budgetarytransfers to public enterprises are also shown; both current and capitalcomponents are included given the fungibility of such funds. "Internalsavings" are calculated as the residual.

16. The central government influences the sources and uses of fundsfor public enterprises, in three ways:

- through the investment approval process- through budgetary transfers- through its stance on foreign and domestic borrowing.

These will be considered in turn below.

17. The Budget Department of the Ministry of Plan has nominal controlover the level and composition of the public enterprises' investmentprogram; however, investment activity is strongly interactive with theavailability of funds, and hence a function of the borrowing rules as wellas the availability of budgetary transfers, direct foreign investment, andinternal savings. Table 2 shows that public enterprise fixed investmentdoubled in importance--from 7 percent of GDP in 1972 to 14 percent of GDPin 1977-78 and again in 1982. It has since declined to only 8 percent ofGDP. Much of the increased investment has been financed by budgetarytransfers to public enterprises, which rose from around 3 percent of GDP inthe early 1970's to a high of 9 percent of GDP in the early 1980's (seeAnnex A for details). In fact, the two peaks in these budgetary transfersoccur in 1977 and 1983, coinciding with the peaks in central government netdeficit and foreign borrowing described earlier. Thus, to some extent, thecentral government has acted as a financial intermediary for publicenterprises, and some of the central government's stock of external debtshould be rightfully included as public enterprise liabilities. Statisticson explicit onlending through repayable loans, known as "pretsretrocedes", have been recorded since 1981 and now show a total ofapproximately 500 million dinar (or $450 million at the current exchangerate).

5/ It was not possible to separate out the change in stocks of the privatesector. They are included under investment of public enterprises,which account for most stock changes.

. - 11 -

TAJLZ 2:PMULC FMWII AOPfIVAII SUMh FIVMCMIC 1, 'IS )

101 1078 114 16wo 167 1s7 101 101 im

$owes" *** 7.1 11.7 12.0 14.4 14.0 18.5 12.2 10.02I 6do meey TcemeFe. 1.6 2.i 8.0 4.2 l.a . 6. 0,4. *.. 1.48 Dire" Forelign Investment 1.2 2.0 1.4 1.0 0.0 0.6 0.86 0.4 2.34 ?mt.eeel Sevin"e RI 8.0 40.0 2.0 2.2 4.0 0.1 2.2 40.2 o*.3* *otle 6.neulsg (MAO) 1.1 2.2 i.e 8.u 2.1 2.8 i.e 2.1 10.2* PereIp 3.creelq (Cet) 2.4 1.1 O0.6 1.2 1.4 4.0 2.6 4.0 2.0

7 Ues 0.0 7.1 11.7 12.0 14.4 14.0 12.1 12.2 10.6F Pix" Investment 7.0 0.8 0.0 6.7 12.0 14.1 18.6 18.8 *.o

6.- ChampeI. suce,h 8.0 0.6 5.1 2.8 1.5 40.1 40.2 -1.1 2.1

PRIZVATIE SMC o10 34wrgee 6.6 10.? 10.1 12.8 11. 10.0 11.? 12.0 13.811 Street Foreig p aveetuset 0.1 0.2 0.0 0.1 1.4 1.0 0.6 0.4 0.412 Istoere Se.WIMP 2/ 6.7 6.2 4.2 6.7 2.6 4.1 8.2 7.8 0.1180 De%to le Srreul (net) 2.6 4.0 5.7 0.1 4.0 8.8 6.0 8.8 T. 314 Perelge U.rr.vlmg (mee) 0.2 0.8 0.0 0.4 2.? 2.0 1.0 1.0 -0.5

is lime 6.6 10.7 10.5 12.8 11.0 10.0 11.7 12.0 13.310 Flied Iavestsset 6.6 10.7 10.5 12.8 11.0 10.0 11.7 12.0 13.3

me hUE

MINNO asn In n s u s e s

to Tote mao-Oswo" tavestmat 16.7 17.6 22.1 24.8 20.1 24.0 21.8 24.2 23.9

1601 160 1968 1is4 1166 1660 166? 166

I $ewrees 12.4 11.2 J.7 .1 6.6 6.1 7.6 1.82* sdeery Tr1sltfer 7.S 6.0 S. 0.4 6.8 0.1 0.0 ' .68 Dir.e"Frelrs aVeentmest 8.6 4.7 2.5 2.4 1.2 1.2 0.0 0.74 Intsral viSewg 2 -8.0 -4.0 -2.0 -3.2 -. 0.8 -8.0 0.0 -1.25r Deuseerrelg u_ 8.8 2.4 2.2 0.6 1.6 1.5 0.4 0.20Forerleg Borrowing (met) 1.6 0.? 0.1 1.0 0.0 0.8 0.7 40.4

7 Uss 11.4 11.2 0.7 18.1 6. 6.1 7.6 1.8I Plied heyeetmeet 11.1 18.5 12.0 11.0 0.0 .60 7.2 6.69O ohe to steeks 1.3 -2.8 -2.8 1.2 4.2 -0.5 0.0 -1.1

PIVATI SECTOI10 Soures 14.6 15.4 14.2 12.0 12.8 10.5 6.0 9.11t Oireet Foreign Inveetme" 0.4 0.8 0.8 0.2 0.4 0.0 0.4 0.412 Interenl lewige1 2/ 9.6 6.8 6.6 10.6 4.2 0.5 5.0 5.418 Omestle lerroslag (met) 6.6 7.4 7.6 1.8 7.3 3.1 8.9 2.814 Foreign lerregia (not) 0.2 0.0 0.7 1.4 0.? 0.4 0.8 0.e

1i Use 14.6 15.4 14.2 18.0 12.8 10.5 6.0 1.0 10 Fixed laveetmet 14.6 15.4 14.2 18.0 12.8 10.5 9.0 9.1

16 Toutl NOO-4overssnm t eetees 27.2 26.0 2S.0 26.7 21.1 12.6 16.6 14.4

Caleulated onc residual

-12-

18. Net foreign borrowing undertaken directly by public enterpriseshas been less in the 1980's than in the late 1970's, when it averaged from3 to 5 percent of GDP. This is partly because investment levels in theearly 1980's were supported by substantial direct foreign investment in theenergy sector and partly because the central government engaged in indirectborrowing on behalf of the enterprises, as explained above. Domestic bankstend to support enterprise financing plans, as they assume an implicitgovernment guarantee, and net domestic borrowing was relatively high in theearly 1980's when aggregate internal savings dropped and investmentremained high.

19. (c) Private sector borrowina. With the exception of 1976-77 andagain in 1984 when it was about 2 percent of GDP, net external borrowing bythe private sector, including non-guaranteed and short-term borrowing, hasbeen small or negative. Investment has been financed primarily by internalsavings and domestic borrowing.6 Private investment is, of course,influenced by the full range of macroeconomic policies carried out by thegovernment, including interest rate policies, trade policy and the foreignborrowing strategy which directly affects the exchange rate. Given therelatively high import-intensity of investment, it is not surprising thatpeaks in private sector investment, as a percent of GDP, coincide with aflat or appreciating real effective exchange rate in 1975 and again in1980-85. The decline in private investment in 1986-88 coincides with adepreciated exchange rate and higher real interest rates on domesticborrowing. These policies were instituted following balance of paymentsdifficulties in 1985-86; they were undertaken with support from both theWorld Bank and the IMF.

