Public Information Notice No. 06/89

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with the Syrian Arab Republic

August 7, 2006

On July 31, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Syrian Arab Republic.¹

Background

The economy proved quite resilient in the face of the unsettling political developments, following the assassination of Lebanese Prime Minister Hariri. Economic activity picked up steam buoyed by private investment and supported by the oil boom in the Gulf region. However, growth was accompanied by a rise in inflation, reflecting, in part, an expansionary monetary policy. The non-oil budget balance improved significantly by about 2½ percent of GDP, offsetting some of the pronounced fall in oil revenues. However, this improvement was mainly due to transfers from public enterprises. Similarly, the non-oil current account balance improved, contributing to maintaining external balance despite the sharp fall in net oil exports. Public and external debts remain moderate, and official foreign reserves cover close to 2 years of imports.

The recovery seems poised to continue in 2006 despite the still volatile regional environment. The non-oil GDP growth momentum is expected to be sustained by robust investment expansion and good export performance, reflecting greater access to regional Arab markets and the benefits from the concerted policy to promote tourism. This, together with the windfall from higher oil prices and an increase in Foreign Direct Investment, will maintain a comfortable balance of payments. The 2006 budget and measures adopted subsequently, including the increase in the price of cement and gasoline, is expected to yield close to ½ percentage-point improvement in the underlying fiscal position. Together with a modest increase in oil revenues, this fiscal tightening should narrow the overall budget deficit to 3¼ percent of GDP and limit the inflationary and crowding out impact of its domestic financing. With the recent measures to tighten credit policy, these developments should help in reining in inflation, if supported by an appropriately restrained wage policy.

Over the medium term Syria faces daunting economic challenges. The decline of oil reserves poses a threat to fiscal and external sustainability, and the associated fall in oil revenues will make it harder to preserve, much less expand living standards. A bulge in labor market entrants will strain an already precarious unemployment situation and increase pressure to protect redundant labor in an overstaffed public sector. These challenges are further compounded by political uncertainties and a volatile regional environment. In this context, the surge in international oil prices has provided a short-term windfall but will aggravate the medium-term outlook when Syria becomes a net oil importer around the year 2010 based on current oil price projections. Based on the latest projections for oil output, staff estimates that budgetary oil revenues and net oil exports will deteriorate by more than 10 percentage points of GDP in the next 10 years.

To address these challenges, a number of reforms have already been initiated to encourage private entrepreneurship, promote market mechanisms, open the economy to the rest of the world, liberalize the financial system, and begin to strengthen the medium-term fiscal outlook. Looking forward, the recently adopted Five-Year Plan (FYP) outlines a comprehensive strategy to deepen these reforms.

Executive Board Assessment

Executive Directors commended the Syrian authorities for their steady progress in implementing reforms aimed at encouraging private entrepreneurship, promoting market mechanisms, opening the economy, and liberalizing the financial system. The ongoing pickup in economic activity is testimony to the impact of these reforms on the investment climate. These reforms, together with the support from the oil boom in the Gulf region, have so far allowed the economy to withstand the heightened political uncertainties and maintain forward momentum.

Directors noted that, although the short-term outlook and positive supply response are encouraging, there are important challenges ahead. The short term windfall afforded by the surge in international oil prices will end as Syria becomes a net oil importer in the next few years, with adverse implications for medium-term prospects. Directors considered that the newly-adopted FYP reflects appropriately the need to confront these challenges. They encouraged the authorities to be ambitious in implementing the FYP's comprehensive reform strategy, in particular by pursuing strong fiscal consolidation and structural reforms to create new sources of growth and income to replace the waning oil wealth. Directors emphasized that putting in place efficient social safety nets will help preserve social equity and engender public support for the reform efforts.

Directors agreed that a sizable fiscal adjustment will be needed to preserve sustainability, and in this context observed that the adoption of a transparent fiscal policy framework, aimed at a steady improvement in the non-oil budget balance, would be key to help maintain fiscal discipline. They noted that a front-loaded effort, taking advantage of the current favorable economic conjuncture, would boost market confidence.

Directors agreed that introducing a broad-based value-added tax (VAT) and phasing out petroleum price subsidies should be the main pillars of the fiscal adjustment. In addition, phasing out petroleum price subsidies should generate significant efficiency gains, redress part of the social inequity in the existing policy, and bolster long term growth prospects by enabling fiscal retrenchment without cutting critical spending on education, health, and infrastructure. While recognizing the challenges involved and the capacity constraints faced by the authorities, Directors underscored that steadfast preparation of both these reforms, with technical assistance support, should be given a high priority. In this respect, they called for faster progress in implementing the reforms of tax administration needed to underpin a VAT. In particular, preparations for introducing the tax self-assessment mechanism and opening the first large taxpayers' unit need to be accelerated. Directors also noted the work to be undertaken to ensure that the compensation scheme to mitigate the impact of phasing out the petroleum price subsidies is carefully designed and implemented.

Directors concurred that a tighter monetary stance, along with wage discipline, is needed to reduce inflation pressures. Going forward, they called for the development of market-based monetary instruments. They welcomed the recent steps toward exchange rate unification and current account convertibility, including the relaxation of exchange restrictions on private sector imports, and encouraged the authorities to move towards unification, building on the broad-based political consensus. Directors called for steady progress in the central bank's preparations to launch the interbank foreign exchange market and to develop the technical capacity to intervene to reduce excessive volatility. They considered that although the level of the real exchange rate appears broadly appropriate, its recent strengthening should be monitored carefully in view of the prospective decline in oil exports and the need to promote non-oil exports.

Directors welcomed the fast-paced expansion of private banking activity and strong investor interest in the financial sector. They encouraged the authorities to build on the preliminary assessment of the activities and financial position of the state banks with further steps toward their restructuring. In this regard, independent audits of state banks could help to guide the decision on the restructuring options, including opening their capital to strategic investors, or liquidating significantly undercapitalized or low-franchise-value banks. Directors highlighted the importance of ensuring that bank supervision keeps pace with financial liberalization, and that Anti-Money Laundering/Combating Financing of Terrorism legislation is effectively implemented.

Directors welcomed the steady progress made in trade liberalization, and the authorities' commitment to greater transparency regarding remaining trade restrictions. They urged the authorities to give priority to eliminating key nontariff barriers in order to signal their determination to address the trade agenda. Implementing the regulatory measures under the Syria/European Union Association Agreement will contribute to making progress towards observance of WTO rules and disciplines. More broadly, Directors encouraged the authorities to press ahead with reforms aimed at scaling down the state's involvement in the economy, improving governance, and fostering private-sector growth.

Directors urged the authorities to improve the quality and timeliness of economic statistics, including indicators of short-term activity. They welcomed the authorities' decision to participate in the General Data Dissemination System, which should give impetus to a far-reaching revamping of Syria's statistical infrastructure.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.