Report No. 1 3274-MAG

MadagascarA Strategy for High Growthand Poverty AlleviationAn Economic Strategy NoteJune 29, 1994

Country Operations DivisionSouth Asia and Indian Ocean DepartmentAfrica Region

FOR OFFICIAL USE ONLY

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onty in hepe*wfance of thier officia duies. Its contents may not otherwisebe disclosed without Wor- Bank autorization

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CURRENCY EQUIVALENTS

Currency Unit Malagasy franc (FMG)US$1.00 = FMG 1,914 (average 1993)

= FMG 1,963 (Dec. 31, 1993)- FMG 2,947 (May 9, 1994 -

first day of free float)

MALAGASY FISCAL YEAR

January I - December 31

WEIGHTS AND MEASURES

Metric System BritishWUS Equivalent

I meter (m) = 3.28 feetI square meter (sq. m) = 10.76 square feetI kilometer (kin) = 0.62 mileI square kilometer (sq. km) = 0.39 square mile1 ton (metric) = 2204.6 pounds

ABBREVIATIONS AND ACRONYMS

AIDS Acquired Immune Deficiency SystemBFV Commercial Bank (Banky Fampandrosoana ny Varotra)BTM National Rural Development Bank (Bankin'ny Tantsaha Mpamokatra)BTU British Thermal UnitGDP Gross Domestic ProductILO International Labor OfficeLDC Less-Developed CountryLIR Liberalized Import RegimeNEAP National Environmental Action PlanNIEs Newly Industrializing EconomiesNGO Non-Governmental OrganizationOGL Open General LicensingOECD Organization for Economic Cooperation and DevelopmentPIP Public Investment ProgramSTD Sexually-Transmitted DiseaseSTIMAD Malagasy Corporation for International Telecommunications

(Societe de Telecommunications Intemationales de Madagascar)UNCTAD United Nations Conference on Trade and DevelopmentUNDP United Nations Development Program

FOR OFFICIAL USE ONLY

Preface

This Economic Strategy Note was prepared by a team composed of Pierre

Demangel (Task Manager), Daniel Tommasi (Consultant), and Louis Goreux

(Consultant). Other contributors were Benoit Blarel (agriculture), Bengt Bostrom

(tourism), Dieudonne Randriamanampisoa (private sector), and AF3PH staff (human

resources). Nicolas Gorjestani (Division Chief, AF3CO), Eugen Scanteie (Principal

Economist), Ulrich Thumm (Lead Economist), Jer6me Chevallier (Operations Advisor)

and Francisco Aguirre-Sacasa (Director, AF3) gave substantial advice and direction to the

work. The peer reviewer was Sudhir Shetty. Helpful comments were received from

members of the Madagascar Country Team and the AFRVP economic office. The

Economic Strategy Note was issued in French as a "white paper" in June 1993 and

discussed extensively in Madagascar with the transition government, with political and

economic groups, as well as with the press and socio-professional associations. The new

government formed in August 1993 has formally endorsed the strategy and cleared the

publication of the Note. In May 1994, the government took a number of important

actions, most significantly floating the exchange rate and abolishing import prohibitions.

The PFP prepared in June 1994 by the Malagasy government, with the joint support of the

Bank and the IMF, is explicitly conceived as a first step in the implementation of the

"dynamic reform for sustained growth" scenario presented in the Note.

This document has a restricted distribution and may be used by recipients only in the perfornmane of their l

official duties. Its contents may not otherwise be disclosed without World Bank authorization. l

Table of Contents

SUMMARY AND CONCLUSIONS i

1. Introduction i2. The sustained growth scenario ii3. Economic policies v4. Managing the transition vii

I. INTRODUCTION I

H. RECENT ECONOMIC DEVELOPMENT AND SOCIAL INDICATORS 3HISTORY OF THE ADJUSTMENT PROCESS, ECONOMIC DEVELOPMENT

AND CURRENT ECONOMIC POLICY 3POVERTY, UNEMPLOYMENT, POPULATION GROWTH,

AND THE ENVIRONMENT 4

Im. LONG-TERM PERSPECTIVES FOR DEVELOPMENT 7BASIC OPTIONS 7SOURCES OF GROWTH 10

National savings and foreign aid 11Development of exports and world markets 13Potential by sector 18The role of human resource enhancement 23

MEDIUM-TERM SCENARIOS 24The "do nothing" scenario 25The "adjustment as usual" scenario 26The "dynamic reform for sustained growth" scenario 27

CONSTRAINTS ON DEVELOPMENT 29

IV. ECONOMIC POLICIES TO ENABLE SUSTAINED GROWTHAND REDUCE POVERTY 30

AN INSTITUTIONAL FRAMEWORK CONDUCIVE TO GROWTH 30Role of the state 30A legal and regulatory system conducive to the development

of the private sector 31Macroeconomic policy 34A growth-oriented human resource development strategy 37

POPULATION, POVERTY, AND THE ENVIRONMENT 39

V. MANAGING THE TRANSITION 41PRIORITIES 4 1

Macroeconomic stability 41International trade and finance policies 42Eliminating the barriers to economic activity 42Private sector development 42Human resources policies 43

THE STEERING GROUP 43PARTICIPATION BY THE PEOPLE 44

ii

The Newly Industrializing Economies (NIEs) example'

v. The example set by East Asia and Mauritius demonstrates that it can indeed be done.Since 1965, the economies of Indonesia, Malaysia, Thailand, Korea, and China have on averagebeen growing by over 6 percent a year. More recently, Mauritius has achieved an average growth

of 7 percent during the 1980s.

vi. The conditions that enabled some NIEs to achieve high annual growth and join the ranksof more developed countries have a number of common features. In all cases, governmentsmaintained rigorous and growth-oriented macroeconomic policies that included: (a) economicexpansion driven by vigorous growth in exports and in the manufacturing sector, made possible byan increasingly productive labor force and an openness to the outside world; and (b) anenvironment conducive to entrepreneurial initiative and private investment, where the state haswithdrawn from sectors unrelated to its essential responsibilities. High domestic savings helpedsustain high investment rates, which in turn contributed to significant growth. Considerableresources were also invested in education and health. Private savings, private investment, anddirect external investment constitute the foundations of the new approach.

vii. Sustained growth is inseparable from measures to eliminate poverty and unemployment,control population growth, develop human resources, and protect the environment. Poverty andpopulation growth are major contributors to environmental degradation. In turn, deterioration ofsoil and infrastructure results in declining output and impoverishment of the population. Theachievement of a sustained high growth rate based on labor-intensive export activities is the bestway to reduce poverty, since it gives the poor the opportunity to capitalize on their major asset, i.e.

their labor. The development of education and of primary health care increases the capacity ofthe poorest to contribute to economic expansion, and share its benefits.

Three main economic policy options

viii. Madagascar is faced with choosing among three economic scenarios. The first assumesa continuation of present economic trends, without any major program of reforms. This scenariowould result in a continuing decline in living standards, and represents the most probable outcomeif no corrective action is taken. The second option would involve a program of partial reform

similar to the one implemented in 1988-90. The result would be moderate per capita growth,where 1971 growth levels would not be attained until 2065. But in the long-term, the program

would be difficult to sustain since the business climate would be plagued by uncertainties andprivate entrepreneurs would be hesitant to invest. The third option, "sustained growth, " is barsedon the hypothesis that given more daring and innovative economic policies, annual growth ofabout 6 percent could be achieved by the year 2000, and 1971 living standards restored in about10years. Only with option three could Madagascar see a reduction in poverty by the end of thedecade. This report will attempt to demonstrate that stustained annual growth of 6 percent canindeed be achieved, and will discuss the economic policies that could make it possible.

Strictly speaking, the term "Newly Industrializing Economies" has been used elsewhere to refer to Thailand, Indonesia and

Malaysia. In this report, it refers more broadly to the group of countries which have achieved sustained high growth

through an export-onented strategy.

iii

2. The sustained growth scenario

ix. The sustained growth scenario is based on Madagascar's potential in the agricultural,industrial, and tourism sectors. Its objective would be to achieve steady economic expansion witha target of 6 percent growth by the year 2000, and to subsequently maintain at least that rate.This would involve full utilization of Madagascar's natural and human resources and require over4 percent growth in the agricultural sector, about 10 percent growth in the industrial sector, and 6percent growth in the service sector.

a. Sectoral sources of growth

x. The agricultural sector currently accounts for 32 percent of GDP and employs 70percent of the labor force. To achieve 4 percent growth, an agricultural strategy would requireexpanded production for the domestic market, the resumption of growth of traditional exportcrops, and most importantly, the diversification of agricultural production for export. Foodproduction--the predominant component of agriculture--could be boosted significantly byincreasingyields. The present low yields are a result of both not making efficient use of irrigationsystems, and not exploiting comparative regional advantages. Some traditional export crops--coffee, vanilla, pepper, cotton, and peanuts--could be developed by better organizing theirproduction and marketing channels (particularly for quality control and export promotion), andlifting the export restrictions on vanilla and cotton. Because of Madagascar's rich diversity ofnatural resources, there is great potential for developing nontraditional exports. In recent years,the cultivation of nontraditional products, such as fruit (litchis), vegetables, maize, cassava, andseafood products, has risen dramatically. Actual export volumes, however, are still low due tosmall market shares in importing countries.

xi. The industrial sector represents 14 percent of GDP Thtough originally geared to thedomestic market, it has recently been boosted by new industries made possible by the free tradezone, and a new investment code. New export niches have opened up, particularly in the clothing,shoe, and wood processing sectors. Successful industrial growth will rest on Madagascar's abilityto establish an economic climate conducive to both foreign and local investment. The recentrelocation of Mauritiun enterprises is a good sign; however, economic policies for attractingforeign investment to Madagascar must continue to improve.

xii. Tourism in Madagascar is underdeveloped, in spite of abundant natural resources. In1990, Madagascar welcomed 50,000 tourists, compared to Seychelles' 100,000, the Maldives'160,000 and Mauritius' 300,000. The number of tourists to Madagascar could be increased to150, 000 by the year 2000 by exploiting the country's potentialfor beach, cultural, and ecologicaltourism. This would require improved medium- and long-range air access to the island and theestablishment of well-targeted infrastructure on the most promising sites. Madagascar has thepotential to develop other services, such as consultant services, telecommunications, insurance,and transport, faster than the overall growth rate.

b. Economicfoundationsfor growth

xiii. The "sustained growth" scenario is based upon a strategy of export promotion linked toproduction diversification and private sector development. Sectoral growth can be achieved onlyif Madagascar succeeds in accumulating the needed productive capital, requiring a significant

iv

increase in both the investment rate and the mobilization of savings necessary to fund such

investment. Also crucial to the strategy's success is further development of human capital.

Savings and investment

xiv. The accumulation of productive capital involves raising investment from 11 percent of

GDP in 1991 to over 20 percent of GDP by the year 2000. This is a feasible goal. Successful

NIEs have investment rates topping 30 percent. The investment structure must change even more

dlrastically: private investment (now 33 percent of domestic investment) will have to increase to 60

percent by the year 2000. Domestic savings, virtually nonexistent today, are crucial to the

financing of such high investment rates. An important step to generating public savings is using^ a

rigorous budgetary policy to bring down the deficit. Private savings can be encouraged by

increasing national revenue, creating a financial market, and setting positive real interest rates.

Nevertheless, the country will still require considerable external savings in the form of direct

foreign investment, public assistance for investment, balance of payments support, and debt

rescheduling. As with the NIEs, Madagascar's ultimate success will rest on a sign ificant increase

in directforeign investment.

An export-oriented strategy

xv. 7he economic successes of NIEs and such countries as Mauritius are founded on an

export promotion policy that yielded faster export growth than the growth of GDP. These

countries took advantage of periods of expanding world markets and exported their most dynamic

products to coincide with those periods. In times of world recession, they boosted their exports by

increasing their market share. The steady growth of their exports was sustained by ongoing

diversification efforts. All these countries passed through similar stages: diversification of

agricultural exports, export of labor-intensive manufactured products, and transition to high-

technology products made possible by enhanced human capital. In Madagascar, the expansion of

the free trade zone export industries in nontraditional sectors (vegetables, silk, leather goods,

essential oils, models, bicycles, watches, jewelry, buttons, and electrical equipment) is a positive

sign and bodes wellfor the country's ability to follow a similar development path.