20. As reflected in debt levels. Figure 8 shows how the higherborrowing over this period was translated into higher debt levels. Fordomestic debt, the annual increase in debt outstanding and disbursed (DOD)equals net borrowing, but for foreign debt, the DOD equals cumulative netborrowing (Foreign A) plus revaluation of the debt in dinars due to changesin the dinar/$ exchange rate and in the various $ cross-rates of the debt-denominated currencies (Foreign B). The vertical distance between ForeignA and Foreign B in Figure 8 shows the change in debt as a percent of GDPdue to revaluation. During the period 1974-77, an appreciation of the realexchange rate led to negative dinar revaluations of the foreign debt stockas a percent of GDP. For these years, Foreign B lies below Foreign A.During the 1980'., a depreciation of the real exchange rate led to positivedinar revaluations of the foreign debt stock as a percent of GDP, andForeign B rises above Foreign A. On balance, foreign debt increased bysome $600 million between 1980 and 1988 as a result of foreign currencyrealignments, the remaining revaluation effect was due to changes in thedinar/$ exchange rate.

21. The Tunisian authoritiss are conscious of the economy's high levelof indebtedness--both foreign and dcmestic--and they are concerned at therapid growth in debt in recent years. An interbank money market has beenestablished to improve the efficiency of intermediation, and new financial

6/ Some domestic borrowing by both public and private enterprises wasfinanced by net foreign borrowing of Tunisian banks, but this has beenrelatively small.

- 13 -

Figure 8

TOTAL DEBT

lo

170

I

1100

a 00-

70a*

1972 1974 197 1973 196 1900 lo 1I9 19a0

0 Total with Foreign B (end of period DOD)

4 Total with Foreign A (1972 DOD plus annual net borrowing)

O Domestic Debt

-14-

instruments are being introduced by the government and encouraged in theprivate sector, to provide non-monetary alternatives for financialinvestments. Also, since 1987, the policy has been to encourage self-financing, and recently minimum equity/debt ratios have been introduced bylaw in two industries: 30/70 in manufacturing and 40/60 in tourism.

Summary

22. The historical analysis above shows that the circumstances andconsequences of external debt accumulation in Tunisia are somewhatdifferent from the prototype high-debt country in at least two respects.First, the debt build-up is not associated with a major external shock.While occurring at discrete points in time, the adverse external shocks forTunisia were not traumatic and were, on balance, offset by favorableexternal events. Second, the external debt build-up has been accompaniedby continued positive growth in real GDP (aside from years of drought) and,until quite recently, a continued high level of real investment as well asreal consumption. Nevertheless, the debt burden, as reflected in the ratioof total debt to GDP, increased in part because the declining quality ofinvestment, as reflected in the steadily increasing ICOR, failed togenerate sufficient output growth. The locus of borrowing was clearly inthe public sector--with 50 percent of total foreign debt (including bankdebt) being held by the central government at the end of the period andanother 30 percent by the public enterprises. Given the large budgetarytransfers to public enterprises starting in the mid-1970's, however, somecentral government foreign borrowing can be interpreted as financialintermediation on behalf of these enterprises. Net foreign borrowing bythe private sector, including non-guaranteed and short-term borrowing hasbeen modest over the entire period.

II. The Fiscal Burden of External Debt Servicing

23. The ratio of external debt outstanding and disbursed (DOD) to GDPhas increased in Tunisia from about 30 percent in the early 1970's to apeak of 69 percent in 1986, declining to 65 percent in 1988. Debtservicing--including both interest and amortization payments--as a percentof exports has risen from less than 10 percent during much of the 1970's to28 percent in the mid-1980's. These two ratios are typical ways ofmeasuring the debt service burden; but the fiscal burden, which isindicated by the ratio of budgetary external debt service to budgetaryrevenues, is also important. This indicator has increased from less than10 percent in the 1970's to 20 percent in the mid-1980's.

24. The fiscal buxrden of external debt reflects the need to mobilizethe local currency counterpart to the central government's foreign exchangedebt service payments. In Tunisia, where approximately 50 percent ofexternal debt has been contracted by the central government, it ispotentially large, and a budgetary problem arises from the fact that thebenefits of the programs financed by the debt accrue to the private sectorwhereas the liabilities are assumed by the budget. The less budgetaryrevenues are directly increased by the activities financed by foreignborrowing, the faster the burden will increase.

-15-

25. Compared to 30 other high-debt countries, Tunisia's fiscal burdenof external debt--as well as its foreign exchange burden--has remained inthe manageable range. In 1985, for example, Tunisia'. fiscal burden was 12percent, compared to an unweighted average of 18 percent; and Tunisia'sdebt service burden was 26 percent compared to an unweighted average of 32percent (de Melo, 1989). However, with projected revenues declining as apercentage of GDP, the external (and internal) debt servicing componentwill become relatively larger. That is, the fiscal burden is likely toincrease. A measure of indirect fiscal burden can also be defined byconsidering debt service on total public and publicly guaranteed (PPG)external debt as a contingent liability of the budget. PPG debt servicingas a percent of budgetary revenues has been around 25 percent in recentyears.

III. Fiscal Conseauences of External Debt

26. A high debt service burden can lead to macroeconomic developmentswhich have secondary effects on the budget--in addition to the debt serviceburden itself. These secondary effects result from a real devaluation ofthe exchange rate associated with a foreign exchange shortage, an increasein domestic interest rates associated with higher domestic borrowing tofinance the government deficit, and an increase in inflation and in thewedge between deposit and lending interest rates as a result of monetaryfinancing of the fiscal deficit and heavy taxation of financialintermediation services. In addition, specific institutional arrangementsassociated with debt management can have strong fiscal repercussions. Thefiscal consequences in Tunisia of such secondary effects are discussedbelow.

Debt-related Macroeconomic Developments

27. A real devaluation in the exchange rate. Like many heavilyindebted countries, Tunisia has undergone a real devaluation of theexchange rate in recent years in response to a foreign exchange shortage.No formal analysis has been carried out on the budgetary impact of thisdevelopment; and, when asked what would be the probable future effect onthe budget of a change in the real exchange rate, most Tunisian officialshad no firm views.7 The effects of a 5 percent real devaluation in 1986and 1988 have therefore been estimated in two ways in order to give someinsight into this issue. The assumptions and results are reported in Table3.

28. The first way is to calculate the first round budgetary effects ofa real devaluation as a percent of GDP by classifying revenue, expenditure,and financing items according to the average traded goods component of

7/ A change in the nominal exchange rate that does not result in a changein the real exchange rate would also have a budgetary effect in Tunisiasince some revenues and expenditures are maintained constant in nominalterms and therefore would not adjust--at least in the short run--to ageneral increase in prices.

-16-

different categories. It is assumed in both this approach and the generalequilibrium approach that dollar foreign financing of the budget is fixed.The net budgetary effect is then translated into a change in the netdomestic borrowing requirement, which is determined residually. Table 3shows that the budgetary effect is positive in 1986, but declines from 0.43percent of GDP in :986 to 0.30 percent of GDP in 1988. The decline is dueprimarily to a fall in the share of revenues from oil and trade taxes and adrop in net foreign financing.

