Public Information Notice No. 04/123

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Tunisia

November 8, 2004

On October 27, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tunisia.¹

Background

Over the past decade, Tunisia's economic performance has been one of the strongest in the region, reflecting gradual but continuous structural reforms, well-targeted social policies, and prudent macroeconomic policies. Tunisia signed an Association Agreement with the EU (AAEU) in 1995, marking the beginning of a significant opening to trade with the EU. Fiscal and monetary discipline has contributed to macroeconomic stability, in the context of a real effective exchange rate (REER) targeting framework with controls on capital flows.

The strength of the Tunisian economy continued in 2003 and the short-term outlook is favorable. Favorable agriculture production and robust nonenergy exports contributed to high growth and a narrowing of the external current account deficit in 2003. A rebound in tourism, a pickup in European demand, and continued real depreciation of the dinar is projected to sustain this strength in 2004. Monetary policy remains prudent and inflation under control. Greater exchange rate flexibility and the appreciation of the euro vis-à-vis the US dollar have led to a depreciation of the dinar in real effective terms. This flexibility has improved Tunisia's competitiveness and helped strengthen its external position.

On the fiscal front, a low tax buoyancy did not permit further consolidation in 2003, despite the recovery in economic activity. The central government deficit remained at 3.5 percent of GDP in 2003 (excluding grants and privatization receipts), about 0.8 percentage points higher than the budget target. Nevertheless, this allowed for a reduction in the public debt by 0.7 percentage points of GDP, to 61 percent. The 2004 budget deficit target of 2.8 percent of GDP is within reach thanks to measures on the VAT and on subsidies expenditures and higher-than-expected profit transfers from state-owned enterprises.

Banking sector indicators deteriorated further in 2003, in part due to difficult economic conditions in certain sectors such as tourism, as well as competitive pressures, which Tunisia is facing in the context of growing openness. NPLs as a share of bank assets increased by three percentage points to 24 percent in 2003. While these weaknesses do not pose systemic risks in the near term, current lending practices dampen Tunisia's growth potential by increasing the cost of capital.

Despite Tunisia's favorable economic performance, its objective of approaching lower-tier OECD income levels has not been met, and unemployment remains high. Meeting this challenge will require strengthening the macroeconomic policy framework and accelerating structural change. Regarding the former, the authorities are preparing to gradually open up the external capital account. To maintain a measure of monetary policy independence, the authorities have begun a gradual transition toward a floating exchange rate regime. They are also in the process of developing a new monetary policy framework, which should be implemented shortly.

On the structural side, the authorities are implementing reform supported by the World Bank, the African Development Bank, and the EU, under the Economic Competitiveness Adjustment Loan. Aside from banking sector weaknesses, impediments include a still restrictive trade regime (especially vis-à-vis non-EU countries), labor market rigidities, and a business climate not yet fully conducive to private sector dynamism. On trade, measures were taken in 2004 to lower and simplify MFN tariffs and streamline customs procedures.

Tunisia continues to improve the quality and dissemination of statistical data and increase the transparency of its economic policies. Tunisia has published all Executive Board documents and staff mission statements in recent years, and intend to publish the 2004 Article IV Staff Report and Selected Issues papers.

Executive Board Assessment

Executive Directors commended the Tunisian authorities for the success in maintaining the economy's resilience and strength, notwithstanding recent shocks and sluggish growth in Europe—Tunisia's main export market. Directors noted that forward-looking and outward-oriented structural policies, in conjunction with prudent macroeconomic management and well-targeted social policies, have put Tunisia among the leaders in the region in terms of growth and market-oriented reforms. They praised the authorities for maintaining close and productive dialogue with the Fund.

Directors noted that, while the economic outlook for 2005 remains favorable—underpinned by a rebound in tourism, agriculture, and exports—the main challenge for Tunisia is to solidify conditions for strong, sustainable growth to attain lower-tier OECD income levels and reduce unemployment. They therefore encouraged the authorities to take advantage of the current environment to accelerate reforms aimed at raising the economy's potential and creating a business environment conducive to private investment. Appropriate sequencing of these reforms while maintaining social cohesion will be key to the success of such efforts.