Human resources

xvi. For NIEs, investment in human resources has proved to be a highly profitableundertaking. Upgrading human capital--for example training workers in improved technical and

management skills-can help develop future entrepreneurs and can contribute to productivity gains

across all sectors. Women's education has been shown to have a positive impact on controllingpopulation growth and improving children's health. Rehabilitation of educationi and health

services can improve the access of the poor to the benefits of growth. As with physical investment

Madagascar has a long way to go before these changes can be implemented. teachitng standardshave declined at all levels, and the health care system is extremely inefficient. Human resourcedevelopment is beneficial in the short- and medium-term as well--the economic benefits of

appreciable improvements in education, including vocational training, and health care could have

an impact very quickly.

v

c. Constraints on development

xvii. In order for Madagascar to successfully realize its growth-oriented strategy, the

government will have to eliminate the constraints that prevent the country from fulfilling its

economic potential The principal constraints can be summarized as follows: (a) Inadequate

infrastructure for transport, telecommunications, and electric power. In terms of the road

network, Madagascar has 84 kms of roads per thousand sq. kms of territory compared with 100

kms in Malaysia, Thailand, and Indonesia. (b) Poor social conditions. Poverty, inadequate

education, and substandard sanitation limit the country's ability to contribute to a strategy of

sustained economic growth. Life expectancy is 50 years compared to 60 to 70 years in Malaysia,

Thailand, and Indonesia. The infant mortality rate is 12 percent compared to 6 percent in

Indonesia and less than 3 percent in the other two countries. (c) The inefficiency of government

institutions and their inability to operate within the context of a market-based economy. Many

sector-specific departments still maintain control over private sector investment and

import/export activities, and the legal and regulatory framework is not conducive to private

investment or initiative. (d) A shortage offoreign exchange, which limits economic activity and

reflects the huge external trade deficit. The high level of foreign indebtedness will require debt

relief measures so that the government can restore sound external relations, including with the

donor community.

3. Economic policies

xviii To achieve sustained growth, the government will need to eliminate the above

constraints, and enact new economic policies and implement them with determination. A profound

change in outlook will be needed to keep the state focused on its essential objectives: establishing

a coherent macroeconomic policy geared to financial stability, liberalizing the economy,

improving infrastructure, and waging a comprehensive battle against poverty, environmental

degradation, and the deterioration of social services.

The government's role

xix. The country needs a strong government that can fulfill its essential duty to the people--to

guarantee security, institute a regime of sound macroeconomic management, ensure that the legal

and regulatory systems function properly, and develop human resources and infrastructure. This

implies that the government must abandon its orientation towards state-administered economic

activity, and withdraw from productive activities, both in public enterprises and in public

investment projects. It also implies a reduction in nonrriority expenditure, increased user fees,

and the privatization of services in order to increase efficiency. The same principles should guide

the decentralization process provided for in the August 1992 constitution. The decentralization

process should aim at developing regional potential without increasing the overall weight of

government administration. Public investment programs should be geared to promote economic

expansion while targeting improvements in transport, telecommunications, and social services.Not only the nature but the quality of investment is critical if funding is to generate the desired

growth. Although a high volume of investment was focused on the public sector and university

construction during 19 79-80, it failed to stimulate economic growth. All available funding must

Tables

Table 1: Economic indicators, selected years 1980-92 3Table 2: Socioeconomic indicators for selected developing countries 5Table 3: Madagascar exports 16Table 4: Comparison between countries 24

Figures

Figure 1 - Per capita GDP and private consumption IFigure 2 - Value added by sector 10Figure 3 - Savings and investment 12Figure 4 - Per capita GDP 25Figure 5 - Adjustment as usual scenario 26Figure 6 - Dynamic reform scenario 28

Boxes

Box 1 - Economic indicators for various countries 11Box 2 - Dynamic export products 15Box 3 - Madagascar: Resistant exports, 1980-1990 17Box 4 - Main tourist areas of Madagascar 21

SUMMARYAND CONCLUSIONS

1. Introduction

The challenge

i. Madagascar is a striking example of unfulfilled economic potential. In the last twenty

years, it has experienced an economic decline unprecedented for a country which was never

invaded, nor torn by civil war. Between 1971 and 1991, per capita GDP plummeted by 40

percent. Yet Madagascar has ample resources: abundant, cheap, and easily-trained labor, and a

wide variety of soils, climates, and natural resources, including unique fauna andflora. Not only

has the country become steadily poorer overall, but there has been a drastic widening of the gap

between low- and high-income groups, and a dramatic increase in the total number of people

living below the poverty line. Under the pressure of meeting the survival needs of a population

growing by 3 percent, the society has used its natural resources in a nonsustainable way, causing

a decline in opportunities for growth. It must find a way to shed the crippling burden of

increasing poverty.

ii. Now that it has completed the process of political reform, Madagascar will have to move

to the economic front to combat poverty. After a two-year transition period, the country now has

democratic institutions and freely-elected leaders. This peaceful changeover bodes well for the

Malagasy people's ability to work together, an indication that differences can be overcome to lift

the country out of poverty and support economic takeoff. This ability to compromise, set aside

conflicts, and build a broad consensus will no doubt be put to the test as the elected government

starts implementing the major planks of its new economic policy.

iii. The start of a new political era provides a unique opportunity to rethink economic

strategy. The government is facing an historical challenge: to unleash the country's immense

potential, and make up for lost ground It must establish economic policies through which it can

bequeath to the next generation a very different economic and social outlook. It must fulfill the

vision of a democratic society with a market-based economy in which economic and social

conditions improve consistently, and where the discrepancy with more advanced countries is

steadily reduced To that end, one foresees a competitive economy where the government plays its

usual role in a market-based system geared to private sector initiative, and where investment in

human resources helps train men and women to enhance their well-being and make them better

able to take advantage of economic opportunities and contribute to lower population growth.

iv. Even if the 1988-90 growth rate were reproduced (0. 5% per capita), it would still take a

century to realize any noticeable improvements in living standards. Only with far more daring

and innovative policies can Madagascar hope to achieve economic growth high enough to

significantly reduce the number of poor within one generation, and provide the means for

government to fulfill people's aspirations. Is there a way of achieving 6 percent growth-the

lowest rate that could double per capita GDP in 20 to 25 years-and regain the country's 1971

living standard within a decade?

vi

be put to the best possible use. It is estimated that $1 billion2 in available donor funding stillremains to be disbursed

Macroeconomic policy

xx. The adoption of a rigorous and stable macroeconomic policy is one of the main factorsenabling successful countries to develop rapidly. Broadly speaking, this implies a low budgetdeficit, moderate inflation, a realistic exrchange rate, and a viable balance of payments.Government financial policy must be aimed at increasing public savings, controlling governmentexpenditure (with a focus on investing in high priority sectors, such as infrastructure and humanresources), and raising tax revenue and user fees. A prudent monetary an2d credit policy isrequired to keep reserves sufficiently high and control inflation. Positive interest rates are neededto stimulate private savings. Restructuring the financial sector and privatizing the banks areadditional measures that are necessary for generating adequate financing for the productivesector, particularly private enterprise. Lastly, the liberalization of external trade-fundamental toany significant growth in exports--would require a realistic exchange rate in step with the rest ofthe world and with competitors in particular. The combination of moderate inflation and acompetitive exchange rate would allow companies to become profitable and thereby increase theirsavings and ability to finance additional investment. Debt relief measures should be an integralcomponent of any program designed to re-establish a viable balance of payments. Only thus canthe economy maintain, and even increase, its competitiveness.

The legal and regulatory framework

xxi. In Madagascar, private investment can be developed only to the extent that potentialinvestors believe they will operate under stable and favorable conditions. This means that themanifold contradictions that exist in current laws and regulations must be eliminated, and that alegal and regulatory framework conducive to private sector activity be established Theindependence and strengthening of the judiciary system provided for in the new constitution iscrucial to that process. The private sector requires an environment in which there are concreteand stable parameters, and not where the whim of the current administration governs theestablishment of businesses, the hiring and firing of employees, and import/export activities.Liberalizing a few of the sectors that are still regulated today, such as transport,telecommunications, and vanilla, would send the right message to business. Furthermore, healthycompetition must be allowed to flourish and an attempt should be made to eliminate all public andprivate monopolies.

Poverty, population, and the environment

xxii. Among the main difficulties facing Madagascar are poverty, high population growth, andenvironmental degradation in the form of deforestation and soil erosion. Poverty and populationgrowth are the principal, though indirect, causes of environmental damage. Environmentaldegradation leads to lower crop yields and infrastructure deterioration. Madagascar's quest fo.growth should not be separate from a strategy of poverty reduction and environmental protection.Sustained growth is the prime weapon in the battle against poverty. To achieve all these goals

2 Unless otherwise noted, dollar amounts in this paper are in current US dollars.

vii

satisfactorily, the country will need a coherent program of environmental conservation, family

planing programs, and specific poverty reduction measures which give the poor better access to

productive and better paying jobs. This can be achieved by investing more resources in primary

education, rehabilitating health care, and establishing nongovernment mechanisms to allow small

private companies to bid on labor-intensive infrastructure projects. To protect the most

vulnerable groups, a social safety net based on specific, carefully targeted assistance must be

established and maintainedfor the present. Furthermore, prompt and dynamic measures will be

needed to halt the spread of AIDS, since an epidemic would be catastrophic and compromise the

country's chances for economic growth.

4. Managing the transition

xxiii. An economic strategy aimed at high sustained growth will mean a crowded agenda of

activities in a wide range offields. The government will also encounter considerable difficulty inchanging people's attitudes and overcoming resistance. It will be forced to introduce reforms

gradually, to allow time both for the administration to put them into place andfor the economy at

large to assimilate them. The principal theme of the first phase of reform should be restoring

confidence. Mobilizing private sector support and external investment are the cornerstones of the

sustained growth strategy. To achieve this a climate of confidence will be required to encourage

both local businesses to invest andforeigners to operate in Madagascar. This will also necessitate

that commitments are respected and carried through to the end In order mobilize more foreign

resources, for which developing countries intensely compete, confidence must be restored among

the donor community. In sum, the government must redefine its priorities, set up an economic

management team that can direct the iransition, and encourage the people to participate.

Priorities

xxiv. The priorities for action in launching the reform program fall under five broad headings:

macroeconomic stability, international trade and finance policies, elimination of barriers to

economic activity, emphasis on the private sector's role, and social policies such as population,education, and health.

xxv. Macroeconomic stability is essential to growth, efficient utilization of resources and

long-term private sector investment decisions. It means moderate inflation, access to foreign

exchange and a stable exchange rate, none of which can be achieved without the following:

(a) A prudent monetary policy that is based on controlling private and public credit.

Credit must be extended to the private sector at the expense of governmentborrowing.

(b) Reinforcing budgetary discipline to reduce the budget deficit and to prevent publicsector borrowing from the banking system. This means raising tax revenue andbringing down public spending while continuing to protect high priority sectors.

xxvi. International trade and finance policies must be geared to promote private sector

confidence and investment, which will be necessary for sustained growth:

(a) International trade policy must aim for a convertible current account, the first steptowards total convertibility. This requires a market-determined, realistic exchange

viii

rate, for example, an inter-bank foreign exchange market, if the financial sectorcan support it. A possible transitional measure could be the reintroduction of theLiberalized Import Regime (LIR), though an appropriate exchange rate must beachievedfirst. Prudent monetary and budgetary policies in concert with realisticmanagement of the exchange rate should enable Madagascar to keep the exchangerate fairly stable.

(b) Import liberalization will depend on rigorous budgetary and monetarymanagement. Moreover, external debt relief will be required, along withsubstantial balance of payments support.

(c) The financial system must be rapidly placed on solidfooting ana should includesound banking operations for the inter-bank exchange market to function properly.The state banks, BTMand BFV, should be privatized Market-determined interestrates are needed to halt capitalflight. A treasury bond market, managed by theCentral Bank, will make it possible to establish competitive interest rates, whichwill in turn stimulate savings.

xxvii. Elimination of barriers to economic activity. The government must declare explicitlythat entrepreneurs are welcome and ensure that its administrative requirements do not hamper theestablishment of businesses, investment, the purchase of goods, and the flow of goods andfunds:

(a) Business creation and foreign investment can be stimulated by an unambiguousdirective outlining the acquisition of real estate by foreigners. The one-stopshopping approach should be implemented and be the only requirement foradmission to the free trade zone system and approval under the investment code.