29. The second way of estimating the budgetary effect of a realdevaluation is with the general equilibrium model for Tunisia presented inde Melo, Leduc, and Razmara (1989). The results are based on the 3 sectorversion, which is calibrated to 1986 data. As the exchange rate isendogenous, a reduced capital inflow to the non-government sector isrequired to generate a 5 percent real devaluation. The resulting favorableeffect on budgetary revenues from oil exports is similar to the first roundestimates. However, the negative exchange rate effect on import volumeslargely offsets the favorable price effect of the devaluation on tradetaxes. The budgetary effect of other revenues and other expenditures issmaller under the general equilibrium estimate in both years becausedomestic prices are constrained in nominal terms by an assumption ofconstant money supply. On balance, the estimated net budgetary effect is.26 percent of GDP in 1986 and -.01 percent of GDP in 1988.

30. Although lower than the partial equilibrium estimates, for thereasons explained above, the general equilibrium estimates indicate thesame direction of change. Thus, whereas expenditure-switching andexpenditure-reducing policies were mutually reinforcing in the past, it isnot clear that they will be in the future. This implies that the budgetaryproblem associated with external debt servicing is likely to be lesstractable in the future than it has been ir the past.

31. An increase in government domestic borrowina. Pressures ondomestic financial markets can grow as governments try to--or are obligedto--reduce foreign borrowing by relying increasingly on domestic borrowing.The unintended and undesired results may include higher interest rates, andhence higher budgetary payments, and lower private sector investment andgrowth, and hence lower future taxes, as a result of crowding out throughprice or quantity rationing of domestic credit.

32. The real stock of central government domestic debt is expected torise significantly by 1993, compared to 1988--the extent of the risedepending on government decisions regarding revenue increases andreductions in budgetary expenditures in the medium term. So far, themajority of central government debt has been placed with the commercialbanks, which absorb government bonds, plus a small amount of savings bonds,up to 25 percent of their assets. However, since the ratio of bonds tobank assets is currently near its maximum and since real bank assets areexpected to increase more slowly, a significant part of this new debt willhave to be placed directly with the private sector, displacing bankingsystem deposits and hence available loans to Tunisian businesses.Recently, Tunisian banks have experienced excess liquidity, as demand forinvestment credit has dropped, but investment demand may now be picking up,and the danger of crowding out is a serious concern for the future.

TABLE 3: Estimatd B ry Effoct ot a 5 Percent DevaluatlonIn tho Ral Exchange Rate with Fixed Foreig Bornoing

(porcent of OW)

1938 1968P1rcent Traded Fi rat G ra Perceto Traded F rot Genral

Of Good Round EquilIlbrim of Good Round EuitibriumGoP Shaere & Effect Effect bi GOP Share */ Effect Eif ct th

DiT-ovenue 6.0 1 .28 .23 5.8 1 .2n .Trad tax" 4.6 1 .28 .00 4.2 1 .21 .01AlI other 21.0 .16 .19 .06 20.2 .20 .20 -._6

Forola FinancinN *ore borrowing 8.0 1 .15 .15 1.8 1 .07 .07

TOTAL .86 .60 .7C .21

_mtic Intret 0.9 0 0 0 0.9 0 0 0 -Foreg Interest 1.8 1 .09 .06 2.0 1 .10 .10Investment 4.9 .80 .07 .06 4.6 .27 .06 .06AlI etber 29.4 .1l .26 .06 20.6 .20 .. 07

TOTAL .42 .24 .45 .22

Not r w dtct a DoclilzIs rb_MIc borrowing

2.8 0 .48 .26 5.0 0 .80 -. 01

/ All trade taxe are assued to be ad valorem aN henc to incroes proportionately. The aosume trad_edgd coeposetof invest_met and other rovenues aW-ip-Ttres Is bed en the econevs-side Ieport-intesslty f laveatent lode andlntordiate and consumer ood respctively.U0Jma the sectoral verTlna of the Tunisia model decribed In de Melo. Ledec, ad lasem_rs (1909). Ia this mals the

,valuation Is cause by reduced, son-budtry capital Inflows.

-18-

33. Under the previous system of fixed lending and deposit rates,crowding out may have occurred through stricter credit rationing. Underthe new system of market determined interest rates, crowding out is likelyto occur through a rise in the real lending and deposit rates. A rise indeposit rates, which have been determined competitively since January 1987,would presumably be accompanied by a rise in the money market ratewhich--together with an agreed margin--determines the lending rate. Thereis little information at this point on interest sensitivities of savers orinvestors, and hence on what the magnitude of the increase might be. Acomparison of interest rate equivalencies by tax status, however, suggeststhat returns on government debt are currently relatively attractive andwould continue to be so in the face of small increases in market-determinedinteres': rates (see Caprio, 1989). Thus, modest increases in the realstock of central government debt are unlikely to cause major problems, butthe domestic financing required for continuing fiscal deficits on the orderof 4 percent or more of GDP may well require a substantial increase in realinterest rates. Total domestic debt in Tunisia is now high and hasincreased from about 45 percent of GDP in the early 1970's to about 75percent of GDP in the mid-1980's. Central government domestic debt hasitself increased from 7 percent to 18 percent over this period.

34. Monetary financing of the deficit and taxation of financialintermediation. Monetary financing of the budget deficit has led to highlevels of inflation in many high-debt countries and, together with heavytaxation of financial intermediation services, has led to a wedge betweendeposit and lending rates--with low, often negative, real deposit ratesleading to disintermediation, in part through capital flight, and high reallending rates choking off investment. Both capital flight and lowerinvestment and growth undermine fiscal revenues and lead to apredictable--if difficult to quantify--deterioration in the fiscalposition. Unlike most high debt countries, Tunisia has followed aconservative monetary policy and avoided heavy taxation of financialservices. These policies, discussed below, may be important reasons whyTunisia has continued to benefit from positive GDP growth and a fiscaldeficit that has been more or less manageable.

35. There is relatively little direct monetary financing of thegovernment deficit in Tunisia. The most important source is Central Bankprofits, which arise primarily from the return on Central Bank credit tocommercial banks and an increase in the dinar value of net foreign assets.These profits have amounted to as much as 2 percent of GDP. In addition,some monetary financing may occur through a drawdown in the Treasury'saccount with the Central Bank, but this appears to be quite small. Inaddition to direct monetization, however, indirect monetization of thedeficit occurs through Central Bank credit to commercial banks that are inturn expected to hold government development bonds. In recent years, suchcredit has been financed largely through a drawdown in net foreign assets;as a result, money growth and inflation have been moderate.

36. Another distinctive characteristic of central government financingin Tunisia is the relatively little reliance placed on taxes on financialintermediation. Table 4 shows the explicit and implicit taxen which havebeen used in the past. Explicit taxes consist of a tax on deposit interest

TABLE 4: TUNISIA: Explicit and Iplicit Taxes oe Financial Interdlitloo Servile

(1) (2) (8) (4)EXPLICIT TAXES () IMLICIT TAXES (MI TA TE ON POSm MUDMETARY RECEIPTS RESERVE RESWM S COY. DEV. 00105 TOTAL EXPLICIT !,CIT TOAL

lRClCS / lPS y LOC / FPC OI TOTAL Sank di Hoid by banks T TOTAL DEPOSITS 2 1/ L1+t&I II+.*2 (14f IE

1978 2.2 8.7 - - C.9 1.2 -2.8 -1.1 600 .7 -. 1 .6

1979 2.0 5.2 - - T.6 2.8 8.7 6.0 964 .6 .6 1.5

1060 2.7 5.2 - - 8.9 8.2 20.6 28.6 1148 .6 2.1 2.

