Mission Concluding Statement 

Syrian Arab Republic —2009 Article IV Consultation, Preliminary Conclusions of the IMF Mission

February 3, 2010

This concluding statement summarizes the preliminary findings and recommendations of the IMF mission, which visited Damascus during December 7 21, 2009 to conduct discussions for the 2009 Article IV consultation. The mission would like to thank the authorities for their excellent cooperation and hospitality.

I. Recent Economic developments

1. The impact of the global financial crisis on Syria has been relatively moderate and mostly through linkages to trading partners in the region and Europe. Overall real GDP growth is estimated to have decelerated in 2009 by 1 percentage point to about 4 percent. This reflected a slight increase in oil production and a decline in non-oil real growth by 1.5 percentage points to about 4.5 percent. Lower growth in manufacturing, construction, and services was partially offset by a moderate recovery in agriculture. Unemployment is estimated to have increased to almost 11 percent. Inflation declined sharply to about 2.5 percent, reflecting a reversal in the global prices of food and basic commodities.

2. The overall fiscal deficit is likely to widen in 2009 by about 2.5 percentage points to almost 5.5 percent of GDP. The consolidation of public finances in the preceding few years provided room for the authorities to undertake counter-cyclical measures to mitigate the effects of the global economic crisis. Total expenditure is estimated to have grown by about 5 percent of GDP mostly due to increases in public investments, as well as in the wage bill and transfers to partly compensate for the increase in fuel prices. The projected implementation of public investment is contingent on further rationalization of appropriations in the initial budget and an implementation ratio that is in the same order as in 2008. Non-oil revenue increased, partly due to strong tax collection, which reflected improved administration and incentives to settle arrears. Furthermore, surpluses of public enterprises to the budget recovered somewhat from their low levels in 2008 which were partly due to the high prices of their imports in that year and to administrative prices.

3. The external current account deficit is likely to widen to about 4.5 percent of GDP in 2009, as the decline in exports of goods and services exceeded that of imports. Tourism receipts were buoyant, and both FDI and remittances dropped only slightly despite the global economic crisis. Gross reserves remained comfortable at about US$17 billion.

4. To support lending, especially to investment projects, the central bank took a number of measures. These included: (i) reducing the reserve requirements by up to 5 percent for banks that increase their lending for investment projects; (ii) requiring selected public banks to write off penalty on overdue debts and extend the repayment time; (iii) reducing the indicative deposit interest rates from 7-9 percent to 6-8 percent; (iv) establishing a Lender of Last Resort facility; and (v) increasing the credit exposure limit for development projects from 25 percent to up to 35 percent for a single project. In addition, the Ministry of Finance introduced tax incentives to encourage companies to contribute to strategic objectives such as locating in remote areas, increase hiring, and placing initial public offers in the stock market.

5. The authorities also undertook a series of actions to mitigate the impact of the draught and higher diesel prices on the agriculture sector. These measures included tax breaks for farmers in the regions affected by the draught, rescheduling loans, writing off penalty on arrears, and increasing procurement prices of key crops. The government established the Agricultural Support Fund in 2008 with a view to replace many input subsidies by cash transfers to farmers. It was allocated SP 10 billion in the 2009 budget.

6. The authorities continued to advance structural reforms, including by simplifying investment procedures, modernizing accounting standards, and streamlining the tax system. Effective June 2009, they raised the minimum thresholds for wage taxes. However, as a compensatory measure, the top income tax rate for individuals with income of SP 75,000 and higher was increased to 22 percent (from 20 percent).

II. Near- and Medium-Term Outlook

7. The ongoing recovery in Syria’s trading partners is expected to contribute to a gradual increase in exports, remittances, and FDI. Also, output in agriculture is likely to continue to recover from the severe draught of the past two years. As a result, non-oil growth is projected at about 5 percent in 2010. Inflation is expected to remain low. Banks’ credit to the private sector is projected to remain buoyant.

8. The 2010 budget envisages a moderate tightening of the fiscal stance underpinned by a slight improvement in revenue and current expenditure restraint. In nominal terms, the budget provides for a 13 percent expenditure growth over the 2009 outcome. It includes a small increase in current expenditure and about 19 percent increase in capital outlays, compared to the 2009 budget (and 30 percent compared to the 2009 preliminary outcome).

9. The external current account deficit is envisaged to narrow to about 4 percent of GDP in 2010, partly reflecting the moderation in domestic public consumption. The resumption in global growth is expected to support an increase in other foreign exchange receipts.

10. The medium-term outlook is projected to improve with the gradual global and regional recovery and progress in domestic economic reforms. However, a delay in global recovery or faltering in reform implementation could worsen the outlook and impede Syria’s economic growth.

III. Policy Discussions

A. Fiscal Policy

11. The widening in the fiscal deficit in 2009 was appropriate to mitigate the impact of the global recession. However, a gradual resumption of fiscal consolidation going forward is necessary in order to preserve fiscal sustainability. In this connection, it would be important to revisit the large budgeted increase in public investment especially after its sharp increase in 2009. This would be more in line with the absorptive capacity and would help reduce the overall fiscal deficit to about 4.7 percent of GDP. For the period ahead, the mission urges the authorities to ensure that increases in public sector wages are linked to performance and to civil service reform, with a view to enhance efficiency. The private sector should also be encouraged to take the lead in upgrading the infrastructure and in implementing other investment programs, including in the context of public-private partnership (PPP) arrangements within adequate safeguards.

12. The commendable recent reforms of petroleum subsidies have led to considerable efficiency gains and a reduction in waste and leakages as reflected in the decline in domestic consumption. The authorities eliminated coupons for diesel and introduced targeted cash transfers to compensate vulnerable households. These reforms will help reduce fiscal costs, while enhancing the targeting of assistance. In this context, the mission encourages the authorities to prevent a re-emergence of the large inefficient price subsidies of the past.

13. The mission welcomes the substantial progress in the preparation for the VAT, but further efforts are still needed. Achievements include the drafting of the VAT law and tax procedures code, the establishment of the large taxpayer office and the General Commission for Taxes and Fees (GCTF), and substantial modernization and advanced preparations for the VAT at customs. The mission recommends accelerating progress in reorganizing tax administration, including by shifting more responsibilities to the GCTF. The mission supports the streamlining of the tax system, and advises against a further increase in the tax rates. It encourages the authorities to streamline excise taxes in line with the recommendations of past IMF technical assistance missions.

14. The mission recommends a shift in the financing of the budget deficit from bank borrowing to issuing treasury bills. The interest rate on the treasury bills should be market determined. At the same time, it would be important to ensure that public investment projects yield high economic and social return in order to justify the cost of their financing.

15. Considerable progress has been made towards improving public financial management. The current and capital budgets have been effectively integrated, and are now prepared and monitored by the Ministry of Finance. For the first time, a program- and performance-based budgeting approach was adopted for the agriculture and education sectors in the 2010 budget. The mission encourages the authorities to extend this approach to other key sectors.

16. Substantial quasi-fiscal operations continue to be conducted by public enterprises and state-owned banks. It is essential to bring on budget these operations and improve the timeliness of expenditure reporting by regional entities. In addition, the efforts to cast the budget formulation and execution in a medium-term framework are welcome and should continue, including by further empowering the newly established Fiscal Forecasting and Planning Units at the Ministry of Finance and facilitating a more timely flow of data and information between these units and the different departments at the Ministry of Finance.

B. Monetary and Exchange Rate Policy

17. The mission welcomes the progress made in implementing the reform agenda to modernize the Central Bank of Syria (CBS) and the monetary policy framework, but important challenges remain. In this context, enhancing the CBS operational independence would strengthen its ability to formulate and implement monetary policy. The mission also encourages the authorities to utilize treasury-bills as an instrument of monetary policy to withdraw the large excess liquidity in the market. Otherwise, the CBS would have to issue its own certificates of deposit. Consideration should also be given to securitizing the stock of government debt to the CBS.

18. The CBS has recently taken a number of decisions to mitigate the impact of the global financial crisis. Adjusting the reserve requirements based on the volume of lending for investment purposes can encourage bank financing of less profitable projects over time. The government needs to phase out the public banks’ preferential lending schemes in order for banks to allocate their credit based on their own internal lending criteria. Furthermore, the recent increase in the credit exposure limit for development projects could increase banks’ vulnerabilities. To limit this risk, the CBS established additional conditions on this credit to safeguard its quality. The intended legitimate objectives of the above measures can be achieved through other means that are more effective and entail lower risks for banks and lesser burden for the supervision department. In general, the existence of the differentiated reserve requirement, indicative deposit interest rates (in the absence of treasury bills), and directed lending by public banks would hinder the intended development of a market-based monetary policy framework. The authorities are, therefore, encouraged to phase out these practices.