(b) Liberalization of key sectors should be pursued to make the economy morecompetitive and to eliminate constraints on development. These include reforms inthe petroleum and telecommunications industries. Liberalizing the vanilla trade isequally urgent if 'adagascar's share of the world market is to be protectedNegotiations with foreign partners are needed to open up international airtransport routes to swpport business operations and give tourism an opportunity todevelop.

xxviii. The private sector's role in the economy should be clearly recognized By withdrawingfrom public enterprises and redirecting public sector activities and investment towards establishedpriorities, the state will clearly demonstrate that its economic policies are irreversible. This willhelp create a climate of confidence neededfor growth. The state must withdraw from activities inwhich it has no comparative advantage. At the same time it must be more efficient in dischargingils responsibilities:

(a) The government must make clear how, and on what basis, it will withdraw frompublic enterprises, and it must start that withdrawal quickly. It will also need todetermine how to withdraw from medium-sized companies in the secondary sector,including textiles, sugar, cotton, oilseeds, mines, and meat processing, privatize theremaining hundred or so small- and medium-sized businesses (including the 11currently being privatized), and deal with large enterprises including banking, oil,telecommunications, electric power, water, and port activities. The mechanisms

ix

that will be established should aim to make the economy more efficient andpromote competition. The state must begin by establishing the same rules foreveryone to ensure that public enterprises do not receive preferential treatment inany industry.

(b) Enough work has been done to enable the Public Investment Program (PIP) to berestructured quickly. Given the new focus on infrastructure and human resources,this will also help support economic growth. Production-oriented governmentprojects, particularly in agriculture, all projects financed with nonconcessionalfunds, and all projects requiring excessive state contributions should be halted orsuspended Resources should be applied to expediting the implementation andfollow-up of priority projects relating to infrastructure, human resources, and thesocial assistance safety net. Implementation of other projects should be phased inaccordance with the priorities, strategies and availability of local counterpartresources. With the help of donors, part of the project portfolio should berestructured to reflect sectoral strategies.

(c) Reorganizing the civil service to serve as an instrument of support for the country'sdevelopment is a long-term prospect. The action plan for civil service reformadopted in 1992 requires the state to reflect upon its essential functions, and thebest means of discharging them in the context of a move towards decentralizationand an enhanced role for the private sector.

xxix. Human resources policies will have an impact mostly over the long term. But efforts totackle demographic, educational, and health care problems must begin now in order to play amajor role in helping Madagascar achieve its goals in the next 15 to 20 years. Family planningsupport programs need to be strengthened Most pressing--in fact the key to long-termdevelopment--are improvements in primary and technical education.

The steering group

xxx. The success of the reform program will depend on the people who carry it through. Thegovernment will have to forge a steering group of politicians and economists with a coherentvision of the overall strategy, and the abilities needed to guide the reform process. The team mustdraw on the country's best intellects and be given all the technical resources it needs. ThoughSouth Korea, Malaysia, Thailand, and Mauritius may serve as examples and sources ofinspiration, Madagascar will have to find its own way of achieving sustained growth and reducingpoverty. Policies will be dictated largely by economic realities; however, the steering group cantailor implementation schedules and management approaches to take into account Madagascar'sspecific needs, and the Malagasy people's particular aspirations.

Participation by the people

xxxi. The reform program is broad in scope and cannot succeed without the confidence andacceptance of the Malagasy people. There must be broad consensus on economic policies, andpoliticians must take great care to keep economic issues untainted by political controversy.Confidence will also be restored if the government complies rigorously with its laws andregulations, ceases to act arbitrarily, and strongly supports an independent and revised judiciary

x

system. To gain widespread acceptance, the government's economic program must be broadlydisseminated, explained, and discussed The stakes are very high. Knowledge of the program'sobjectives and rationale cannot be confined to a limited group of technocrats, but must be shared

with all citizens. In this way, the Malagasy people can come to understand that everyone must

make sacrifices so that the benefits of growth and a better standard of living can be shared by all.

I. INTRODUCTION

1. Madagascar is a striking example of unfulfilled economic potential. In the past twentyyears, its economy has deteriorated in a way unprecedented for a country which was neitherinvaded, nor tom by civil war. Its GDP per capita plummeted by 40 percent between 1971 and1992 (Figure 1). In the same period, countries such as South Korea and Malaysia--which formerlyhad living standards lower than Madagascar's--now have a per capita income 10 to 30 timeshigher. Not only has Madagascar grown steadily poorer overall, but there has also been a drasticwidening of the gap between low and high income groups. Moreover, there has been a dramaticincrease in the total number of people living below the poverty line. Under the pressure of meetingthe immediate survival needs of a population growing at 3 percent, the country has used its naturalresources at a nonsustainable rate, causing a degradation of the environment and a decline inopportunities for growth.

Filgure 1 - Per capita GDP and private consunption

250

~230

170I150130

I i o

N N N N N ~~~ ~~~00 00 co0 0

Source: World Bank data

2. Is there a way for Madagascar to escape this cycle of poverty? The structural adjustmentprogram introduced in the mid-1980s seemed to offer some hope. Measures to lift price controlsand liberalize internal and external trade, coupled with better management of the exchange rate andforeign exchange allocation, resulted in real GDP growth between 1988 and 1990. However, onaverage, this represented an annual increase per capita of only 0.5 percent. At that rate,Madagascar would need 70 years to regain its 1971 living standard and 139 years to double its percapita GDP. Is it possible to envision a more promising goal--for example, a growth rate thatwould boost the country to its 1971 living standards in 10 years and double its per capita GDP in25 years? That goal could be achieved if annual GDP growth reaches 6 percent by the end of thedecade. Economic expansion in East Asia and Mauritius is evidence that such rapid growth is

2

possible. Some countries, such as South Korea, Thailand, and China, are expanding at rates thatwill double their citizens' per capita income in 10 years.

3. Analysis of the conditions that have enabled several countries of East Asia, and the

countries of Chile and Mauritius to achieve such high annual growth and leave the ranks of thelower-income countries reveals a number of common features. In all these countries, thegovernment maintained sound macroeconomic management; economic expansion was driven byvigorous growth in the manufacturing sector, and in agricultural and industrial exports. Thatgrowth was enabled by a greater openness to the outside world, recognition of private sectordevelopment as a priority, and the liberalization of economic activity including disengaging thestate from sectors unrelated to its essential functions. By contrast, despite the adjustment effortsinitiated in 1987, Madagascar's institutions and regulatory framework are still under thegovernment's pervasive pressure in the economic sphere of activity. Significant reforms are neededto create a climate conducive to expansion based on exports and private sector activity.

4. An essential objective of economic policy is to significantly reduce poverty. If per capitagrowth remains below 3 percent, it will be virtually impossible to bring about a perceivablereduction in the percentage of the population living below the poverty line. Rapid growth istherefore a crucial weapon in the battle against poverty. No country has significantly reducedpoverty without considerable and sustained growth. But rapid growth is not enough: the structureof growth is crucial if the poor are to participate in the process and escape poverty. Thosecountries that have succeeded in reducing their poverty rates have fostered development that usesthe most abundant resource the poor have: labor. They also emphasized enhanced governmentexpenditure programs in health and education, improving the poor's output and ability to earn. Inaddition, population control policies have succeeded in significantly reducing the populationgrowth rate.

5. The purpose of this report is to review available economic policy options to meet theMalagasy government's goal of eliminating poverty. Chapter II describes recent economicdevelopments and illustrates the formidable challenge presented by the extent of poverty inMadagascar. Chapter III discusses medium-term perspectives, based on an analysis ofmacroeconomic and sectoral foundations for growth. Chapter IV outlines the economic policyoptions associated with the "dynamic reform for sustained growth" scenario, and Chapter Vdiscusses the factors that must be considered in setting priorities for implementing selected policiesand managing the transition.

3

II. RECENT ECONOMIC DEVELOPMENT AND SOCIAL INDICATORS

HISTORY OF THE ADJUSTMENT PROCESS, ECONOMIC DEVELOPMENT AND CURRENT ECONOMICPOLICY

6. Madagascar's economic history in the 1980s was largely the result of the "all-outinvestment" approach of 1977-80, preceded by nationalization and economic control policieswhich discouraged development of the private sector, including farmers. Massive investment inthe productive public sector was supposed to drive growth, in turn leading to a rapid increase indomestic savings. Instead the budget deficit rose from 1.5 percent of GDP in 1977 to 13 percentin 1980. The banking system's net assets rose from $8 million1 in 1977 to $20 million in 1980, andthe Central Bank exhausted all its reserves. External public debt, which was $250 million in 1977(13 percent of GDP) rose to $1 billion (32 percent of GDP) in 1980. Automatic adjustment wasinevitable and brutal.

7. As a result of foreign exchange shortages, imports fell between 1980 and 1983, causing adecline in output, particularly in industries that were unable to obtain supplies (Table 1). Thegovemment was forced to adopt a stabilization program designed to contain demand; this led to ageneral shrinkage of GDP, exports, imports, and public expenditure and revenue. By 1986, thestabilization program had achieved its objective. The current account deficit had dropped from 16percent of GDP in 1980 to 6 percent in 1986, while inflation had dropped from 30 percent in 1980to 15 percent in 1986. Drastic spending cuts had brought the public deficit down to 8 percent ofGDP.

Table 1: Economic indicators, selected years 1980-92Indicator 1980 1983 1986 1989 1990 1991 1992GDP (1984 = 100) 109.9 98.3 103.1 112.3 115.6 108.8 109.7Per capita GDP (1984 = 100) 122.3 101.1 97.2 96.3 96.2 87.4 86.2Percentage of GDP:

Imports 29.7 17.5 14.1 21.4 26.9 26.2 24.5Exports 13.3 10.6 12.0 18.0 15.9 17.3 16.1Investment 15.0 8.4 9.0 13.4 17.0 10.6 8.8Domestic savings -1.4 1.4 6.9 10.0 6.0 -0.8 0.4Current account balancea -15.7 -8.6 -6.3 -8.7 -12.9 -11.4 -10.1Budget deficitb -12.8 -4.7 -8.0 -14.0 -9.3 -12.6 -13.1

a. Excluding grantsb. Excluding grants and including interest after rescheduling.Sources: Government of Madagascar, and World Bank staff estimates.

8. In 1987, the government launched a macroeconomic adjustment program to revitalizesupply and enhance competitiveness. The program rapidly boosted output by introducing a seriesof measures to liberalize domestic trade, deregu!ate prices, devalue the currency, and liberalize theimport system. These measures covered the external sector, taxes, government spending, public

I Unless otherwise noted, dollar amounts in this paper are in current US. dollars

4

enterprises, the financial sector, the regulatory framework, the environment, and human resources.

For the first time in several years, Madagascar saw a modest increase in per capita GDP--about 0.5

percent annually between 1988 and 1990. Private and foreign investment also increased,

particularly in the export-oriented industries.

9. Despite its success on the democratic front, the 1991-93 transition exacted a heavy

economic price. The slight 1 percent rise in GDP in 1992 was not enough to recover from the

substantial 7 percent drop in 1991. GDP growth in 1993 was only around 2 percent. The

macroeconomic problems still overshadow the accomplishments, and have led to a decline in

Madagascar's competitiveness. Tax revenue, excluding grants, has flattened out at 9 percent of

GDP, public debt is 13 percent of GDP, and the current account deficit is 10 percent. Arrears on

external payments reached $700 million by end-1993. The investment climate is greatly depressed.

The news is not completely bad, however, since the government was able to eliminate taxes on

coffee and cloves, relaunch privatization efforts, and successfully manage an expanding free trade

zone.

10. The new government is at a crossroads. It is faced with an impoverished country, in

which the constraints en growth are formidable, it must devise a new recipe for growth. The

adjustment program has left a respectable legacy: most of the economy has been liberalized and

productive forces are better able to react to world market or economic policy incentives. But most

of the major reforms have yet to be enacted. The adjustment program had the right approach, but

it was not implemented effectively enough, and the reform measures were incomplete. The limited

success of the years 1988 to 1990 shows that the program was not sufficient to reverse the

inexocable slide towards; poverty.

POVERTY, UNEMPLOYMENT, POPULATION GROWTH, AND THE ENVIRONMENT

11. Madagascar has great development potential. However people live at standards which

are below average levels in Sub-Saharan Africa: the chronic malnutrition rate is 40 percent, infant

mortality represents 11 percent of live births, endemic malaria has become a major problem, the

incidence of tuberculosis and other contagious diseases is rising, and educational standards are

declining. Productive assets are unevenly distributed, and neither urban nor rural areas can offer

equitable access to economic opportunity. Due to distance, inefficient markets, and inadequate

infrastructure, the southern tip of the island is constantly threatened by food shortages, even when

the country as a whole has a food production surplus.

12. The poorest groups are affected by deteriorating health and educational services. Even

though a healthy and wvell-educated population is more productive, rapid population growth has

forced more people to share fewer resources. The deterioration in the services and coverage at all

levels in the public health sector was caused by inefficient sectoral management, and a real decline

in resources allocated to this sector during the 1980s. The education level among the population is

declining. Teachers at the primary and secondary levels are unevenly distributed, with large urban

centers receiving more and better qualified teachers. Funds for nonpersonnel expenditures are not

adequately managed. Finally, universities extract an exceptionally high share of the education

resources, especially fo: students' room and board.

5

13. The severity of poverty is reflected in the employment situation, population growth, andthe degradation of land and infrastructure. Acquiring a wage-earning job is the best way of leavingpoverty behind--yet the data for Madagascar reveals significant underemployment. Only 2.7percent of the population are in nonagricultural, wage-earning jobs, while in countries likeMalaysia, Thailand, the Philippines, Indonesia, and Mauritius, that figure is 20 to 30 percent (Table2). In order to absorb the expanding labor force, the development of salaried employment isessential. Madagascar's labor force is projected to grow by 3.1 percent annually between 1995 and2000; this means that some 220,000 people--more than half the total number of existingnonagricultural jobs--will be joining the labor force each year.

Table 2: Socioeconomic indicators for selected developing countriesCountry Population GDP GDP Non- Life Adult Km of

growth per growth agricultural expectancy literacy roadscapita rate jobs

(percent) ($) (percent) (percent of (at birth) Men Women (per 1, 000population) km2 of

territory)1980-91 1991 1980-91 1991 1991 1991 1991 1991

Malaysia 2.6 2,490 5.6 27.0 71 87 70 122Thailand 1.8 2,580 7.8 17.4 69 96 90 143Indonesia 1.8 610 5.8 18.5 60 84 68 115Chile 1.7 2,160 3.4 n.a. 72 94 93 105Mauritius 1.0 2,420 7.2 21.5 70 86 76 966Madagascar 3.0 210 0.5 2.7 51 88 73 84

n.a. - not availableSources: World Bank, International Labor Office (ILO), UNDP

14. The problems of poverty and employment are linked to those of population growth.From 1985 to 1989, the average annual population increase was 3.1 percent. The rate for 1990-94is down to 2.8 percent, apparently as a result of lower fertility rates. If the downward trend in thefertility rate (now 6.1 percent) can be confirmed, population growth should stabilize atapproximately 2.75 percent for 1995-2000. This represents an annual increase of 400,000 people,who will have to be absorbed by the health and educational systems. If the downward trend in thefertility rate is maintained, Madagascar will have 26 million inhabitants in 2025, more than doublethe 1990 population. If the fertility rate does not fall, however, the population will reach 32million by 2025, elimirating any hope of improving living standards appreciably. Rapid growthcountries (Table 2) have succeeded in bringing population growth down to 1-2 percent. Thesecountries can be certain that their populations in 2025 will be less than double the 1990 level.Population growth in Madagascar multiplies the strain on the environment, already severelydegraded in recent decades. Deforestation, caused by clearing new farmland and harvestingfuelwood, has already led to soil erosion on slopes, and silting in the irrigation systems, reservoirs,ports, and infrastructure. These conditions exacerbate the survival problems of the poorestmembers of society.

15. The emergence of AIDS is a threat to Madagascar's economic prosperity and futurewelfare. Until now the island's isolation has protected it. Though few cases have been declared todate, medical experts estimate that several thousand people are infected by the virus, which has a5-15 year incubation period. Other countries in Asia and Africa with health conditions comparable

6

to Madagascar's experienced an explosive spread of the disease once the virus had taken hold.

Many governments waited for the problem to become acute before taking decisive preventive

measures. At this late stage, controlling AIDS becomes very difficult and much more expensive

If Madagascar takes rapid, comprehensive action now, it still has a chance of minimizing the

impact of the disease on its economy and society. Calculations have shown that, in many African

countries, the AIDS epidemic will cause GDP to fall by some 0.6 percent annually. These figures

suggest that a massive escalation in prevention efforts would be cost-effective in strictly economic

terms.

16. The complex interactions between poverty, unemployment, population growth, and

environmental degradation make it imperative that they be tackled through an integrated economic

development strategy. In East Asia and Mauritius, rapid economic expansion made it possible to

break the vicious circle. However their experience makes it clear that the structure of growth is as

important as the growth itself in ensuring that economic benefits are distributed equitably among

social groups and regions. There are two preconditions essential for equitable distribution: first,

the efficient operation and mobility of the goods, finance, and labor markets, making it easier for

expanding regions to attract labor and disseminate products and wealth to other regions, second,

the availability of education, primary health care and infrastructure throughout the country. With

abundant, high-quality infrastructure, market segmentation, which blocks the spread of growth, can

be prevented. Education and primary health care enable the poor to take better advantage of

opportunities created by accelerated growth.

17. The difficulties are numerous, and the obstacles appear insurmountable. It seems that no

problem can be tackled without exposing a host of associated barriers or encountering

contradictions. However, East Asia demonstrates clearly that a country can be rescued from

apparently desperate straits and achieve a brighter future. NIEs have made the breakthrough

because their leaders distanced themselves from immediate, day-to-day concerns and conceived a

long-term vision of the future. They also made the people understand and share that vision.

7

III. LONG-TERM PERSPECTIVES FOR DEVELOPMENT

18. When we try to imagine what Madagascar will be like in 2010, we realize that our visiondepends on the ability of its government and society to liberate itself from the constraintspreventing it from fulfilling its potential. Assuming the constraints are overcome, the vision willshow the advantage of a competitive labor force being translated into a number of small- andmedium-sized export firms, and diversified, expanded production in the agricultural, industrial, andservice sectors. In that context, poverty is reduced, and better education and health services helpestablish a foundation for greater human productivity and even further progress in the battleagainst poverty.

19. What type of society, and what type of economic system, can be envisioned forMadagascar? A politically and economically liberal system presupposes making certain choicesbetween short- and long-term benefits. This chapter provides an outline of the basic options,followed by a review of the macroeconomic and sectoral basis for growth that could generateappreciable benefits in the medium term. The "scenarios" corresponding to possible economicstrategies are reviewed, and finally the constraints Madagascar will have to overcome to fulfill itslong-term development objectives are summarized briefly.

BASIC OPTIONS

20. Although everyone will benefit from a well-managed economic policy in the long term,the government will inevitably be forced to make some initial choices between certain groups'short-term interests. These choices include trade-offs between: savings and consumption, wagesand jobs, protectionism and exports, looking outward and looking inward, playing by the rules andacting arbitrarily, and the poor and the less poor.

Savings and consumption

21. With memories of the "all-out investment" policy of the late 1970s still fresh, thegovernment might have second thoughts about any proposal to increase the investment rateappreciably. However, some facts cannot be ignored: high growth cannot be achieved withoutsignificant growth in the investment rate. Even without attempting to attain comparable rates toNIEs (30 to 40 percent of GDP), the current rate of 11 percent will have to be raised significantly.High investment rates in turn require a considerable increase in national savings, therebypostponing the expansion of private consumption in response to growth. An "all-outconsumption" policy would have the same disastrous results as the "all-out investment" policy.Such alternatives make it incumbent on the government to accept only economically-justifiedpublic investment projects and ensure they are rigorously implemented. They also entail greaterprivate sector involvement in investment, mechanisms enabling public savings, and foreign aid tocontribute to the funding of private investment.

Wages and jobs

22. Per capita income has been dropping almost continuously for the past 20 years, and wageearners have not escaped. Civil service wages have fallen in constant francs, as have private sector

8

wages. Since unions are demanding that wages catch up, a new government will find it difficult toresist the temptation to make a popular decision in resolving a difficult problem. Yet this wouldrisk further compromising the re-establishment of a macroeconomic balance which is sodesperately needed. In particular, it could jeopardize the availability of a cheap, hard-workinglabor force, so attractive to investors. Quite simply, this could mean abandoning the perspective ofrapid growth and its corollary benefits: an increase in the number of wage-paying jobs and areduction in poverty. A different approach would seem more reasonable: to make benefits forwage earners flow from a general expansion of the economy and base real wage increases onincreases in productivity. Once the economy has taken off, wages should rise more quickly thanaverage income, as the East Asia example has shown.

Protectionism and exports

23. The government and private businesses might consider protectionism a tempting, evenlegitimate, means to achieve growth in the industrial sector. This is a temptation to whichindustrialized countries succumb easily. However, when the policy "succeeds," higher costs forconsumers and industries that use the protected goods as raw materials are the resultProtectionism has also kept nonprofitable enterprises afloat, thus delaying and even exacerbatingthe inevitable outcome. Protectionism is even more dangerous for a small developing countrysince it does not have a domestic market for its domestic producers to capture. In Madagascar,the domestic market is at such a low economic level that it cannot bring about the development ofsectors geared solely to import substitution.

24. New and existing businesses that want to survive must capture a share of the worldmarket--the size of which dwarfs every sector of the Malagasy economy. The enterprises createdfor import substitution, which have remained inefficient under the protectionist umbrella, aredemanding that protection be maintained. Export-oriented companies, such as the garmentindustry, would like to see protectionism eliminated in favor of an open system, an environmentwhich fosters, rather than hampers exports, where supplies could be easily obtained at optimal costand goods subsequently sold outside the country.

Looking outward and looking inward

25. Should Madagascar look outward and participate in world economic activity, with all therisks and profits it would involve? Or should it prevent foreigners from "getting their hands" on itsnational assets? Government policy has often given in to an instinctive suspicion of foreigners,sometimes even nationals of foreign origin, the result is lost opportunities. But production isincreasingly organized along global lines: for example, a US company may have its productionfacilities in Hong Kong, with the Hong Kong subsidiary in turn subcontracting to Malaysiansuppliers, In light of this globalization, Madagascar must decide whether it wants to be part of thenew system and become another Thailand or Mauritius, or just sink deeper into the trap ofunderdevelopment. Eventually, foreigners' investment can contribute to growth, or they tnaybecome partners in opeiling new markets and bringing in new technology.

26. Another aspect of an inward-oriented policy is the movement of monetary capital. Nogovernment has succeeded in controlling capital flight by regulating foreign exchange. Thesecontrols have merely discouraged foreign investment and prevented the repatriation of any capitaltransferred outside the country. Economic expansion requires considerable investment by nationals

9

and foreigners--investment that itself requires a climate of confidence in which each party knows itcan freely dispose of its profits and capital.

Playing by the rules and acting arbitrarily

27. For many years, the authorities believed the state should be omnipresent in the economyand control as much of it as possible--including taking on the role of producer where necessary.Instead of protecting the weak and promoting the country's best interests, this approach has led tothe proliferation of fiefdoms where officials impose their decisions and frequently benefitpersonally. A liberal economy cannot exist in such a setting. Economic agents cannot be efficientif they are subject to arbitrary action. The rules of the game must be clear and respected by allparties. To that end, the justice system must be independent, as Madagascar's constitutionstipulates it is. The judiciary system must be strengthened along with legislation governing itsstructure, and economic activity must be revised. This represents a tough choice for futuredecision makers, bearing in mind that progress will be contingent on eliminating the privileges ofan administrative class with which they frequently have close ties.

The poor and the less poor

28. Envisioned adjustment programs are often accompanied by governmental comments onthe sacrifices the people will have to make. First it should be made clear that the downward spiralof poverty has been caused by the ill-conceived policies of the past, rather than by adjustmentmeasures. Second, the overall impact of the measures, not only their impact on a particular group,should be explained. For example, liquidating nonprofitable public enterprises will mean layoffs.But to continue to operate them would force the country, including its poorest citizens, to continuesubsidizing an activity that gives them nothing in return. The taxes, foreign aid, and bank creditsused to keep them afloat could be put to more profitable use. Another example is the allocation ofresources in education. While the primary education system is at an appallingly low standard, thenation spends a great deal on lodging and feeding university students whose academic performanceis mediocre at best. Families are supposed to pay part of the cost of primary education, but not ofhigher education. This leads to an incongruous transfer of funds from the poorest families to thosewho are less needy.

29. While the connection is less obvious, devaluating the artificially-high exchange rateaffects income distribution. This often translates into higher living costs for urban wage earnersand better incomes for farmers and other producers in the short run. In this case, the purpose ofdevaluation would not be to effect a transfer of income but to expand the total output of goods andservices in the long run. Its impact on income distribution should be fully analyzed to avoiddecisions geared to the welfare of any given segment of the population.

30. The new government will be faced with many such economic choices that will weigh theinterests of some groups against those of others. Often it will be the more privileged classes, thosecloser to the government, who will be the most vocal. The government will have the difficult taskof making decisions that are in the best interest of the country as a whole, and will help the poorsurvive in the short term and emerge from poverty in the long term.

I0

SOURCES OF GROWTH

31. In formulating an overall vision with the potential to mobilize the people, it is importantto reflect upon the type of growth that would enable that vision to become reality.2 Growth needsto be high: to regain the 1971 living standard within 10 years, annual economic growth will haveto be over 6 percent. The structure of growth is important too; we are assuming that thegovernment will strive for sustainable, long-term growth, while reducing poverty and protectingthe environment. What are the economic foundations for sustained growth? Emphasis on thedevelopment of diversified, labor-intensive export activity would seem the best course to take. Anessential contribution to growth would involve all economic sectors. The combination cif over 4percent growth in agriculture, 10 percent in industry, and 6 percent in services would enable totaleconomic activity to expand by more than 6 percent (Figure 2).

Figure 2 - Value added by sector

Dynamic Reform Scenario987

63-

2- I_r 00 oo g 0% 0% 0% 0% 0\ 0% 0 x o goo 0% 0%0% as0 % 0 % % 0 % 0

| * Agficulture I Industry E[ Services

Source: World Bank data.

32. This increase in growth cannot be achieved without an increase in production capacity--that is an increase in investment. Despite the willingness of donors to assist Madagascar in itsdevelopment, foreign aid, or external savings, will not be sufficient to finance the requisiteinvestment level. As in NIEs, domestic savings will therefore have to grow significantly. Togenerate higher domestic savings means a rapid growth in exports. Given Madagascar's debt (120percent of GDP), the continuation of external savings should be more oriented toward the flow ofnon-debt-generating capital, such as direct investments and grants.

2 Henceforth the term 'scenario' will denote a quantitative description of the progress towards future econornic conditions.

ii

National savings and foreign aid

33. Strong economic growth will require higher domestic investment rates than the currentones. During 1987-92, investment in Madagascar represented only 11.8 percent of GDP, lowerthan the African average rate of 19 percent. Countries currently experiencing rapid growth havemuch higher investment rates (Box 1). Private investment in Madagascar represents only 30percent of total investment, in comparison to 60 percent in high ,rowth countries. Any economictarget of 6 percent annual GDP growth by the year 2000 must be based on an expansion ofinvestment, reaching above 20 percent of GDP during 1997-2000 (Figure 3). By 2000, privateinvestment should represent 66 percent of total investment.

Box 1: Economic indicators for various countries

Country GDP/capita Growth rate Investment rate Exports1991 ($) (1980-91 mean) (as % of 1991 GDP) (as % of 1991 GDP)

High-income countries

Hong Kong 13,200 6.9 29 141Singapore 12,890 7.1 37 185

Middle-income countries

Korea 6,340 10.0 39 29Malaysia 2,490 5.6 36 81Thailand 1,580 7.8 39 38Mauritius 2,420 7.2 28 64

Low-income countries

Indonesia 610 5.8 35 27China 370 9.4 36 20Madagascar 210 0.5 11 17The South-East Asia NIEs in this table have applied the same strategy of sustained,export-based growth. Since they started at different times, they are at different stages ofdevelopment. Hong Kong and Singapore have joined the ranks of high-income countries.Korea has reached upper-middle-income level, while China and Indonesia are still low-incomecountries. Nonetheless, they all share common features. high growth, high investment rates,and a high export volume. They differ in the forms of industrial development they haveachieved. While Thailand and Malaysia still have numerous labor-intensive industries,

Hong Kong, Korea, and Singapore have moved on to the use and creation of leading-edgetechnologies, built on the industrial base of previous labor-intensive development.Source: World Bank

34. Low national savings is one of the main obstacles to the scenario. Others include thedeficit, the decline in private consumption, and inefficiencies in public investment. Between 1987and 1992, national savings, excluding foreign grants, represented only 1.2 percent of GDP. Thecontribution of national savings to investment has plummeted from an annual average of 33 percentof total investment in 1988-89, to 18 percent in 1990 and into negative figures in 1991 and 1992.

12

The lack of national savings can be explained by the negative figures for public savings. Thismeant that private savings had to be mobilized, indirectly through the banking system, to financethe budget deficit. Another obstacle is the current account deficit. Excluding grants, it rose to10.6 percent of GDP during 1987-92. Because equipment may need to be imported, theinvestment required for high GDP growth will tend to increase the current account deficit.Without a substantial rise in national savings, the deficit would reach a nonsustainable level, thusdashing all hopes of achieving sustained long-term growth on schedule. A rise in the savings rateis therefore essential to sustained growth. Thirdly, private consumption per capita persistentlydeclined during 1980--92. By 1992, it had fallen to 62 percent of the 1980 level. If the emphasisis on raising private consumption and increasing tax revenue, it will be difficult to increase theprivate savings rate. Measures to increase national savings will initially have to focus on boostingpublic savings, by increasing the difference between government revenue and operatingexpenditures.

Figurv 3 - Savings and InvestnmrntDynranic Refonn Scenario

25

20iz 15.

*10

A.0

-S _ i I I .. .. I I .... I I I I

00 i -a, e 0 r

o 0' 0' 0' 0' 0' 0' 0' C ]

-ia- Nationalsavings -Eemal savings -4-- Investnetn

Isource: World Bank data.

35. Finally, the need to increase investment rates to achieve high growth should not meanrepeating the mistakes of the "all-out public investment" program of the late 1970s Two measuresthat make it possible to avoid those errors are: making private investment a priority, and carefullyselecting public investment projects. High-quality investments are essential if they are, indeed, toresult in high, sustained growth. The high investment volume of 1979-80 focused on the publicsector industrial enterprises and universities, and failed to improve the economy. Furthermore, thegovernment will have to put available funding to the best possible use. It is estimated that$1 billion of the funding currently available for all donor-financed projects has remained unusedPublic investment from 1987 to 1992 represented 59 percent of total investment volume. In 1993,the Public Investment Program (PIP) still covered some production-oriented projects with a low

13

economic return. Adequate public investment in social sectors and infrastructure must bemaintained, and can serve as justification for a modest rise in public investment volume. However,any investment increase in these sectors should result primarily from a redirection of the PIP.

36. The sustained growth scenario provides for dynamic growth in the industrial sector. Thegrowth is based on the establishment of small, labor-intensive export industries. Success willdepend largely on Madagascar's ability to attract foreign investment in the sector, and thus toextend the scope of its free trade zone activities. To some extent, this model also makes it possibleto eliminate some of the constraints associated with inadequate domestic savings, due to the netinflow from foreign investors. Mauritiun investors have expressed a lively interest in relocating inMadagascar, provided that the economic and regulatory framework is favorable. In addition,contacts with South-East Asian and European business delegations may lead to more prospects.This is a prime opportunity for Madagascar to forge ahead with industrial development. Inaddition to these external funding sources, a rise in the national savings rate will be needed tofinance the current account balance. Pursuing the sustained growth scenario will double thecurrent account deficit by the year 2000, since initial export expansion will not be enough tocompensate for the escalation in equipment imports. This is true even if the deficit is kept at nearlythe same percentage of GDP as during 1987-90.

Development of exports and world markets

37. High export growth rates are a common feature of most newly-industrialized countrieswhich have developed rapidly. This applies not only to the four "dragons"--Singapore, SouthKorea, Taiwan, and Hong Kong--but also to such countries as China, Indonesia, Malaysia,Mauritius, and Thailand. In Malaysia, GDP has grown by an annual average of 6 percent in thelast 25 years, driven by an annual 8 percent expansion in exports. Parallel figures for Thailand are7 percent and 10 percent, respectively. In these countries, export growth has been the engine ofeconomic expansion. Exporters faced with international competition were forced to boost theirproductivity by adopting the appropriate technologies, and improving management and qualitycontrol. They quickly discovered that rapid growth required a large investment in foreign-madeequipment, and therefore rapid export development to generate the necessary foreign exchange.

38. Madagascar would do well to study how these countries have succeeded in developingtheir export industries so rapidly. A common initial feature in the rapid development of exports isgrowth in agricultural exports, especially through ongoing diversification. In the 1970s, averageannual growth of agricultural exports in Indonesia, Malaysia, and Thailand was over 20 percent.These countries also used the resulting surpluses in a system of resource mobilization to diversifyinto exports of manufactured goods. In a second phase, the South NIEs' export strategyemphasized export of labor-intensive manufactured goods. They geared their export developmentefforts to increasing their share of developed countries' import markets for labor-intensive goods.They attracted foreign firms to invest in production facilities for export, and benefited from theinternational division of labor evolving from the operating strategies of large multinationalcorporations. NIEs have now reached a third stage: they are capitalizing on skilled labor and thecomprehensive development of their industrial base to export a growing proportion of high-technology products. The export development strategy focused on market penetration indeveloped countries. Given their size, even a small share of those markets represents a large

14

export volume. Bv forming ties with companies in the target markets, NIEs succeeded insmoothing out difficulties and gaining a part of the market. Exports blossomed almost entirelythrough the efforts of private companies, which were encouraged by a policy of open competitionand less protectionism within the country, and clear and well-defined administrative regulations.

39. In recent years, growth in world trade has occurred predominantly in manufacturedgoods, which account for over half of less-developed country (LDC)s' exports. Between 1970 and1990, exports to the Organization for Economic Cooperation and Development (OECD) countriesof goods manufactured by developing countries grew by an average of 20 percent a year. Thethree principal markets for industrial exports from developing countries are the United States.Europe, and Japan. The US market is still the largest, though Europe and Japan are growingsteadily. In the 1980s, the dollar volume of Europe's industrial imports from developing countriesrose on average by 10 percent a year. The Japanese market expanded at a rate of 19 percent. TheLome agreements have made Europe an especially promising market for a growing Madagascarexport industry.3 The expansion of trade in finished products is reflected in a steadily rising volumeof trade in parts, components, and partially assembled products, all driven by direct foreigninvestment in developing countries. Companies in industrialized countries are relocating theirproduction facilities to developing countries, and exporting their products to their country of originor to a third country. Some 20 percent of US imports come from overseas subsidiaries of UScompanies. Japanese firms also encourage trade expansion by importing consumer goods and rawmaterials, and subcontracting industrial activity overseas. As companies in South Korea, HongKong, Taiwan, and China find their operating costs rising, they are relocating to LDCs. TheMauritiun textile company, Floreal, has already begun to relocate to Madagascar. Madagascar'sbest prospect is to be the relocation site for small- and medium-sized companies based in OECD),East Asian, and neighboring countries.

40a These trends reveal a number of common features:

(a) A small number of developing countries dominate export trade. Four--SouthKorea, China, Hong Kong, and Taiwan--are Japan and Europe's principal LDCpartners. However, other countries, such as Turkey, Malaysia, Indonesia, Thailand,Pakistan, and the Dominican Republic, have established a significant presence inindustrialized markets. For all of these countries, annual growth in industrialexports to OECD countries in the 1980s was 14 to 35 percent.

(b) A small number of "traditional" products, such as textiles, clothing, and shoes,continue to account for a significant share of exports from LDCs, even therelatively advanced ones.

(c) Among the most imported products are steel, jewelry, semiprecious stones,chemicals, and construction materials to Japan; steel, electrical equipment, officeequipment, and vehicles to the United States, and steel, electrical equipment,jewelry, semiprecious stones, and chemicals to Europe. More recently, suchproducts as computer hardware, vehicles, and heating and cooling equipment haveappeared in those markets,

3 In 1990, most of Madagascar's exports were destined for the European Community (51 percent) and North America (27percent). Exports to Sub-Saharan Afnca represented only 5 percent of total volume.

'5

41. The prime factor for export development in newly industrialized countries has been thecapture of a large share of world markets in the most "dynamic" products: those for which therehas been a faster than average expansion in total world trade, Dynamic products are particularlyattractive, in that it is easier to acquire a large share of a rapidly growing market. Box 2 contains a

Box 2: Dynamic export productsProduct Expansion in global value of expors

1980-1990 1970-1990percent percent

Computers, office equipment 18.6 18.4Plastic items 14.7 15.7Travel equipment 13.9 17.3Cassette players 13.5 16.9Silk 13.3 7.3Toys, sports, and hunting equipment 13.3 14.8Manufactured leather 13.1 15.6Leather 12.9 12.6Perfume, cosmetics 12.7 16.2Clothing 12.6 14.7Electrical equipment 12.6 15.9Art 12.3 15.0Telecommunications equipment 12.0 14.1Furniture 11.7 15.5Fresh fish 11.7 13.9Pigments, paints 10.9 13.4Office stationery supplies 10.5 13.2Dyes, indigo 10.5 9.7Shoes 10.4 14.1Jewelry 10.3 17.5Hides 10.1 9.8World trade 5.9 11.5Rates indicated represent average annual growth in current dollarsSource: United Nations Conference on Trade and Development (UNCTAD)

list of the major dynamic products that could be profitable for Madagascar. The average growth indollars of world trade between 1980 and 1990 was about 6 percent. In volume terms, this isvirtually stagnate. By increasing their market share of dynamic products, however, the countries

16

involved boosted their exports rapidly. Today it is clear that, among developing countries, thenewly industrialized countries are world export leaders in dynamic products.4

42. For some nondynamic products, exports were boosted by increasing market share.Analysis of comparative advantages shows that most countries can find "niches" in which acomparative advantage allows them to increase their market share substantially. Between 1980and 1990, this is what Madagascar succeeded in doing for cinnamon, quartz, semiprecious stones,textiles and processed wood (Box 3).

43. Madagascar's exports over the last 20 years have reflected the country's general economicdecline. After increasing by 25 percent between 1971 and 1979, export volume plummeted to lessthan 70 percent of the 1971 level by 1983, where it languished until 1988. After 1988, exportspicked up in response to trade liberalization measures, regaining real 1971 levels in 1991. In 1991,per capita exports were at 50 percent of the 1971 level, covering only 65 percent of imports. The20-year stagnation in export volume considerably reduced Madagascar's share of the worldmarket. In 1971 Madagascar's exports represented 0.05 percent of the world market. By 1980this figure had fallen to 0.025 percent, and by 1990 to 0.011 percent. This plunge had the greatestimpact on Madagascar's major exports: coffee, vanilla, pepper, shellfish, graphite, and mica(Table 3).

Table 3: Madagascar exportsPercent of world marketProduct 1970-72 1980-82 1988-90

Coffee 1.4 1.1 0.7Vanilla 77.0 61.6 56.3Other spices 8.6 7.6 2.5of which:pepper 1.9 1.7 0.8cinnamon 3.6 0.4 2.1cloves 38.6 44.4 36.8

Shellfish 0.7 0.6 0.4Mica 5.7 4.9 3.2Graphite 17.6 12.4 7.3

Source: UNCTAD

4 World leaders in exports arnong developing countries of certain products are as follows: computers and office equipment:l'aiwan (() percent), llong Kong (3 percent), Korea (2 percent); travel equipment: Korea (19 percent), Taiwan (17percent), I long Kong (3 pcrcent); toys, sports, and hunting equipment: Taiwan (21 percent), Korea (8 percent), Hong Kong(3 perccnt), jeitelvn: I long Kong (7 perccnt), Thailand (4 percent), Korea (2 percent).

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Box 3: Madagascar: Resistant exports, 1980-1990Product Value exported in 1990 Comparative resistance Share of world market

(millions of ) index a in 1988-89 (percent)

Fresh fish 0.3 5.4 0.005Maize 5.1 19.4 0.056Fresh fruit 15.5 4.8 0.058Fresh vegetables 7.7 1.9 0.035Sugar and honey 12.8 2.9 0.176Cinnamon 1.9 8.3 2.070Hides and skins, unprocessed 0.9 6.0 0.016Oil-bearing nuts 2.0 3.9 0.013Processed wood 1.9 17.0 0.006Cotton 2.2 3.6 0.019Quartz 2.1 8.1 1.640Chromite 15.2 2.0 3.740Crude animal products 0.9 2.7 0.020Wood manufactures 0.6 6.8 0.007Fibers (sisal-hemp) 0.6 201.2 0.800Yarn and thread 1.3 7.1 0.221Other textiles 0.9 14.6 0.010Nonmetal mineralsb 2.1 14.8 0.035Precious and semi-precious stones 5.2 4.8 0.140Furniture 0.6 10.7 0.002Travel equipment 0.1 2.1 0.001Clothing 11.6 5.0 0.006Toys, sports, and hunting equipment 0.8 6.3 0.003Zoo animals 0.3 11.3 0.086Total 92.6a. The comparative resistance index for a given product is the ratio of its relativemarket share in 1988-90 to its relative market share in 1980-82. (Relative marketshare is the ratio of Madagascar's market share for the product to Madagascar's totalshare of the world market.)b. Does not include cla)

A comparative resistance index higher than I for a given product indicates thatMadagascar's market share for the product held up better than did exports as a whole.Since Madagascar's share of the world market fell almost by half between 1980 and1990, an index higher than 2 indicates that its market share for the product increased.Many products important to Madagascar have a comparative resistance index lowerthan 2, indicating a drop in market share. They are: coffee, cocoa, vanilla, cloves, petfood, shellfish, graphite, vegetable oils, mica, essential oils andperfumes, leather,cotton textiles and shoes.

Source: UNCTAD

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44 How can Madagascar hope to reverse these catastrophic trends and stimulate rapidgrowth in exports? First, it must regain its former share of markets for traditional products byinstituting appropriate economic policy measures. Second, it must diversify its agricultural andindustrial exports through partnerships with producers and distributors in consumer countries, orwith investors seeking to relocate production facilities. In spite of the overall collapse, thestructural trends in exports observed in the 1980s are encouraging in this regard. Though itsexports declined overall, Madagascar was able to maintain or increase its market share for manyproducts, thus showing there is potential for new production. Box 3 shows the major productsthat were still profitable during the recession in the 1980s. In particular, growth in the marketshare for "dynamic" products like luggage, sport and hunting equipment, furniture, clothing, andhides is evidence of the export industry's still embryonic potential for diversification anddevelopment. Exploitation of this potential and accelerated diversification of exports offers achance of achieving "sustained growth."

Potential by sector

45. Agriculture and fishing. The agricultural sector has considerable potential for growth.Since agriculture can pull the rest of the economy upwards, it will play a major role in any nationaldevelopment strategy aimed at accelerating economic expansion, reducing poverty, and eliminatingfood shortages, while protecting the environment and the sustainable use of natural resources.

46. In view of Madagascar's geography, population distribution, and the extent of thesociological barriers to migration and development in areas of low population density, the bestapproach to boosting the agricultural sector in the short- and long-term is to develop it in denselypopulated areas with high agricultural potential. Primarily, this would mean improving yields,diversifying farming operations, and shifting towards market-based rather than subsistencefarming. In addition, greater regional specialization geared to both export and domestic marketsshould be a part of this strategy. This development would be enabled by the expansion of bothexport and domestic agricultural markets, private sector growth, and the decentralization ofagricultural support services.

47. The potential for growth in all agricultural subsectors is considerable. With regard tofoodstuffs, the economic and financial analysis suggests that Madagascar has a regionalcomparative advantage for producing enough food to meet almost all its requirements. Thepotential for intensification is significant and financially attractive to farmers. Agricultural yieldsare consistently low, and have seen practically no improvement since Independence. However, thesector has considerable productive capital in the form of high-density irrigation systems covering40 percent of the cultivated land. In those areas, exploitation and yields are both low , there islittle or no crop diversification, and the emphasis is on subsistence farming. Despite the fact thatpaddy fields represent 40 percent of the value of total production, and they take up almost all theirrigated land, less than 15 percent is commercialized. The marked comparative advantages ofindividual regions underline the driving role that interregional and external trade can play in theintensification and diversification process by giving farmers access to profitable markets for theirproducts.

48 Potential demand for food products is significant for two reasons. First, national outputfalls short of current food requirements, particularly for grain (annual shortfall: 180,000 tons) and

19

vegetable oils (annual shortfall: 13,000 tons). Second, consumption levels are low: riceavailability per capita fell by 35 percent between 1982 and 1992, and 35 percent of the country'spopulation are food insecure (42 percent in urban areas and 34 percent in rural areas).5 Projectionsfor 2005 indicate that, on the basis of past crop yields and a 1 percent rise in per capita income,shortfalls in grain (rice: 215,000 tons, wheat: 150,000 tons) and vegetable oils (42,000 tons) willincrease.6

49. The growth potential of agricultural exports for both traditional and nontraditionalproducts is noteworthy. In the foreseeable future, traditional export products (vanilla, coffee,pepper, lima beans, cotton, and peanuts) will continue to contribute to the development of exports,generation of foreign exchange, and higher incomes in rural areas. There is significant potential forthe intensification of such products; however, that potential continues to be underexploitedbecause marketing channels are highly disorganized and constitute a barrier to quality enhancementand product promotion. Furthermore, there are restrictions to export policies for vanilla andcotton, marketing costs are pushed up by dismal means of communication and insufficient credit,and prices for producers are unattractive.

50. Despite their recent and spectacular development, nontraditional exports7 still have anarrow base. This does not include shrimp which is the second largest source of foreign exchange.The expansion and diversification of the other exports are essential to sustained agricultural growthbecause they will boost and stabilize exchange revenue, and provide access to profitable outletsand employment in many areas of Madagascar. New export industries will capitalize on the widevariety of conditions and natural resources in the country, and thus have an impact on almost everyregion. They have enormous potential for development: in the fishing sector alone, a wide rangeof resources are currently underexploited, including crab, green crawfish, tuna, and seaweed.There is also considerable potential for expansion and diversification of animal and vegetableproducts. The development of this resource should be managed carefully. Experience in otherbasins illustrates the hazards of overexploitation and its negative impact on the resource. TheIndian Ocean has not yet reached the point of overexploitation, but the situation could deterioraterapidly with indiscriminate use.

51. Industry. Madagascar's industrial sector is fairly small, accounting for approximately 14percent of GDP. It consists mainly of public enterprises which were geared toward importsubstitution. The main subsectors are textiles, clothing, preserves, beverages, shoes, andpharmaceuticals. Smaller private sector enterprises have demonstrated a greater capacity to makethe change towards exports, particularly in clothing and shoes. New enterprises, established in thefree trade zone and under the investment code, have opened up new export niches. For example,free trade zone certification was obtained for exporters dealing in silk, leather goods, essential oils,models, bicycles, watches, jewelry, buttons, and electrical equipment.

S A household is considered to be food insecure if its income does not enable it to maintain a minimum nutrition level of 1680calories per person per day.

6 The income elasticity demand has been estimated at 0.4 for rice, 0.7 for wheat, and 0.9 for vegetable oils.

7 In volume, from 1985 to 1990, corn, cassava, fish, trepang, shark fins, squid, and octopus rose over 200 percent, fruit andvegetables 100-200 percent, and beans, potatoes, cashew nuts, shellfish, and livestock 50-100 percent.

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52. For industrial expansion, Madagascar will rely less on developing existing production

than on positioning itself in world markets with highly dynamic products. However, as experience

has shown, it is also possible to increase market share in less dynamic products. The industrial

sector's current dependence on locally-produced primary materials, such as cotton, hides, fruit, andvegetables, will decline insofar as a skilled, highly competitive workforce can enable the country to

import primary materials to process for export. In Southeast Asian countries with rapid expansion,

the industrial sector has grown even more quickly than the economy, attaining a concomitantlylarger percentage of GDP. Thus Malaysia, with an annual growth of 7 percent between 1973 and

1981, saw its industrial sector expand by 9.5 percent. Between these dates, the share accounted

for by the industrial sector grew from 15 to 20 percent of GDP. Thailand experienced 7 percent

growth between 1963 and 1987, together with an industrial growth rate of 9.5 percent. In that

period, industry's share rose from 14 percent of GDP to 25 percent. The lessons for Madagascarfrom the East Asia examples are clear. First, industrial expansion in all countries seems to proceed

in the same successive stages: (a) an initial stage of labor-intensive, unskilled production, based on

local raw materials and geared to import substitution; (b) rapid replacement of such production by

export-oriented industries comprising an increasing proportion of skilled labor, initially focusing on

assembly of imported components, and (c) a broadening of the productive base, through the

intensive application of imported technologies and utilization of competent foreign managers.

53. Companies and investors in the most advanced economies (Taiwan, Hong Kong, Japan,

and the United States) have been approached and actively encouraged to establish production

facilities in partnership with local private entrepreneurs. Madagascar could develop its industrial

sector successfully. It has the major asset the NIEs began with--plentiful, cheap labor, which is

easily trained in production methods. However, this potential cannot be realized unless the legal

and regulatory framework of economic activity unfetters productive energy by facilitating the

establishment of new businesses, foreign investor activity, and job creation. Furthermore, it cannot

be realized without suitable physical infrastructure, and the development of human capital. Only by

developing a labor-intensive export industry can Madagascar hope to bring down its

catastrophically high unemployment, which could well become a source of political and social

unrest. Developing the industrial sector will by no means be an easy task. Markets for

manufactured goods and financial services are increasingly globalized, while technology,

marketing, and business management are forging rapidly ahead. In industrial markets, produci

quality and on-time delivery are becoming the dominant factors. This means that it is increasingly

important for Madagascar to seize opportunities for investment and trade with its neighbors,

particularly Mauritius and South Africa, as well as with the industrialized countries of East Asia.

54. Tourism and other services. Tourism has become a dynamic component of

Madagascar's economic diversification. Between 1985 and 1990, the number of foreign visitorsrose from about 23,500 to almost 53,000--unfortunately it then fell to 35,000 in 1991. Certifiedhotels offered 1,597 rooms in 1985 and 3,040 rooms in 1991. Gross tourism earnings, though they

fell from $40 million in 1990 to some $29 million in 1991, were in both years higher than export

earnings from coffee.

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Box 4: Main tourist areas of Madagascar

The high plateau region

The high plateau is centered on the capital, where economic activity and a significantadministrative and political presence are conducive to international and domestic business tourism. Theregion is also important as a hubfor travel to other areas. Furthermore, it offers many opportunitiesfortours and exploration. A wide range of activities is available, such as the hot springs in Anisirabe andscopefor outdoor activities in Ampefy and Mantasoa. The region's total long-term capacity is estimatedat 6,800 rooms (over 12,000 beds). Current utilization is less than 13 percent.

The Virgin Island Coast (Northwest)

This region comprises the northwestern coast from Soalala to Cap d'Ambre and a portion of thenortheastern coast, including Antsiranana (Diego Suarez) and Sambava. The emphasis will be on beachtourism; the climate is very pleasant, except during the hurricane season, which lasts from Januarythrough April. Beach activities could be complemented by a wide range of land and sea tours. Threesites stand out: Nosy Be, Antsiranana and Mahajanga (Majunga). Due to its outstanding qualities, NosyBe would be the prime site. The region's total long-term capacity is estimated at more than 8,000 rooms(over 15,000 beds). Current supply represents only 5 percent of capacity; this underscores the region'stremendous potential.

The Capricorn Coast (Southwest)

This region offers two types of possibly complimentary activities. beach tourism around Ifaty,where the lagoon has outstanding flora and fauna; and discovery activities through land tours on theIsalo Massif where the scenery andflora reflect the "island continent's" immense diversity. In the longterm, secondary sites could be established for beach tourism (Morondava and Morombe) or discovery(Ampanihy). The region's total long-term capacity is estimated at more than 3,700 rooms. Currentutilization is less than 5 percent.

The Spice Coast (Southeast)

This region has 650 km of coastline, extendingfrom Mananjary to Taolaflaro (Fort Dauphin). Ithas many stretches of straight coastline and a steep hinterland leading up to the mountains. This site canbe promoted as a dual destination (sea and mountain). The region's total long-term capacity is morethan 3,500 rooms. Current utilization is less than 5 percent.

The Rosewood Coast

The northern continuation of the spice coast is referred to as the Rosewood Coast. It stretchesfor 700 km from Vatomandry to Antalaha. One of the region's prime sites is the island of Sainte Marie.Tourist activities in the entire region focus on natural beauty: the flora are particularly luxuriant, andthere is extensive scope for beach, lake, and river tours. Toamasina, Madagascar's second largest city,is the region's second site. The region's total capacity is estimated at some 2,000 rooms. Currentutilization is 7 percent.

22

55. Obviously, tourism could be a rich source of revenue for Madagascar. But demandforecasts in this sector are always uncertain, particularly in cases like Madagascar where theindustry's base is weak and initial expansion would have to be rapid. The country can best becompared to the Maldives and Seychelles, though it is much bigger and more diverse. In theMaldives, the number of tourists rose from 33,000 in 1979 to 158,000 in 1989. In the Seychelles,

tourism showed less expansion, rising from 55,000 visitors in 1977 to 104,000 in 1990.8 These

figures indicate that Madagascar could receive at least 100,000 to 150,000 visitors a year in thecomning decade. Two extensive studies on tourism have been conducted in recent years. The firstsupported an ambitious project to build hotels on three sites (the islands of Nosy Be and SainteMarie, and near Fort Dauphin in the south) and concluded that the annual number of visitors couldreach 140,000 by 1995. The second study, conducted for the United Nations DevelopmentProgram (UNDP) in 1992, concluded that in ten years the number of visitors could rise from70,000 to around 460,000. These figures indicate the scale of Madagascar's tourism potential,

though estimates are widely varied (Box 4). Madagascar's natural resources, low wages rates, andthe emphasis the Malagasy place on quality of service are all factors conducive to tourismdevelopment. The beauty and variety of Madagascar's landscape, its natural riches and its diversityof flora and fauna9 are further assets in tourism development. "Ecological" tourism is showing thefastest growth. It is estimated that the number of tourists who visited Madagascar especially for itsnatural beauty rose from 4,000 to 8,000 during 1988-90. Thus environmental protection is asessential to the development of tourism and associated jobs as it is to agriculture. Keeping sitesand beaches clean, pollution free, and protected from environmental degradation, will have a

positive impact on traditional tourism.

56. To fulfill the more ambitious projections, Madagascar would need accelerateddevelopment of hotel infrastructure and equipment. This means private foreign financing, at leastfor the hotel component. Only very limited projects have been implemented to date: a new hotelproject for Antananarivo and some sites south and north of Toamasina, and financing for some

access roads to tourist areas in the south. In the short- and medium-term, limited operationswould seem to be more viable than the construction of groups of hotels with over 100 rooms

apiece. With existing infrastructure, Madagascar could start receiving approximately 70,000 low-cost individual tourists a year. It will be some time before the country can support high-value-added tourism. Thus, it is most likely that growth will be primarily generated by beach tourismorganized through charter companies and travel agents.

57. Development is also hampered by the distance from major markets, and hightransportation costs. Air access is limited by restrictions on both charter and regular flights to andfrom Europe, Nairobi, Mombassa, and Reunion Island. The projected liberalization of domesticflights will facilitate the transfer of tourists from Antananarivo, now the principal point of arrival to

other tourist destinations. In conjunction with the medium-term development of air traffic, directinternational access to Nosy Be could be another means of developing regional tourism. Touristsfrom Southern Africa and the Indian Ocean region could quickly grow to 20 percent of the total

This is a small increase compared to Mauritius, where tourism rose from 115,000 visitors in 1980 to 300,00() in 1991 Thcfigures for the Seychelles could have been much higher, but the governmcnt is deliberately limiting thc number of visitorsthrough a luxury tourism policy, pnrmarily as en,ironmcntal protcction.

9 Madagascar has an estimated 150,000 .pecies unique to the island

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number of tourists visiting Madagascar. Direct access already exists for Toamasina. With limiteddevelopment, potential tourism is estimated at 100,000 to 150,000 foreign visitors annually by theyear 2000, generating $80 to $120 million a year in gross foreign exchange earnings (incomparison with $50 million from vanilla and $45 million from shrimp), with $53 million-$80million in value added. The hotel capacity required is double the number of rooms now available(about 3,000) in certified hotels. Other constraints on tourism development are inadequateinfrastructure in the tourist areas, especially telecommunications, electricity, and water.

58. In addition to tourism the overall development of other services is linked to generaleconomic activity; they should therefore grow at the same rate as the economy as a whole.However, Madagascar does have the necessary human potential to develop certain services evenfaster, including: consultants and chartered accountants, computer services, telecommunications,insurance, transportation, and export services.

The role of human resource enhancement

59. The experience of high growth countries, which initially faced the same limitations asMadagascar, has shown that the quality of a country's human resources is an essential factor inshort-term development and sustained long-term growth. The enhancement of human resourcescontributes to growth by: a) generating an educated, healthy labor force which can rapidly expandproductivity, and thus raise the average income; b) providing the management, technical, andbusiness skills needed for growth; c) making farmers less reluctant to implement modern, high-yield agricultural methods; and d) creating an environment that will foster the development of newentrepreneurs. Qualified, healthy labor is one of the prime factors that will attract investors toMadagascar, insofar as they are seeking not only cheap labor, but cheap productive labor.Investing in human resources will contribute to increased productivity in the agricultural sector,where crop yields are very low. Experience has shown that farmers who have had some primaryeducation achieve higher yields, because they are more receptive to modern methods and are betterable to communicate with their suppliers. With specialized training, they can achieve even higheryields. Health also has obvious impacts on productivity--healthy farmers can work harder, gofurther to markets, and so forth. Industry and commerce have everything to gain from access toskilled labor. Any modern labor force must have technical and business skills. Moreover asanalysts have noted, the dearth of qualified managers constitutes one principal constraint ondevelopment. The fact that workers with technical, management, and business skills findemployment faster shows that these workers are in high demand. However these skills are unusualin Madagascar.

60. Table 4 uses two indicators to illustrate the profound impact which investment in humanresources has had in East Asia and Mauritius. In a rapidly changing economy where technologicalinnovation is constant, the importance of general primary education cannot be overstated. TheNIEs had attained almost universal primary education before they started on the path toindustrialization. Though Madagascar has made significant progress, it still lags behind all thecomparison countries, except Thailand. There are also disparities in education quality. It isacknowledged that certified primary school teachers in Madagascar have minimal qualifications.The impact of investment in basic health care is even more remarkable. In all the comparisoncountries, infant mortality in 1990 was down to at least a third, and in some countries even a fifth,

24

of its 1960 rate. By contrast, in the same period Madagascar only cut its infant mortality rate inhalf The 1990 infant mortality rate in Madagascar was still higher than the 1960 rates in allcomparison countries except Indonesia.

Table 4: Comparison between countriesCountry Primary school attendance rate Infant mortality rate

(percent of school age children) (per 1000 births)

1960 -65 1970 -75 1985-90 1960 -65 1970 -75 1988 -90

Hong Kong 103 119 105 27 15 7

South Korea 101 107 108 62 40 17

Malaysia 90 91 96 55 37 16

Thailand 78 83 88 88 55 27Indonesia 72 86 118 128 109 61China 89 126 135 90 46 29Mauritius 101 107 103 65 45 21Madagascar 65 95 92 201 159 114

Source: World Bank, 1992 Economic Development Trends

61. Investment in human resources must be accompanied by measures to ensure that eachgroup has the opportunity to fulfill its economic potential. Special consideration of the role ofwomen in development is essential. There is a close correlation between women's education andeconomic and social development. Countries that invest in women's education reap the benefits ofhigher economic productivity, lower infant and childbirth mortality, longer life expectancy for menand women, and lower birth rates. Better educated women can also earn more. The children ofeducated women are healthier, and stay in school longer and learn more quickly, both of which arepositive feedbacks to development. Madagascar is certainly making an effort: women nowrepresent 39 percent of the labor force, a level higher than that in some comparison countries (seeTable 2 in Chapter 2). However, literacy among women (73 percent) is still significantly lowerthan among men.

MEDIUM-TERM SCENARIOS

62. The scenarios described below were developed to illustrate the medium-term impact ofthe various economic strategies the new government could adopt. They should not be interpretedas an exercise in prescriptive planning, but rather serve to reveal links and macroeconomicconstraints associated with the strategies, reminding us that everything is interconnected. Threescenarios are discussed, The first is based on the premise that current economic trends will bemaintained and no major reform program implemented. This is the "catastrophe" scenario; nodetails are provided here except that its repercussions would be disastrous for the Malagasy. Itillustrates the crippling cost of relying on a day-to-day management strategy, and instituting noreforms. The major consequences would be a continuing slide in the living standard and ongoingdegradation of the environment, infrastructure, and health conditions. If the Malagasy governmentfails to take corrective action, this scenario--economic stagnation--is the far most likely to occur.The two other scenarios discussed in this report are based on an entirely different premise: that

25

Madagascar can restructure its economy and achieve sustainable growth. Both scenarios have theultimate objective of increasing GDP per capita and reducing poverty, and both assume theenactment of measures to arrive at a more balanced budget, keep public investment high, andmobilize relief for the balance of payments to allow financing of its imports. The scenarios involvethe formulation and implementation of a sound reform program. The "adjustment as usual"scenario is based on a reform program similar to the one instituted in 1988-90, and provides forlimited GDP growth. The "dynamic reform" scenario--sustained growth--entails generous privateinvestment and accelerated export development. The three scenarios are illustrated in Figure 4.

Flgue 4 - Per caita GDP

110

"1W5

~95__ _ __

-85

75 l l1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

- [yInanic Refo-n- Adjustnrnt as usual D)D nothing

Source. World Bank data.

The "do nothing" scenario

63. Madagascar's economy has been in decline for twenty years, with only brief interruptionsin the downward slide. In 1992, per capita GDP was 40 percent lower than in the early 1970s.The slight gains achieved during the period of limited growth in 1988-90 ended in the exhaustionof Madagascar's foreign exchange reserves in 1990, and were ultimately wiped out by a freshcontraction of the economy in 1990 and 1991. The 1991 losses were not made up in 1992. Inearly 1993, Madagascar encountered difficulty in meeting external payments, a high budget deficitand an inefficient public sector. Potential foreign investors hesitated to commit themselves, waryof uncertainties associated with the political transition and worried that the rigidly-planned, state-controlled economic system might persist after the changeover. In this scenario, economic declineis unavoidable. The country would become even poorer, with a 10 percent drop in per capita GDPby the year 2000, leading to more generalized poverty.

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The "adjustment as usual" scenario

64. The "adjustment as usual" scenario is based on the economic policies implementedbetween 1988 and 1990, although they followed the right approach, they lacked sufficient energyand were incomplete. The scenario involves. (a) a prudent government finance policy, (b) bettermanagement of the Public Investment Program, enabling it to be implemented faster and tomobilize more assistance, (c) reintroducing the Open General Licensing (OGL) or some other openforeign exchange allocation mechanism, as well as maintenance and expansion of the free tradezones, (d) higher productivity in the agricultural sector, measures to promote traditional exports,particularly vanilla, (e) reform of the regulatory framework to encourage increased privateinvestment, somewhat higher in real terms than GDP growth, and (f) mobilization of assistance forthe balance of payments and debt restructuring. The scenario assumes these policies will lead to 4percent annual growth in the industrial sector by 2000, and as high as 3 percent annual growth inthe agriculture sector by 2000.

65. Under these circumstances, and assuming that the 1990 level of economic activity can berestored by 1994, Madagascar could attain its 1988-90 growth rate by 1995-96. Average annualGDP growth would be 3.2 percent between 1993 and 2000, reaching 3.6 percent by 2000. Privateconsumption per capita should begin to rise by 1996. Real annual growth in exports would be 4.4percent, and in imports would be 3.9 percent. The investment ratio would be fairly stable,representing 12 to 13 percent of GDP (Figure 5), with public sector investment continuing topredominate. Domestic savings would represent, on average only 4 percent of GDP. Madagascarfor the first time in many years, would see an increase in GDP per capita for more than two orthree years running But this scenario does not provide for an absorption of the external tradedeficit, and maintaining it beyond the year 2000 would leave little hope of regaining even the 1971per capita GDP before 2065.

Flgue 5 - Adjustnmnt as usual scermiuo

160 --1401 120 -100 ----------I

60-40 \,,-

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

WDP - Investent a tport

|Source. World Banik datal

27

The "dynamic reform for sustained growth" scenario

66. In the recent elections, the people of Madagascar clearly expressed their aspirations: they

elected new leaders, not to see them "do nothing," but to have them do something concrete to lift

the country out of the seemingly inexorable poverty which is slowly suffocating it. This scenario

provides for full realization of Madagascar's potential. It assumes that the formidable obstacles

currently blocking it will be overcome by means of a dynamic economic policy, aimed at raising

living standards through sustained growth. This requires a profound change in people's conception

of economic development, and the adoption of a new paradigm integrating the basic choices

outlined in the first part of the third section, "Long-term perspectives for development." All of

Madagascar's economic sectors will need to expand (see earlier Figure 2). Sustained growth

cannot be achieved without a dynamic private sector, and significantly accelerated growth in

exports; this will enable the country to reduce the trade deficit--the major obstacle to balance of

payments viability. A first objective of the policy could be to restore the 1971 living standard

within 10 years. As things stand, this is already a major challenge. Once the 1971 living standards

are reached, the physical and human investments made to foster growth should help begin to close

the gap with countries like Mauritius. Calculations show that if this scenario were implemented,

annual growth of at least 6 percent should be possible by the year 2000. Its implementationinvolves all the economic measures described in the "normal adjustment" scenario, as well as a

determined focus on the development of exports and private investment. The measures required

are described below.

67. In this scenario, the 1990 economic level of GDP will be restored by 1994, GDP growth

would then be approximately 4 percent around 1995, and reach 6 percent towards the end of the

decade (Figure 6). Initially the necessity of increasing private savings will limit private

consumption. However private consumption per capita should begin to grow by 1996. Domestic

savings, virtually negligible in 1990, should expand to 14 percent of GDP by 2000. The increase in

the savings rates would make it possible to establish the conditions required for sustained, long-

term growth. The development of export-oriented activities could enable exports to expand by areal annual average of 10 percent between 1992 and 2000, and 12 percent thereafter. The

promising success of free trade zones is evidence that such results can be achieved. Through the

enhancement of a competitive labor force, the country can develop agricultural and industrial

exports, as well as tourism. Exports, which currently represent only 15 percent of GDP, would

expand to over 20 percent of GDP by the year 2000 and over 30 percent of GDP after 2005.

28

Figure 6 - Dynamic reform scenario

250 -

8 200k

.' 50

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

r. ~GDP Investnnt Exponis

Source. World Bank data.

68. The experience of countries with high economic growth nas proved that a highinvestment rate is essential. According to this scenario, the investment rate should attain 22percent of GDP by 2000 (see earlier Figure 3). The increase will be generated by strong growth inprivate investment. By the end of 1995, real private investment would be restored to the 1990level and would then grow at an average annual rate of 22 percent. This may be an ambitious goal,but it reflects the need to invest in activities which only the private sector can develop. In 2000,private investment will represent 14 percent of GDP, in comparison with 7 percent in 1990 and 4percent in 1992. The increase in private investment will involve a far more open attitude to foreigninvestment. In addition, an appropriate credit policy which shifts sectoral credit distribution tofavor private sector instead of public sector credit should be put in place. Credit to the privatesector should go up by an average of 22 percent a year. If the government finance policy makes itpossible to expand public savings as expected, then private sector credit can be increased in thecontext of a prudently managed money supply. Public investment, which could be mairtained atabout 8 percent of GDP, would be focused on infrastructure and human resources, enabling thestate to make the best possible contribution to economic development.

69. To launch itself on a path of sustained growth, Madagascar will need an approachradically different from that of the late 1980s. An investment rate which is higher than 20 percentof GDP and generates sustained growth cannot reasonably be attained unless the government canoffer foreign investors appropriate legal and political conditions, entrepreneurial freedom, ansdliberal transfer, settlement, and property rights. Financial stability is a prerequisite for such a highinvestment rate, as is the generation of national, public, and private savings. National savings netof external grants, now a negative figure, should thus increase to 12 or 13 percent of GDP by theend of the decade. As with investment, any measures to generate savings will place a burden onboth the private sector and the state. Since balance of payments deficits will be inevitable during

29

the period in which investments grow, an expansion in the volume of external financing, as well as

a reorientation of its structure, will be essential.

CONSTRAINTS ON DEVELOPMENT

70. The purpose of this chapter has been to provide an overview of Madagascar's potential

for growth and the means by which that potential can be fulfilled. As we have indicated, the

potential has been there for some time, but its fulfillment has been blocked by numerousconstraints, which must be eliminated before Madagascar's ,government can make any strides in

achieving its goals for the coming decade. The constraints are related to infrastructure, humanresources, the macroeconomic and regulatory environment, and the balance of payments.Infrastructure for transportation, telecommunications, electricity, urban networks and markets areinadequate for an intensive development plan. Telecommunications are not sufficiently extensive,while roads, the electric power distribution grid, and urban networks are deteriorated. The

Malagasy's ability to contribute to high economic growth is limited by poverty, low quality

education and inadequate health conditions. Macroeconomic and regulatory constraints include

the government's lack of institutional capacity to run the state in the context of a liberal economy,

the uncertainties engendered by current economic policies, and the lack of depth and consistency in

the reform measures introduced in recent years. To eliminate these constraints, the governmentneeds to make good use of its basic resources and focus on its essential functions, abandoningdirect intervention in the economy. Finally the dearth of foreign exchange, a major obstacle toeconomic activity, reflects the huge imbalance in external trade. The balance of payments is nolonger sustainable in its present form. To date, the accumulated debt, including arrears, stands at120 percent of GDP. Debt relief is an absolute prerequisite if relations with other countries,

including donors, are to be restored to a sound footing.

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IV. ECONOMIC POLICIES TO ENABLE SUSTAINED GROWTH ANDREDUCE POVERTY

71. This chapter mill explore the economic policy options through which Madagascar could,in the medium term, rrmake full use of its economic potential and significantly reduce poverty.Among the scenarios set forth in Chapter III, the "dynamic reform" option is the only one whichmakes it possible to redulce poverty within a reasonable time and, as a first stage, restore the 1971living standard within a decade. The goal is to implement economic policies which achievesustained growth, redu.ce poverty, and protect the environment, in the medium term. Thechallenge resides in elirninating the serious constraints set forth at the end of Chapter III. Thischapter will study three major courses of action: achieving an institutional framework conduciveto growth, reducing poverty, and protecting the environment.

AN INSTITUTIONAL FRAMEWORK CONDUCIVE TO GROWTH

Role of the state

72. The establishment of the rule of law took concrete form in August 1992, whenMOadagascar adopted a new and far more liberal constitution. The process has been completed bythe democratic implementation of discrete, yet complementary, executive, legislative and judicialpowers. Moreover the new constitution provides for political decentralization with local elections.The new government has an excellent opportunity to reflect upon the ways in which it can moveaway from direct intervention in economic activity and take on the role of "facilitator," with themotto: "less government but better government." The functions assumed by the state must reflectthe new constitution's liberal orientation and the financial means available. The state will have toreinforce some of its core functions: maintaining security, enforcing the law, ensuring that thejudiciary system works as it should, formulating and implementing macroeconomic policy, andlevying and collecting taxes. Other expenditures--those related to the control of economic activityand "management" of the agricultural sector--will become superfluous, since they will no longerhave a raison d'c&re once a market-based economy has been established.

73. Logically, the genesis of economic growth through private sector development requiresthat the state withdraw from direct production activities by privatizing industrial and commercialenterprises and liquidating nonviable public enterprises. The state must direct its efforts towardsestablishing a physical and institutional environment conducive to the development of acompetitive private sector; the experience of newly industrialized economies has shown that this isthe most effective way of achieving a sustainable reduction in underemployment and poverty. Thiscannot be accomplished without substantial improvements to infrastructure and the enhancementof human capital, particularly in the areas of health and basic education. Since needs will farexceed available budgets, the state will need to assume its responsibilities in cooperation withprivate organizations. These could include: churches and local nonprofit organizations forteaching, Non-Governmental Organizations (NGOs) and local organizations for health services,and private companies and NGOs for technical training and infrastructure maintenance.

3]

74. The planned decentralization policy provides for the decentralization of federal staffand/or reallocation of administrative services to local authorities. This would bring localcommunities closer to development activities, and make it easier to adjust programs in accordancewith the different resources and comparative advantages of individual regions and subregions. Oneoption is to decentralize the central administration by relocating personnel to outlying areas.Another option is to reallocate administrative services by transferring many of the centralgovernment's primary responsibilities to local authorities--with some activities, particularly inteaching, health, safety, and infrastructure, eventually shifting to the private sector. With thesecond option, local authorities will need access to adequate financial resources, including costrecovery from households willing to pay for better services.

75. The overall direct and incidental taxation effort will have to be intensified to mobilize thesavings to finance investment growth, which is the essential precondition of sustained growth.However, before raising taxes or levying new ones, the central government must decide how localgovemments are to be funded, and how the public and private sectors are to divide responsibilityfor delivering essential services. One option is to implement a local tax system strong enough to

collect a substantial portion of total tax revenue and finance most of the local governments' needs.Another option is for the central government to increase tax revenue and share it with localauthorities. To choose between these options, the government must decide how much financialautonomy it wants to allow local communities, and determine how efficient the central tax systemis in comparison with local systems. Most likely the local systems will be established gradually andwith the assistance of the central tax department, so transfers from the central government wouldinitially represent the major portion of local revenue. