Mission Concluding Statement 

•It is important to press ahead with preparations for the transition to an inflation targeting regime in view of the increasingly open capital account. The authorities aim for full capital account liberalization and a free-floating exchange rate regime over the medium term.

•A sound and competitive financial system is essential for harnessing the full potential of Tunisia's economy. The mission notes that prudential indicators have improved significantly since 2003, although the NPL ratio remains relatively high at 19.2 percent of total loans at end-2006. The authorities have been implementing a comprehensive strategy based on the main recommendations of the 2002 Financial Sector Assessment Program (FSAP) and its 2006 update.

II. Trends in the Economic and Financial Situation in 2006

4. Over the past two years, the Tunisian economy has shown great resilience in the face of surging prices for oil and other imported commodities, sustaining relatively strong growth while maintaining macroeconomic stability.

• Real GDP growth accelerated, from 4 percent in 2005 to 5.4 percent in 2006, owing to a rebound in agricultural output, expansion of nontextile manufacturing, and vitality of the services sector. Robust income growth and abundant liquidity boosted domestic demand. The more rapid pace of growth did absorb the substantial flow of new job seekers but was unable to reduce the unemployment rate.

• Inflation has been kept under control, after a spike in the first half of 2006 on account of rising international prices for oil and other commodities, as well as episodes of excess liquidity and deteriorating terms of trade. However, it was swiftly restrained following the monetary policy tightening by the Central Bank of Tunisia (BCT) in the second half of the year. Inflation fell to 2 percent on a year-on-year basis in April 2007 after having reached 5.3 percent in May 2006.

• The BCT tightened its monetary policy during the second half of 2006 by raising its lead rate by 25 basis points in September and the reserve ratio from 1½ percent to 3½ percent in November. Inflation has trended downward ever since.

• Asset prices are rising. The stock market has recorded substantial gains (the TUNINDEX and BMVT indices increased by 44 percent and 40 percent in 2006, respectively), owing partly to foreign investment. Similarly, the real estate market has also experienced inflationary pressures although lack of real estate data hinders a precise assessment.

• The depreciation of the real effective exchange rate slowed down in 2006. The dinar recorded a depreciation of about 0.8 percent in 2006 in real effective terms. The depreciation of the dinar since 2001 largely reflects the worsening terms of trade and trade liberalization particularly with the EU. The BCT's intervention on the exchange market, in decline over the past five years, is limited to liquidity injection operations, given the structural deficit on the foreign exchange market. This deficit is attributable to the fact that the foreign exchange market intermediates only current account transactions, which are in structural deficit. Indeed, most capital account transactions still face restrictions. Furthermore, the sizable foreign exchange inflows from privatization are generally managed by the BCT.

• The current account deficit remains sustainable, although it increased from 1.1 percent in 2005 to 2.3 percent in 2006 due to rising oil prices. Excluding energy, the current account balance is close to equilibrium. The balance of payments recorded a surplus thanks to the partial privatization of Tunisie Télécom, which yielded
US$2.2 billion. At end-2006, international reserves amounted to about five months of imports of goods and services. The use of a part of the privatization receipts has made it possible to reduce the stock of long-term and medium-term external debt from 54.1 percent of GDP in 2005 to 47.9 percent in 2006. Total external debt (including short-term debt) fell from 65.4 percent of GDP in 2005 to 59.1 percent of GDP in 2006.

• Fiscal policy remained prudent. The budget deficit for 2006 is estimated at 2.9 percent of GDP, well below the 3.6 percent projected in the budget law, reflecting restraint over non-subsidy expenditure and improved performance of nontax revenue. Early debt repayments reduced public debt from 58.3 percent of GDP in 2005 to 55.4 percent of GDP in 2006.
III. Outlook

5. The short-term outlook is positive. Growth is projected to accelerate to about 6 percent in 2007, owing to strong agricultural output, a recovery in textiles, and a buoyant services sector. This growth acceleration is presaged by a substantial increase in imports of capital goods and commodities at end-2006 and in early 2007. After decelerating rapidly over the first four months, inflation may increase slightly in the latter half of 2007 due to the 6.3 percent average increase in domestic prices of petroleum products, in addition to seasonal factors. Nonetheless, average annual inflation should be around 3 percent. Although the budget balance will change little in comparison with 2006, the external balance will slightly worsen in 2007, reflecting a small increase in the deficit in factor services.