19. The impact of the global crisis on the financial sector has been limited due to the low degree of its global exposure and CBS’s prudential requirements. The capital adequacy ratio for the consolidated banking sector is reported at about 20 percent. This is above the minimum requirement of the CBS and the Basel Committee. Private banks continued to be liquid and their average non-performing loans (NPL) ratio remained low. Profitability of private banks and their non-performing loans remained stable.

20. The mission welcomes the authorities’ good start at implementing the recommendations of the 2008 FSAP report, including by advancing the regulatory and supervisory framework and improving collection of data on public banks. The authorities are encouraged to continue to strengthen supervision in order to maintain the health of the financial sector, especially in view of the rapid growth of private sector credit. Furthermore, implementation of a number of recommendations requires amending the central bank law. The mission encourages the authorities to adopt the amended law as soon as possible.

21. Priority in the period ahead should be placed on public banks’ reform. The average capital adequacy ratio for these banks is reported at about 23 percent, and their average non-performing loan ratio at about 6 percent. However, the NPL ratio is likely to be significantly understated as public banks do not classify many of their loans that are in arrears as bad loans, since most of these loans are implicitly guaranteed by the government. In general, roll-over of bad loans is extensive, hindering a meaningful calculation of these indicators. The recent CBS regulation limiting the roll-over of loans should help clarify the true position of these banks in the period ahead. The mission welcomes the closer collaboration between the Ministry of Finance and the CBS regarding supervision of public banks. The CBS should have full supervisory and regulatory independence with respect to these banks in order to ensure their compliance with prudential regulations and to effectively address deficiencies identified by the supervisory process. The mission welcomes the intention to require all public banks to undergo independent audits.

22. The Syrian pound has appreciated by about 6 percent against the dollar in 2008 in nominal terms. This contributed, along with the high domestic inflation that year, to a real effective appreciation of about 14 percent. This trend has started to steadily reverse since March 2009 with the substantial depreciation of the dollar against the Euro and the decline in Syria’s domestic inflation. Preliminary econometric estimates, which suffer from serious data shortcomings, suggest that the real exchange rate of the pound may be moderately overvalued relative to its medium-term equilibrium level. The mission does not recommend a change in the current nominal exchange rate level in the present context, as it appears in line with market forces, and in view of the data shortcomings highlighted above.

23. The Syrian pound’s de jour peg to a band around the SDR can provide a strong monetary anchor while allowing some flexibility in the pound’s rate vis-à-vis major currencies. This increases the scope for monetary policy independence. In practice, the pound appears to be de facto pegged to a basket in which the dollar has a larger weight than its weight in the SDR basket. Adjusting the de facto basket in line with the de jure regime would be more consistent with Syria’s direction of trade. The dollar has the largest share in the SDR basket, which is also consistent with the key role it has in foreign exchange markets and international trade pricing and payments. A gradual move toward greater flexibility over the medium-term as the monetary policy framework develops would further increase monetary policy independence and maintain external stability.

C. Structural Reforms and Other Issues

24. Advancing structural reforms are essential to accelerating growth, economic diversification, and employment creation in line with the authorities’ objectives. Progress has been made in many areas, including reducing import tariffs, shortening the import negative list, reforming fuel and agricultural subsidies, and improving the business environment. It would be crucial to sustain the reform momentum in these areas, as envisaged in the 11^th five-year plan. Emphasis should be placed on further reducing the number of goods subject to administrative pricing, and modernizing the legal and regulatory framework in order to encourage private investment and enhance competitiveness. The authorities recently introduced reference prices and customs duties that vary by country of origin to protect against unfair trade practices. The mission recommends that the authorities address the underlying problems by other measures such as enhancing customs’ capacity to examine invoices through computerization and cross border cooperation.

25. The mission welcomes the authorities’ intention to accept the obligations of Article VIII of the IMF’s Articles of Agreement. Each citizen is now allowed to purchase up to $10,000 per month from a local bank and to transfer this amount abroad in payment for current transactions or credit cards bills. The mission recommends that the authorities remove any remaining restrictions in preparation for the acceptance of the obligations of Article VIII.

The mission urges the authorities to improve data quality and provision to facilitate economic analysis and inform policy making. Data quality and provision are significantly below what has been achieved by countries that are at a similar stage of development.