A quarterly magazine of the IMF

March 2003, Volume 40, Number 1

Escaping the ghosts of central planning

Many of the MENA countries are grappling with the failed legacies of central planning, including unviable state companies, bloated bureaucracies, a narrow tax base, and expensive subsidies. Public sector reform is one of the keys to reinvigorating these stagnating economies that have been missing out on the benefits of globalization and world economic integration.

Many countries in the region, like others throughout the world, experimented with central planning and nationalization during the 1960s and 1970s in an attempt to promote economic growth and development. But for reasons that are now well known, the dream proved to be unrealizable. State companies tended to be less efficient than their private sector counterparts. Lacking market motivation, state companies were less productive and innovative and therefore registered low returns or losses. They were often launched in sectors in which the country had no comparative advantage and thus required subsidies, explicit or implicit. The pressures on the public purse resulting from losses or subsidies led to underinvestment; any investment that did take place was often misallocated and driven largely by noneconomic criteria. These factors tended to reduce, rather than raise, the growth potential of countries with large public sectors.

Most MENA countries now recognize the need to reform their public sectors; in the last 10 years, many have made good progress in reining in this sector, improving the efficiency and value of public services, and modernizing public finances. But several countries—particularly Libya and Syria—still have very large state-owned sectors. The share of the state in the economies of the region is, on average, one of the highest in the world, even surpassing that of the former Soviet Union and Eastern Europe. The size of central governments is also large by international standards. Measured by the ratio of expenditure (plus net lending) to GDP, the share of the central government averaged about 30 percent in 2001, versus about 27 percent in developing countries generally (Chart 1).

The realization that centralized planning and public ownership were in many ways counterproductive to economic development led several MENA countries to follow the privatization and divestment programs adopted in other parts of the world in the 1980s. Their record, however, is uneven. While good progress has been made in some countries (see box, for examples), progress elsewhere has been slow and, in some cases, nonexistent. And, even among countries making progress, efforts have slowed in the past couple of years, partly because of rising regional tensions and generally deteriorating global capital market conditions, and partly because there are fewer easy (politically or financially) firms to sell.

The region's relatively slow rate of growth, combined with the rapid expansion of its labor force, has resulted in persistently high levels of unemployment. High unemployment has inhibited public support for privatization because it is usually seen as likely to increase unemployment, at least initially, as newly privatized companies lay off workers. Public support for privatization has been especially hard to mobilize in countries with very large public sectors even when governments have the political will to attempt it. This is because vested interests in both labor and management with a stake in maintaining the status quo are better organized and more powerful than the more diverse potential beneficiaries (consumers and taxpayers) of a more efficient system. Some governments have been tempted to sidestep this resistance to privatization by restructuring state-owned enterprises and giving them new management rather than selling them. This approach is usually costly and has rarely proved successful. But many other countries have overcome public resistance to privatization and made progress in divesting. These include Djibouti, Egypt, Jordan, Lebanon, Mauritania, Morocco, Pakistan, Sudan, and Tunisia.

Privatization programs have generally started with the incorporation and sale of state companies in the industrial sector, followed by the more complex process of divesting the state of public utilities and financial institutions. Inevitably, the more profitable firms are usually sold first because they are more attractive to buyers and less likely to involve large-scale layoffs. When more problematic companies move up the list, the pace of privatization tends to slow. Public utilities usually take longer to divest than industrial companies because the vested interests involved include both the producers (employees) and the consumers (who usually enjoy a subsidy), and because privatized utilities (which are often natural or de facto monopolies) require the prior establishment of appropriate regulatory frameworks. Smaller (solvent) financial institutions are usually easy to sell, but larger ones, like big commercial banks, have been difficult to bring to the market. This reflects their high political profile, their role in supporting the rest of the public sector, their large workforce, and the likely cost of recapitalizing them. As a result, the financial systems of most countries in the region—including several that have made good progress in privatization generally—are still dominated by state banks. Such countries include Algeria, Egypt, Iran, Libya, Morocco, Pakistan, Sudan, Syria, Tunisia, and Yemen.

While not all countries in the MENA region have embraced the concept of the market economy, nearly all, to varying degrees, have sought to reduce fiscal costs and improve efficiency by tackling a variety of complex and politically sensitive issues, including the need to

• broaden the tax base and reduce budget deficits;
• address spending on subsidies, public sector employment, pensions, and health; and
• introduce greater transparency as part of governance reform.

Reflecting the heavy burden of the public sector and state expenditures, narrow tax bases, and the slow pace of reform, most governments of the region were consistent net dissavers during the 1980s and early 1990s, with central government budget deficits averaging about 7.6 percent of GDP, compared with 4.4 percent for developing countries as a whole. After the pace of reform picked up and governments began exercising greater fiscal responsibility, the second half of the 1990s saw major adjustments in fiscal imbalances in the region. By 2001, budget deficits had declined to an average of only 1.1 percent of GDP (Chart 2), although there were still some outliers, such as Lebanon and Morocco, with large fiscal deficits. Overall, the improved fiscal situation has been accompanied by lower inflation, smaller balance of payments deficits, more resources for private sector investment, and faster growth rates.