1961 D.8 9.J - - 11.6 6.0 8.7 79.7 162 .0 5.O o.o

1062 8.8 18.0 - - I1.8 2.2 85.2 37.4 1611 1.0 5.4 6.4

106 8.6 17.5 - - 21.8 1.2 59.6 60. 180 1.1 8.2 4.8

1904 4.0 22.4 11.2 8.7 41.8 1.0 76.6 70.6 2142 1.0 8.7 5.7 'o

Io5 5.9 29.4 0.0 6.7 52.8 1.0 48.6 49.6 24U 2.1 2.0 4.2I6 6.1 87.4 6.6 14.8 66.4 .9 -18.0 -17.1 2616 2.5 -. 7 1.9

1N? 6.6 52.5 7.5 16.8 84.9 .5 27.4 23.2 8006 2.8 .0 8.6

106 13.2 26.0 6.6 14.1 5.6 .6 W 6.7 7.5 877 un 1.6 1.1 2.9

/ Withholdia tax e. 11.55 on deposit interest Incem (IRC) oot credited against ilce tax plus a special solidarity levy (CES) eal to 23 of IK.(IMDF).Ta em Int ceares on Bank loans. Tho TPS rate hrx varied m mae rediced to 6X ln 1967. (0/lOF).I/ Lose guarsetee cemlsalosl (OC) of 0.625 perent on vewrdraft*. (CT).

Esdrsk guarantee fund c_ sloeteno (FPC). (Ien bri, 106, ad ICT)./ Calclted os te dinar coat of foreign borroing by the Central Governmet on LIR-bed extrnal loes tim the reeerverequr _mn free Table VII-1-A of SXt~ilsaan ci -re.

/ Calculated - the difference beetho dinrrco tef forelg1borroinfe In ined shove aW the contranctalinterels rate on governmet dsvelopmst bonds tilm the a ors btading.F trom Table 111-2 of Stetletios Finanieir".

-20-

income (IRC), a tax on interest charges on bank loans (TPS), a loanguarantee commission (LGC), and an exchange rate guarantee commission(FPC). These budgetary receipts increased from less than one percent ofdeposits to almost 3 percent of deposits before declining in 1988,following a number of financial sector reforms, to 2 percent of deposits.They will decline further in 1989 since the single largest tax, the TPS,was eliminated at the end of 1988.

l37. Implicit taxes consist of those generated by reserverequirements--which are zero on all but blocked, non-resident accounts--andby bank holdings of government bonds. The former are calculated as thedifference between the dinar cost of central government foreign borrowingat commercial rates and the zero return on required reserves times thestock of required reserves. The latter are calculated as the differencebetween the foreign cost of borrowing and the contractual interest rate ongovernment development bonds times the average bonds outstanding. Thefluctuation in these implicit taxes, which reached a peak of 5.8 percent ofdeposits in 1981, is due primarily to variations in the exchange rate,which affects the local currency cost of foreign borrowing. Column (4)shows that the explicit plus implicit tax rate on deposits increasedsubstantially in the early 1980's but has recently declined to a level ofabout 3 percent. On balance, this explicit and implicit tax rate isprobably smaller than such taxes found in most countries, and certainlyless than in other high-debt countries, where reserve requirements, forexample, have ranged up to 50 percent of deposits compared to a maximum of2 percent of deposits in Tunisia in 1981.

38. Looking towards the future, a cautious stance will be needed. Asnet foreign borrowing declines, the pressure to finance budgetary needsfrom a variety of domestic sources will increase. The 1988 budget year hasalready demonstrated that political pressures on a new and more populistgovernment may make it more difficult to hold down non-financial currentexpenditures such as wages and salaries as well as current subsidies andtransfers. Taxes on financial intermediation services and an inflation taxresulting from monetary financing of the deficit are both financingoptions. Experience ir other countries, however, would suggest reliance onalternative revenue sources.

Effects of Institutional Arranzements

39. So far, Tunisia has not engaged in any debt conversion schemes.These schemes--involving the conversion of foreign exchange liabilitiesinto domestic currency liabilities, usually at a premium--can result inbudgetary pressures if undertaken by the central government. Nor has thegovernment assumed any external debt liabilities of the private sector.Difficulties in debt servicing by public enterprises have been treated on acase by case basis. There is no overall assessment, however, of budgetaryassistance to public enterprises as a result of the unanticipatedrevaluation of debt stocks versus other causes of losses such as declinesin international prices or lags in domestic tariff adjubtments.

-21-

40. One institutional arrangement affecting the budget is noteworthy,namely the Foreign Exchange Risk Guarantee Fund (FERGF). This fund, whichhas its counterpart in other countries, was set up in the early 1980's toencourage the official development banks to expand their domesticactivities through foreign financed loans. The cost of the latter wasreduced by guaranteeing the initial dinar/foreign currency exchange ratefor the debt service. Accrued foreign exchange losses on this account bythe two largest development banks, BDET and BNDT, had reached 83 milliondinars (or $107 million) by end-1987. Receipts generated by the exchangerisk guarantee fund commission amounted to about half this amount (seeTable 4), but the remaining losses will have to be covered by otherbudgetary receipts. Ben Bahri and Benzaghou (1988) show that for the 8year period, 1988-95, additional losses of 100 million dinars can beexpected even if there is no further depreciation of the dinar vis-a-visthe foreign currencies. This is unlikely, howev-er, since Tunisia'sinflation rate is higher than the inflation rate in creditor countries.Losses on the exchange guarantee program for the development banks couldeasily be twice the above amount, constituting a significant budgetaryburden.

41. The FERGF in Tunisia had limited coverage and has now been totallyredesigned to reduce the risk but not to shift the foreign cost ofborrowing on to the budget. During its operative years, however, itencouraged the development banks to borrow in hard currencies with lowinterest rates (such as the yen and the deutschmark). These were, ofcourse, the currencies that rose the m,ost against the dinar and hencecaused the greatest losses to the FERGP. The FERGF is a good example ofinstitutional arrangements that can result in significant budgetaryproblems if not properly designed.

IV. Fiscal ODtions

The Sustainable Deficit ARproach

42. A general expression for a sustainable primary budget deficit ispresented in de Melo (1989). It assumes a steady state for the variablesincluded in the expression and accounts for three alternative financingsources: foreign borrowing, domestic borrowing, and money creation. InTunisia, there is traditionally little direct monetary financing of thebudget deficit, so the expression can be simplified to account for domesticand foreign borrowing only, as follows:8

d - b (y-r) + p x (x-(r*e))

The variables are defined in Table 5, which provides estimates of themaximum sustainable deficit for Tunisia's central government budget under

8/ Independent estimates can be made to ascertain the prudent amount ofindirect monetization through the transfer of Central Bank profits tothe budget or Central Bank credit to the deposit money banks. De Melo,Leduc and Razmara (1989), for example, provides estimates of moneydemand in Tunisia.

- 22 -

Z&5LL: ESTIMATES OF THE SUSTAINABLE PRIMARY DEFICIT/GDPFOR THE CENTRAL GOVERNMENT (CG) BUDGET

(porcent)

AVERAGES FOR 1989-93

Tunisiaorn GDP Higher domestic t)Iswenario growth + real devaluatiin

VARIABLES

1) Initial CG domesticdebt/GDP (b) a/ 18.0 18.0 18.0

2) GDP real growth (9) 4.5 2.5 4.5

3) Real average interest ondomestic borrowing (r) 0.0 0.0 3.0

4) Initial CG foreign debt/exports(p) g/ 78.0 78.0 78.0

5) Average exports/GDP (x) 42.0 42.0 42.0

6) Export real growth (x) 4.5 2.5 4.5

7) Real average interest on $debt (r*) 4.5 4.5 4.5

8) Change in the realexchange rate (8) 0.0 0.0 3.0

9) Sustainable primarydeficit/GDP (d) b/ 0.8 -0.2 -0.7

10) Estimated budgetary interestpayments/GDP 3.0 3.0 3.0

11) Maximum sustainable overalldeficit/GDP 3.8 2.8 2.3

_/ Initial ratios are for 1988.k/ Calculated as d - b (9-r) + p x -

E: The primary budget deficit (i.e. before interest payments) was 2.6 in1986, -0.1 in 1987, and 1.5 in 1988.

-23-

alternative scenarios for the 1989-93 period. Sustainability isinterpreted here as maintaining constant the ratios of central governmentdomestic debt to GDP (b) and central government foreign debt to exports(0). It does not mean that future budgetary revenues vill cover the newdebt -t-.rvice payments but rather that it should be possible to generateadditional revenues for this purpose since the debt ratios are notincreased. Where real export growth exceeds real GDP growth, there is animplicit assumption that export revenues can be captured to cover thefiscal as well as the foreign exchange debt service burdens.

43. The Tunisian government's own medium-term scenario assumes anaverage annual growth in real GDP and real export growth of about 4.5percent, and no change in the real exchange rate. Real interest rates areapproximately zero percent and 4.5 percent on domestic and foreignborrowing respectively. The maximum sustainable primary deficit underthese assumptions is shown to be 0.8 percent of GDP. With projectedbudgetary interest payments of about 3 percent of GDP this implies anoverall maximum net deficit of 3.8 percent of GDP. This compares to thegovernment's average projected overall deficit of 2.6 percent of GDP.Lower GDP growth of 2.5 percent, also shown in Table 5, indicates the needfor a -0.2 primary deficit as a percent of GDP, or an overall deficit ofabout 2.8 percent of GDP. A real interest rate on government debt of 3percent and an average annual devaluation in the real exchange rate of 3percent would imply a minimum primary surplus of 0.7 percent rather than amaximum deficit of 0.8 percent. Since realistic assumptions regarding thelevels of go-vernment expenditures suggest that adverse circumstances mayresult in a primary deficit close to the maximum sustainable one, seriousconsideration should be given to maintaining government revenues at theexisting level until such time as additional expenditure reductions can lecarried out. This level already represents a substantial reduction in tCerevenue/GDP ratio from a peak of 34 percent in 1984. As of 1988, less thai40 percent of reduced revenues were on account of lower revenues from oil.

The Desirable Deficit Approach

44. Given Tunisia's recent success in export growth and the potentialfor continued increases in per capita GDP, a more ambitious adjustmentprogram--one that is oriented towards a desirable deficit, rather than amaximum sustainable deficit, would seem appropriate. It would also beconsistent with the Tunisian scenario. Tunisian authorities at theMinistry of Plan, the Ministry of Finance and the Central Bank were askedfor their views on desirable debt levels. Their responses, which differedmore in emphasis than in substance, are recorded below. The historicalcontext as well as considerations of future options are consideredimportant.

45. In 1981, just prior to the VIth Plan, Tunisia's total externaldebt (including short-term and private non-guaranteed) as a percent of GDPwas 43 percent. Debt service, as a percent of exports of goods andservices was 15 percent of GDP. These levels were considered acceptableand reasonable, given Tunisia's need to promote growth with the assistanceof capital inflows. Since 1981, however, the increase in the debt/GDPratio due to a real devaluation of the dinar with respect to the dollar has

-24-

been substantial. Changes in the debt/GDP ratio due to currencyrealignments in the 1980's have been more or less offsetting; however,year-to-year changes have been important.9 By 1986, the total debt/GDPratio reached a peak of 69 percent and the debt service ratio a peak of28.5 percent. Creditors found these levels too high, in particular sincethe government also depleted its foreign exchange reserves in this year.External financing became scarce, and a donors meeting was organized tomobilize support for stabilization and structural adjustment. Medium-termadjustment programs were agreed with the IMF and the World Bank, andsufficient program lending was provided to tide the economy over to 1987.

46. Export earnings surged in both 1987 and 1988, to the point whereinternational financial institutions are now quite interested to lend toTunisia. Tunisian authorities, however, believe external debt levels arestill too high, and parlementarians have also voiced concern about thelevel of debt service. There continues to be a general sense that debt anddebt service levels just prior to the VIth Plan are appropriate for theTunisian economy, with most officials expressing more concern for debtjervice ratios than for debt/GDP ratios ner se. This concern is consistentwith a strategy to obtain the maximum amount of loans with low interestrates and longer maturities. A consensus view of the debt problem might beexpressed as follows: the foreign debt/GDP ratio should be somewherebetween 40 to 50 percent, and the debt service ratio should not exceed 20percent. In order to reach these lower levels, the VIIth Plan calls for areduction in the current account deficit to 3 percent of GDP, implying azero non-interest current account deficit. This target has already beenexceeded in 1987188 because of the good export performance.

47. The focus on a desirable fiscal deficit rather than a sustainableone will entail twc major decisions: (i) the rate of adjustment from theexisting overall debt level to the desired one and (ii) the mix of foreignversus domestic financing. The first decision is a matter of judgementabout the extent of fiscal austerity that is desirable or appropriate givenother circumstances--assuming that the adjustment w4 11 be in a down7arddirection. The second decision depends on several considerations, amongwhich is the relative cost of borrowing discussed below. Other legitimateconsiderations include the need for short-run balance of payments support,uncertainty about the availability of international credit, and the stateof domestic financial markets.

48. Tables 6a through 6c provide data on historical differences in theaverage domestic and foreign costs of borrowing to finance the consolidatedcentral government budget deficit in Tunisia. Table 6a is from Tunisiansources and shows domestic and foreign net financing of the budget from

9/ The Tunisians are concerned now about the need to match the currency ofdenomination for foreign borrowing with the currency of denomination ofexport revenues. Tunis Air and Groupe Chimique are already thinkingalong these lines, and the Central Bank not only advises on foreignborrowing strategies but is developing the capacity to engage in swapsand options in order to provide hedging facilities where needed. Thereis also a concern to encourage borrowing primarily by exportingcompanies and by development banks, whose business is to promoteinvestment projects with favorable rates of return.

- 25 -

TABLE 6a: pIWeC OF MIAL GOYNMB4 COOIUDAIO SAET (MII Ii..of T. dIners)

y., 166 1061 106 1'6 16 136 106 167 106

NET DOOUITC fNANCDM n 122.8 1IO.0 140.8 10.1 176.8 161.4 206.C 16

Capital EquIpmnt Boods 60.5 1o'a "4.4 6.7 110.6 141.7 126.4 so.* 41.6

Natilnal beotot" 0 ° ° 0 0 $1.5 -6 74.2

Treasury I/ 10 20 22.2 48.0 3I.8 a. 8.5 132 40

NET FUSON FIWANCINQ $0.0 so.? 170.4 276.0 228.0 168.1 207.0 20.6 218

TOTAL OEFICIT 110.0 216 26 410.0 420 841.4 we 227 n77

nn e.lf e - - -

I/ Calcwleted residu.ly.

TABLE 6b: AVEAGE F ON COST OF BECWOfI

10o 11 106 1068 1064 I16 1to" 1067 im

STOCK

Centrl gev.SDOD 1642.7 1567 1604.1 1744.8 1766.3 2167.8 2672.5 8106.8 815

Exch rate 0/, (4op) 0.417 0.518 0.618 0.724 0.67 0.757 0.640 o0.77 0.600

X Change In 0/6 -0.80 28.164 19.411 16.024 10.770 -12.668 10.990 -7.421 15.111

Central gov. OOD (MD) 642.660 604.02 M62.682 1262.001 1547.814 1640.58 2245.485 2416.285 2680.275

AV. iNT*L INTEREST RAT (1) 5.518 5.858 5.247 4.276 5.216 4.906 5.102 4.6 5.509

REVAL.OUC TO 0/8 OCHNO (2) -0860 28.164 10.411 1U.064 19.770 -12.658 10.906 -7.421 11.511

REVAL.OUE TO 6/GTN (8) -2.54 U 4.670 -8.797 -4.05U -7.8U4 6.U 6.146 11.409 -$.54

Net OD Iners 104.1 24.8 87.1 140.2 41.2 381.6 505.2 488.6 48.7

Net I dlsburnnte 142.1 127.2 96.6 210.7 170 228.9 829.0 126.9 215.6

RevaluatIon *DtO0D -88 -102.0 -59.5 -79.1 -126.6 157.9 170.6 804.0 -171.9

6E60HTED AVERAGE COSTOf FORSIGN OUT (1.2.8) 2.790 21.U47 20.201 17.406 17.611 1.179 24.246 90664 15.576

NI: Total eost, a *I dE * v] ECU

Perent cost a I3 * d . v * (1) * (2) # (8)

where: s6 a *OO, at betanning e the periodI * the Diner/S xchange rate

dl * the peen chane In the 0/ *exchange atea0 * the ese on v'ot' detm .te p e ealte *f a due, te Chnge In

Ie cency eatee

- 26 -

TABLE 6c: AVERAGE DOMESTIC COST OF B4 NWO (MIIlene nf T. diners)iWO 191 1f 10S 1964 1n$ 196 1967 19

STOCKS

Capital Equiplmt Sond 806.B 496.2 578.6 670.3 761.1 922.6 1049.2 1129.7-. 1171.5

Deposit banks 201.4 242.5 201.4 838 402 499 672 627 645

Social security 111.7 107.2 202.2 210.0 214.1 211.1 226.1 221.9 217.7

cmr8 $81.8 8.6 37.6 6.4 96 123 138.6 150.$ 166.6

Insurance 24.3 2o.1 as 40.6 40.2 50.7 40.2 70.2 st.2

Other 13.2 16.6 17.4 21.3 21.0 27 40.1 60.8 $0.3

National Soerringe 0 0 0 0 0 0 31.5 25.3 90.7

Trea"ry -49.7 -29.7 -7.5 3.1 121.4 1IS 161.1 298.5 341.5

CCP (privat, sector) 30.9 42.4 11.0 67.2 62.1 34.8 77.2 90.7 9057

CuNT U4 46.7 61.1 68 38.9 15.7 21.8 40.2 49.2

central Bank, not -15.8 -82 -20.0 -43.4 -36 -11.2 -24.6 -0.7 -70.4

Other trasury I/ -990. -68.6 -90.9 -45.7 41.6 *9.2 67.4 157.8 266

INTEREST RATES

Capital Equipment Bonds

Ooepeit banks 5 1.5 5.6 5.5 5.5 5.5 6.5 6.5 6.5

Secial security 6 5.5 6.6 5.5 5.6 1.5 5.5 6.5 6.5

cuff5 5. 5.5 6.5 6.5 5.5 5.6 6.3 6.6

Insurance 6 6.5 6.5 6.5 5.5 5.5 5.6 5 6. 6.C

Other 1 5.5 6.5 1.5 3.5 5.5 5.5 6.5 6.5

National Borrowings N.A. N.A. N.A. N.A. N.A. N.A. 9.6 9.6 9.5

Teasury

CCP 0 0 0 0 0 0 0 0 0

CENT a 5.5 5.5 5.1 5.5 6.7 6.7 7.5 7

Other trasc.oporatlone 0 0 0 0 0 0 0 0 O

WE10H4 AVERAGE COSTOF OOMhSTfC OUT 4.621 5.a96 5.818 5.398 4.966 4.708 5.001 5.475 5.510

NBt Total cost a r(1)eO(1)# ... (.. orn)*d(n)

Percen cost a total cost/(O(1)....0(n))

where: r() a domstic Intenet rate on the Ith type debt0(1) a domestic debt of the ttb type

1/ Estimated 1996 end-yor stocks for other treosury are as tollows (MD):Etablissement publiess S Collectivites localess 170 CCP (banking* sector): 6Entreprises publics: 50 Privat wall orders: a5

tI previous years, stocks are derlvod as a rsidual. Were the residual Is positive, It Is asswuedthat Treasry boetitm from interest-free deposite. Where the reidual Is neative, It is assmWethat Trscsay's borrostlg osts are offost by Its l_dig riate so that not costs are still zero.

-27-

1980 through 1988. The following two tables show the stocks of debtoutstanding and disbursed and the weighted average coat of borrowing. Forforeign borrowing, Table 6b is based on World Bank debt reporting service(DRS) data and shows the average cost over this period as a function ofthree elements: the average international interest rate on the dollardenominated debt, the revaluation of the dollar debt in dinars due tochanges in the dinar/$ exchange rate, and the revaluation of the dollardebt due to changes in the dollar exchange rate vis-a-vis the other debt-denominated currencies. The second and third components reflect theaccrued rather than the cash cost. For domestic borrowing, Table 6c isbased on Tunisian sources and shows the average cost of borrowing as aweighted avsrage of the cost of alternative domestic debt instruments.Sources of domestic finance include the development (capital equipment)bonds, national borrowings, and Treasury operations.

49. The historical experience over this period shows that the cost offoreign borrowing averaged 14.5 percent over this period and exceeded thecost of domestic borrowing, which averaged 5.2 percent. The variation inthe average annual costs of foreign borrowing was large, ranging from 2 to24 percent, and was due to the two revaluation effects distinguished above.The variation in the cost of domestic borrowing was small. Clearly,budgetary costs would have been lower with less foreign borrowing, althoughadditional domestic borrowing may have required an increase in interestrates. To estimate the likely cost differentials in the future, somejudgment needs to be made on the direction of change in the currencyvaluations as well as in domestic and international interest rates.

50. The valuation of foreign currency debt in dollars is difficult topredict, and Tunisia may have derived as much benefit as cost from cross-currency movements in the past. Moreover, Ben Bahri, Benzaghou, et al,(1988) show that debt service payments and current receipts are fairly wellmatched over the period 1983-86--with the exception of the yen, whichaccounted for 5 percent of debt service but no receipts. For the future,however, the large U.S. current account deficit suggests that the dollarwill decline vis-a-vis other debt-denominated currencies--especially thedeutschmark and the yen. This would cause an increase in dollar-denominated debt.

51. The valuation of dollar debt in dinars is more predictable sincethe authorities have stated their intention to adjust the exchange rate bythe inflation differential between Tunisia and a trade-weighted average ofdollar-tied countries. Since this inflation differential is likely to be3-4 percent, the minimum foreign cost of borrowing from financial marketsis likely to be around 12 percent, or significantly higher than thedomestic cost of borrowing, which may nevertheless rise to 8 or 9 percentin the near future as a result of financial sector reforms. On balance,the evidence would suggest little or no LIBOR-based borrowing on costgrounds. To the extent that central government can contract foreign loansat less than commercial rates, these of course should be considered.

-28-

Revenue and Expenditure Options

52. The Tunisian model referred to above was used to simulate theeffects of two revenue and expenditure options for increasing budgetarysavings over a five year period. The revenue option is to maintain directtaxes at the 1986 level of 6.5 percent of GDP rather than letting them dropto the proposed 1991 level of 4.6 percent of GDP. The expenditure optionis to cut government employment by 10 percent in the base year and allocatethe nominal value of dinar savings to government investment over the next 5years. The simulation results are explained briefly below.

53. In the case of the additional revenue generation, real GDP at theend of the period is only marginally higher than in the base case, but realgrowth rates end employment creation are clearly accelerating as a resultof the higher budgetary savings and hence higher investment, which resultsfrom the model's assumption of savings-driven investment. The higherdirect taxes depress real consumption slightly through year 3, but theconsumption gap narrows progressively thereafter. An important advantageof this option is the additional credit made available to the privatesector--resulting in credit levels which appear more consistent with theassumed investment activity.

54. In the case of expenditure adjustment, real GDP in year 1 declinesdue to the drop in government employment and hence output, but it regainsthe base case level by year 5 as a result of the annual reinvestment ofbudgetary savings from the employment reduction. In other words, thehigher investment generates a higher growth in real GDP. By year 5, 70percent of the jobs lost in government employment have been recreated inthe private sector as employment growth is slightly higher than in the basecase.

55. There are, of course, real life administrative as well aspolitical constraints to such revenue and expenditure options, butTunisia's need to not only maintain macroeconomic balance but also reducethe heavy burden of internal and external debt warrants their seriousconsideration.

- 29 -

APPENDIX

Tunisia's Central Government Consolidated Budotet 1972-88

1. The historical analysis of (a) fiscal causes of external debtaccumulation in Tunisia and (b) fiscal consequences of the debt overhangrequires a complete and consistent set of budgetary data for the periodexamined. The results of an effort to develop such a series are providedin Table Al. Some of the problems encountered are discussed below.

2. A major objective in the historical analysis of budgetarydevelopments in Tunisia is to provide some insight into the trends andoptions for the future. Thus, a requirement for the historical series wasthat it be compatible with the classification system used in makingprojections for the VIlth Five-Year Plan, 1987-91.1 This was relativelyeasy for the period 1981-86, as aggregated historical data compatible withthe Plan projections are provided in the Plan document (VIIth Plan, TablesV-2 and 3). For the disaggregated categories shown in Table Al, theMinistry of Plan's Annexe Statistigue au Rapport sur le Budget Economicue1986 was used to identify trade taxes, capital revenues, budgetary savings,current and capital expenditures of the special funds, and extra budgetaryoperations. Updated estimates for 1986-88 were obtained from the MOP inFebruary 1989.

3. For the period 1972-80, constructing an historical seriescompatible with the VIIth Plan classification proved quite difficult. Theaggregate revenue and expenditure levels, distinguishing between currentand capital operations, are taken from the Ministry of Plan's SeriesRetrospective 1985. A more detailed breakdown of some of the aggregatecategories is obtained from the Ministry of Finance's Budget. Detailednotes to Table Al, indicating assumptJ,ns used to reconcile different datasources, are available from the World znk country desk.

4. Table Al also includes an estimate of budgetary transfers topublic enterprises over the period. "Balancing subsidies" are taken fromthe "comptes economiques", and "operations financeres" are the same as line33. "Onlending" ("prets retroc6d6s") were provided by the Department ofPlanning and are subtracted from total extrabudgetary foreign borrowing toobtain "capital subsidies" (see Annex B for further explanation). "Loanrepayments" are obtained from the Series Retrosoectives and the VIIth Plantables.

1/ An historical series, known as "comptes economiques", is available forthe period 1972-88; but it omits the special funds and extrabudgetaryoperations and is not compatible with budgetary projections.

sem t utt ost st *-U i tins *- s*s s-0 ssi t1O-Ct- e-l sn- e- se- me- o- e* si$_- hasinAVm MV-N w" VI" VIN V VN VIM WIN tCr m mauuet

tN VV VI WIN V#- VI" Vi V tVI" WIN VI" (sOAIv t*-Ut 5-t5 53"t COSt 5W Pi *-U *-5 S-i t iImd U- C s-Ot st *-n em rot tmt t-s vt tul gn __m _awu

UALH & CEII_L a o

@ *- 0 5t *1- St- 010 V0* *It SW 11 l St

ow it- see is t rt *'St T:*s elm sm2 AM *uMs eto-n a 'All ous elw s 0 ote ems ed s a C:uw mua w AmVP

so Als *ls *I5" w SIM #'A ra C51 -C -I eN otosu SI= I'mU *-0s s1o s-C gt flt v0 wainnu nsA eM Its*On- rSM- *`mU- AIt- rsw-ust oem- 1t-1 0e- .u_Ao As wMo t

-4:t *-tO 41,1101 *-UL elm 0-60 OIL" 91- I'm (-VDt#t)7 Ic 'N"OlBlom VTA& s,As tms& sltI'oslw SGSom os.Oe * vCamweuw m 111 WJAL aPe*emi *-tL *-m vie o'm ttei sst ros eon mise s_LtO0want e

set set vms set inst sm9 Ala a's csl- wnmi 5U wAV aVIiN VI N tWI VI" VN V*N t-N VI WI m AN AMR= aVW WN VI" VI" VI" 5N VIN VIM WIN Am" iam orV-N V-N t-N VN SN V-N VN V*N t-N mu mset Aet An Is n* is oem sla t ets 0 I II Ou N tC emts*I mlm *s11t semi s19 tis *-U isa *,t MId iVDm asemi remi mmmi m t- nm O-U ga st esa _sin nms e*ss *tm urn sew seem iisi smt ems tes inmi walc is

set sow sem em s-n stOt seeb see1 g-* m sems emi5"t-t -ti5 CUt s-Oi eli 55 55 55 S110 z 55 sel s e se Al I Ol* S ,1 el' :i A3U110t*-t fl ou s'tl snt *ln l*- t tt 'ts 1S11110 1W11 5VI" VI W V IM WIN VI" N VI" WN ui N VNM emWIN tWN VI VN VIIV VI" VI" WN VI" UI11Ail AM &WAZZU W

i *.s@ot e *V at us S tII oost OW N Q" 5 do oW0Ol 0--0 O 0@0 Ollt t- 0-0 0c0 MD "Cam m aO-U smisot*s-t ems so Ote e*as ei,i mestu. t-Y mutem-in Uelm1 *-t?,1 elm OtS oel SW *tt es i*tn 1US IM SUtO1 DerAS -'t ' n a" slot *-19 ra 9-tt j1xL#"t V orPI SIM Als Alta *'M sagee 92ti elan smi 9ITTI uliwwS I o" arte rsm *-m rse est e; r tI rs rovti 11dilw*- 51rou" O0 setm f- 'm- tim sl-e flo eta Gwm u-INu a

15101 OIP O-5 O-5 m-iSt ici nm sn sm" wsme aiD attw re nos eent vt Oesst AlM *- t *-a Sl ewzt)lUm wAIaW St

655 t Isi set 0 Olt se- so 0tt- Inws mun St111lt seot mct aso eA isa A's Ill st 'Af xvi-... am VIst slo ctt -e *Ie *- s-t 11S st en tslm *In se ts- *e-t etl t-n tm t S Ad- WM lWUUCt 5el" Oes ra Um sOt el rsi ii *It iA mao ti

&le $la *`1 s-tttt lot *" *InZ #lK slot S!11111 vO attiL n 55 O- W Set Se* t C-U 5lS t*St -et *_i s ff *-vm $ u -tt sem vto m-m se. -*s gem ems m _U NVSet set * s t tolt t e as st st 5315 Now AI'mt slo tIOL lem st 1it eIn els slo e. 51510111161121111 do Sea&t ,tm elm senm ,a t-U got *,a *,- MISS J W 5

'*sw emin sre tet vtU iou r* ms6 Olt 55 $M s t*-~~~~~~l *111- *In S It *" SI"W el $-"t Alf Isemi semi ~~elm lto dta s oiwe see slm 211111Mit

sgi@t met sel. t,em slue so elm a,= AIM svq WA

Mt elt out Ast ost gast nt mast 11st

I. mum mA=-in u

es.' rscl em smm esis -tie em |cm Iv0oe toe s- sum- 0c *- ot- *c- *et- Kmeav wat0oo set e,0 #It *flu es eIn SAD (moiwi &hwAd) aewneOtS *,4Ot Wt cma sls i*tOt VIOL 0-0 Ce) urm WAdO inun0'0"t t-OM *-61 *- tAO Xec g- 0-"I *`= SU23O _<J NUOout 0tor ten t" %li i,s Alm elm (I i1 zu maw"

mimeUP =3IWW OS

ress T*sec Ocis elm ins sectt SIMt s*sit .eIj.wzA.vif A vAOL Sto*lo ice rm flu eom cAB #la Wet AAarUwAteast oot neit SIM flat c e e_ aAM NNW" Str°e t-eo oe- oa cm cot o*tt i. C.-umetzuDsw _ m te

o-ne t-m o-n test teet sec meet ct mYe LLmaireu

sin- o*- oe- VIs- tie- *'eTe- Wies- 0*ss- miin AI. iwci it

oec Ies seems* ilte s te"m slts cowet teett OtUIInM AMeWAnA 6c

rem fla Al" cist tlab va teet sos sM EO INWAV Rtseco Al" t'm ot el" tes -t sintt s-m0 WIfU V AN aN aVIM" Al" *la $l -S6 -10 t-U^ *-9 {-SlDlf AO nSU0

toe 0ut ter cm - *,Tm ses eTo smt iAi Aevi W

3 om *,te *-n *Im tttc sees sue sect t WU0M *At os _

s3 sas tue to tOte 0-s te cit waUzisn Wav isW3-s rues scc vac t-, Ote see tm" U55A1 wvesc

3-0t 0-0 0- OVI sot SI" el" o*c slo JAM ia

ltm oDM SIMI *em net reon tIAs Al" WIWAVd AMO At

O no cm ne ec e sm enc umSfeu.

3c cot sla *a cm ems its flt Uzvi uotn& me AW2e W0-tS 0-41 ol-l O-t O-"t O- flt olt - " WV40'N AMALU

rum VoI elm onie Ot-s cmi ese6t etet *f w'ua low INd te0ect oes 0O t cI 0ee *o 1A ec = tw do ac0"° em tel tc tIM sla em clCi: inwdi v mnvn aOWu Olen tI-a cmi slm Aom elm root mtn,i s sow s°Se neSs VAU cOIs tem C'S s*61° t'tt utW?ES9 ow em

ctsM scat -tWAt -sssT eim t avert sstt 0-n miizUS e Am_D at

oti tic test tnt c:t e*sAT tes i:sI t Mit No" Tmel Ztet ten nec a on e ces O- M XVs-sw - ttw t

,,, .,, el$ 5 I's Ot - - 1~ at

-m em seo - e s *- *,t se u.-MC nt O- MD" *icer elm te-U see s0 t-ei elmt seem cS wan n

see *-on *-ngit' m * te I sa lt 0 es c t' no t

ItM elm e-tU celm elm elm slow crn W Swe xO- eslat SIM t:As sec sos l #0 li ims i etwv doa sDIM VeM VA&i sow elm sim tWM sitw -W.L AMiO t

sos ut *-et ciso-tnt Oeem sut seas mai iii n5teems slam sons1 secs c,os eIt46 ,MNt flab offS wvin tt-_$ 11-PA A-d A."1t8 IS r-"At *.VW ronW t

MT M set _se set sMt mt t

(marid urin la)

mm eSHWWW MUeNO 'T-W IWL

- 32 -

BIBLIOGRAPHY

Akin-Rarasapan, Aysegul, and Ishac Divan. "Republic of Tunisia: ExternalLiabilities and Risk Management", February 1989.

Ben Bahri, A., and S. Benzaghou. et al. "Endettement Exterieur De LaTunisie", Preliminary draft, August 1988.

Ben Bahri, A., and S. Benzaghou. "Systeme De Couverture Du Risque DeChange", December 1988.

Caprio, Jerry. "The Tunisian Financial System in Support of Investment",mimeos 1989.

de Melo, M. "Fiscal Aspects of External Debt in LDCe", unpublisheddraft (July 1989).

de Melo, H., M. Leduc and S. Razmara. "A Policy Model for Tunisia withReal and Financial Flows," PPR Working Paper No. 157, January1989.

Faini, R., and J. de Melo, A. Senhadji-Semlali, and J. Stanton."Performance Under Adjustment Lending", The World Bank, November1988.

Government of Tunisia. Various statistical publications.

World Bank. "Adapting Public Expenditures to Changing ResourceAvailability", Unpublished Report No. 6604-TUN, January 1987.