6. Overall, the balance of risks is tilted to the downside. The positive short-term outlook hinges on agricultural output returning to trend, oil prices remaining below $70 a barrel, and growth not faltering in the EU, Tunisia's main export market.

7. The medium-term outlook remains favorable. The medium-term potential outlook is estimated at about 6¼ percent, underpinned by the reforms announced in the XI^th Plan. The budget and current account deficits are expected to converge to respectively 2.1 percent and 2.0 percent of GDP by the end of the XI^th Plan. The public debt and the total external debt (including short-term debt) should move toward 45 percent and 51 percent of GDP, respectively.

IV. Economic Policy Issues

9. Although Tunisia's economic performance has been impressive over the last ten years, the level of growth is insufficient to absorb the sizable flow of new job seekers, particularly university graduates, and to significantly reduce the existing stock of unemployed workers. This Article IV consultation discussions centered on how to strengthen the macroeconomic position and advance structural reforms to achieve higher growth and lower unemployment. More specifically, the mission focused on: (a) consolidating the fiscal position; (b) strenghtening the monetary and exchange policy framework; and (c) addressing the remaining weaknesses of the financial system. By enhancing the flexibility and adaptability of the economy, such reforms are essential in the context of Tunisia's deeper integration into the global economy, including through a gradual liberalization of capital flows.

A. Fiscal Consolidation

10. The fiscal policy stance has been prudent. In spite of the surge in prices of oil and major commodities, the budget deficit was reduced from 3.2 percent of GDP in 2005 to 2.9 percent of GDP in 2006, significantly lower than the budget forecast of 3.6 percent. The mission welcomes this fiscal consolidation effort in a challenging external environment. The rate of indebtedness significantly declined, including through the use of a portion of the privatization receipts. Although total public debt fell significantly between 2005 and 2006, it remains well above the average debt for countries with a similar sovereign rating to Tunisia's. Consequently, the mission supports the authorities' decision to earmark two thirds of privatization receipts for early debt retirement.

11. Fiscal consolidation efforts should continue in order to address growing budget pressures, particularly from demographic changes. Sustaining these efforts will be crucial to preserving fiscal sustainability over the long term, given the outlook for declining nontax revenue and tariff receipts resulting from privatization and trade liberalization, and particularly in light of rising expenditures associated with demographic factors.

12. The financial performance of the social security system has steadily worsened since the end of 1990s. This deterioration reflects major demographic changes leading to the aging of the population. The social security system moved from a surplus of 1.3 percent of GDP in 1999 to a 0.3 percent deficit in 2006. The recent reform of the health insurance system—with the creation of the National Health Insurance Fund (CNAM) which should become operational in early July 2007—is expected to help restore the financial position of the social security system. As for the pension system, the mission supports the authorities' strategy of raising pension contributions in early July 2007. This should eliminate the deficit of the social security system over the coming years, pending a comprehensive reform of the pension system planned for 2010 intended to ensure the system's viability at least through 2030.

13. Given the sizable budgetary impact of medium- and long-term demographic changes, it is important to develop a fiscal framework that allows forward-looking analyses of long-term budgetary issues. The medium- and long-term outlook can be more effectively incorporated into fiscal policy provided the authorities move from cash basis to accrual basis accounting, extend fiscal projections to five years, and conduct studies at regular intervals on the budgetary impact of demographic changes.

14. Considerable progress has been made in the tax administration and policy areas. These reforms—reflecting most of the recommendations made by IMF technical assistance missions in 2005—pertain to tax administration and policy. Among key measures, the mission notes the reduction of the corporate income tax from 35 percent to 30 percent for most economic sectors, the closer alignment of onshore/offshore regimes with exporters taxed at a rate of 10 percent, the simplified VAT rate structure with the abolition of the maximum rate of 29 percent, the establishment of the Large Taxpayer Unit (a one-stop shop for major enterprises), and the ongoing restructuring of the General Directorate of Taxes. The mission encourages the authorities to continue implementing the recommendations in the technical assistance reports.

15. Fuel subsidies continue to weigh heavily on the government budget and should be phased out, given the long-term nature of oil price increases. A more effective and less costly mechanism for helping the poor would be to replace subsidies by better-targeted transfers. This method has been implemented successfully in other countries.