For the oil-producing countries, and especially those in the Gulf region (including Saudi Arabia), rising oil prices in recent years have undoubtedly helped turn fiscal deficits into surpluses. Given that reliance on oil prices to balance the books is a risky strategy, many—though not all—oil-producing countries now take a longer-term view of the "permanent income" of the country and are using "oil stabilization funds" (or their equivalent) to institutionalize the saving of surplus oil revenues in good times.

In reducing deficits, countries need to raise fiscal revenues in a manner that minimizes distortions in the economy and in sufficient amounts to limit borrowing. Toward these goals, there has been an impressive regionwide move to introduce value-added taxes (VAT). Almost all of the new VAT systems have simple rates, few exemptions, and an efficient administration. There are, however, a few countries that do not have VAT or related systems. These include the Gulf countries (which do not have taxes), as well as Libya, Syria, and Yemen. The story of income tax reform is rather different. Most countries in the region still have complex, opaque income tax systems and large and inefficient income tax administrations, often leading to poor, costly revenue collection and abuse. Similar problems exist with customs arrangements, with the majority of countries operating with high and diverse tariff rates and cumbersome and lengthy administrative processes. This has led to significant problems for external trade, depressing business activity and growth in general.

The era of central planning left many countries with an extensive range of subsidies, sometimes explicit in the budget and often implicit, through price controls on public utilities (leading to lower profit remittances to the budget) or bank support for public entities (requiring periodic bank bailouts by the government). Few of these subsidies had a good economic rationale. Nor were they efficient. Most were expensive and distortionary and, when they were provided implicitly through low interest rates or written-off bank loans, risked undermining the financial system and destroying confidence in it. Recognizing these problems, most countries have worked to reduce subsidies and price controls and to make them explicit or to improve targeting of existing subsidies. However, there are still some countries, such as Iran, Libya, and Syria, that maintain extensive generalized subsidies throughout their economies.

The size of the bureaucracy is also a problem. Many countries in the region have large numbers of people on the public payroll, in part an inheritance from the era of central planning. This is an inefficient use of (often well-educated) labor, which could be more productively employed in the private sector (should there be fertile ground for it to grow) and is also a financial drain on the budget. Central government wage bills in the region averaged around 11 percent of GDP during the second half of the 1990s, about double that of developing countries generally. Despite these drawbacks, there has been relatively little progress in civil service reform, in part because the civil service is seen as a convenient device for absorbing the growing numbers of unemployed. Many countries in the region are also burdened by a high level of military spending, whose share of the budget is again about twice the average of developing countries, although these expenditures often reflect ongoing regional tensions. If, and when, these tensions ease, it will be important for countries to ensure that military expenditure is scaled back.

Public services, including pension schemes, health care, and education, also face a variety of problems. Following the sharp increase in population growth in most countries in the 1960s, the average age of people in the region is low. In consequence, most pension systems are currently in surplus, with more young people paying in than old people taking out. However, this belies a critical need in many cases to overhaul these (mostly "pay-as-you-go") systems, which are generally not actuarially viable—as will become clear when the present working generation ages and retires. Careful attention will need to be paid to better aligning benefits and coverage with contribution rates while protecting the budget and future contributors from assuming too heavy a share of the burden. A number of countries have avoided this difficult calibration by funding their schemes. These countries include the oil-producing countries in the Gulf area; they have put their surplus oil revenues to good use so that future pensions can be financed by savings rather than by future generations.

The majority of countries in the region still have considerable work to do to improve the provision and coverage of health care, although a number have good and widely available care, including the Gulf countries, Jordan, Lebanon, Libya, Sudan, Syria, and Tunisia. Some countries have improved standards of care in urban centers but have further to go in extending these services to rural areas (Egypt and Yemen). The region scores better in education, with the majority of countries offering education up to secondary school, and many students go on to university. As with health care, in some countries there is an imbalance in the provision of education between urban and rural areas and, in a few countries, such as Egypt and Iran, there is possibly an overemphasis on tertiary education, with a resulting excess supply of university graduates.

The concept of transparency has become a mantra of modern economic thinking, especially in the wake of the Asian crisis of the late 1990s, and is now seen as crucial for the healthy development of the world economy. The efficiency and fairness of a country's public finances depend no less on transparency than do other elements of a country's economy.

The MENA region has traditionally lagged behind other developing countries in promoting transparency, but important progress has been made in recent years toward reducing the opacity of public finance. Many countries, including Djibouti, Egypt, Jordan, Lebanon, Mauritania, Pakistan, Sudan, and Tunisia, have achieved notable improvements in the reporting of fiscal data, and some of these have also increased the transparency of the budget process. A number of countries have recently submitted their public finances to an IMF review of standards and codes. Reviews for Mauritania, Pakistan, and Tunisia have been published, and more are under way.

Much has been achieved in reforming the public sectors of the MENA region in the past 10 years. But more still needs to be done, both in the public sector and in other areas, if the region is to realize its growth potential and reintegrate with the global capital market. As the experiences of other regions—the former Soviet Union in particular—show, it is possible to escape the legacy of central planning, provided the political will exists and a compelling vision of the fruits of reform in terms of growth and employment prospects can be successfully communicated to the people to garner their support.