Directors welcomed the fact that the mix of monetary policy and gradual increase in exchange rate flexibility has helped improve external competitiveness and strengthen the external position. They agreed that the current monetary policy stance is appropriate, but encouraged the authorities to remain vigilant against price pressures as the economy expands, in order to safeguard the competitive gains that have been achieved thus far.

Directors endorsed the authorities' phased approach to liberalizing capital flows and plan to eventually float the dinar. They underlined the need to lay the groundwork for such a transition by strengthening the banking sector, reducing public debt, and deepening the development of money and foreign exchange markets. Directors welcomed the recent steps to increase the role of market forces in determining the exchange rate—including decisions to reduce the surrender requirement and to eliminate the requirement for banks to transfer foreign exchange balances to the central bank on a daily basis, the "nivellement"—and encouraged the authorities to discontinue posting bid/ask spreads for the exchange rate. They noted the considerable progress that has been made in developing a monetary framework aimed at price stability, which is a prerequisite for a floating exchange rate.

Directors expressed concern that banking sector weaknesses, especially the high level of nonperforming loans (NPLs) could potentially constitute a major vulnerability. They welcomed the steps taken recently to strengthen supervision and accounting standards, reduce NPLs, and increase provisioning. However, Directors noted that additional measures are needed and urged the authorities to adopt stricter provisioning rules, enforce sanctions against banks with insufficient provisioning or capital, and reduce the government's role in the financial sector. They also encouraged the authorities to broaden the banking sector reform agenda in line with the FSAP recommendations. In this connection, Directors welcomed the authorities' intention to request an update to the 2002 FSAP. They underscored the importance of consolidating the banking sector before any substantial progress is made toward an exchange rate float and capital account liberalization.

Directors commended the authorities' efforts to contain the negative impact of high oil prices on the 2004 budget and supported their intention to carry out a broad reform of the tax system, with technical assistance from the Fund. They stressed the need to adopt a budget for 2005 consistent with the objective of reducing the public debt-to-GDP ratio, especially external debt, over the medium term. This, together with prudent debt management, will help strengthen confidence in the currency. Directors urged the authorities to redouble their revenue-enhancing efforts, through improving tax collection and administration, phasing out tax exemptions, and widening the tax base. They also encouraged the authorities to undertake a reform of the subsidies system and to consider a broad-based civil service reform to enhance the efficiency of the public administration and contain the wage bill, while protecting allocations for health and education. In this regard, the planned introduction of a performance-based budgeting system should help guide budget decisions.

Directors commended the authorities' structural reform efforts and noted that emphasis should remain on enhancing the business climate, attracting foreign direct investment, and improving the regulatory framework. They welcomed, in particular, the progress in integrating trade with the European Union and the continued efforts to enhance regional integration within the Maghreb region. Directors nevertheless highlighted the benefits of accelerating trade liberalization on a multilateral basis, in terms of improved productivity and greater trade opportunities. To this end, they encouraged the authorities to continue lowering most-favored-nation tariffs within the 2005 budget law, and to reduce nontariff barriers, including by pursuing further reforms in customs administration, and liberalizing the distribution and transportation sectors. Directors welcomed the decision to study options for dismantling state import monopolies.

Directors noted that the recent measures to enhance labor market flexibility are important steps to reduce unemployment and support labor reallocation in response to changes in the economic structure. They encouraged the authorities to streamline labor regulations, continue to pursue active labor market policies, and explore further ways to enhance labor market flexibility, with a view to ensuring that growth translates into reduced unemployment.

Directors commended the authorities' record of transparency. They welcomed the ongoing efforts to improve the quality and dissemination of statistics within the framework of the Special Data Dissemination Standard (SDDS), as well as the intention to update the 1999 data ROSC.

Directors welcomed the recent creation of a Financial Intelligence Unit and the adoption of a law on anti-money laundering and combating the financing of terrorism (AML/CFT). They looked forward to the full implementation of the law, which is expected to contribute to a significant improvement in the country's AML/CFT regime.