B. Strengthening the Monetary and Exchange Policy Framework

16. The short-term monetary policy stance remains appropriate but risks of overheating subsist. The tightening of monetary policy in the second half of last year eased inflationary pressures with inflation expected to return to its historical range of 2-3 percent by year's-end, barring another spike in oil or basic commodity prices. However, the BCT should remain vigilant considering the increase in petroleum product prices observed in May 2007, the likely structural nature of the excess liquidities, and the impact from sizable infrastructure investment projects. The latter should be phased in gradually in order to avoid fuelling inflationary pressures, especially considering the already tight real estate market particularly in the Tunis metropolitan area. Close coordination of fiscal and monetary policies will be necessary.

17. The authorities are pursuing a gradual transition toward an inflation targeting framework and free floating exchange rate in the context of capital account liberalization:

•The transition toward an inflation targeting framework continues. Tunisia has recently adopted a broad money (M3) targeting framework with reserve money as its operating target, and the BCT has increased its reliance on indirect monetary policy instruments, such as repos and open-market operations. Last year's amendment to the BCT law strengthened the central bank's independence and defined price stability as the main objective of monetary policy, hence establishing the legal framework for inflation targeting. The recent technical assistance mission by the Monetary and Capital Markets Department (MCM) of the IMF assessed progress to date and outlined the remaining challenges toward an inflation-targeting framework (Box 2).

• Regarding exchange rate policy, the mission encourage the authorities to continue their policy of increasing the flexibility of the exchange rate in both directions in view of the gradual liberalization of the capital account. The mission also encourages closer coordination between monetary and exchange rate policies. In an open economy like Tunisia, exchange rate fluctuations have major repercussions on inflation, debt service, business costs through prices of capital goods and imported inputs, and the purchasing power of households.

•Deep and well functioning money and foreign exchange markets are essential for an efficient and flexible monetary policy. The mission supports the BCT's policy of enhancing the autonomy of the money and exchange markets, thereby contributing to their development by allowing interest and exchange rates to better reflect market conditions. In this context, the mission welcomes the decline in the BCT's fine-tuning operations since the launching of the Real Time Gross Settlements (RTGS) system in November 2006. This measure has had the effect of increasing interbank activity, as evidenced by the heightened variability of the money market interest rate (TMM). The mission encourages the authorities to continue enhancing the autonomy of the money and exchange markets, particularly by improving liquidity management in order to better anticipate the impact of volatile Treasury operations upon bank liquidity, by eliminating the requirement that banks transfer daily foreign exchange balances to the BCT (nivellement), and by delaying the quotation of the daily exchange rates, prior to eliminating this practice altogether at a later time. Ultimately, the de-indexation of bank assets and liabilities from the TMM should give the BCT greater flexibility in using the TMM as a monetary policy instrument. Accordingly, it is important to continue notifying economic agents—particularly banks—of these changes and their resulting implications. This will enable agents to prepare adequately for the total convertibility and floating of the dinar, as well as for the transition to an inflation targeting regime.

C. Strengthening the Financial System

18. The financial sector is expected to play a key role in the implementation of the XI^th Plan. The financial system plays a fundamental role in a country's economic growth via its direct influence on the level of investment through project financing, and its impact on productivity through the selection of quality projects. Therefore, the BCT's efforts to reduce the stock of NPLs is of the utmost importance. While it poses no systemic risk to financial stability, the stock of NPLs dampens economic growth by inhibiting investment through a higher cost of investment financing and reducing productivity growth by slowing down economic reforms, particularly capital account liberalization.

19. To strengthen the financial system, the authorities adopted in 2006 the new banking law designed to promote good governance and improve credit culture. This law has several components. First, it strengthens the governance of banks through systems of internal control, credit committees, and compliance control. Second, the law simplifies the operating conditions for banks. Third, it clarifies relationships between banks and their customers. Furthermore, since 2004, the BCT has prohibited the distribution of dividends by banks that are inadequately provisioned. In addition, the BCT will soon require banks to provision at a rate of 70 percent any new claim recently classified as an NPL. The authorities' strategy reflects the main recommendations set forth in the Financial Sector Assessment Program (FSAP) and its update (Box 3). These assessments were conducted jointly by the IMF and World Bank in 2002 and 2006.

20. The strategy followed by the authorities has produced positive results. For commercial banks overall, prudential indicators show a significant improvement in 2006 compared to 2003, with the NPL to total loans ratio declining from 24 percent to 19.2 percent, the provisioning to total NPLs ratio rising from 43.1 percent to 49.2 percent, and the average risk cover ratio at a comfortable level. This improvement was recorded as much by private banks as by public-sector banks.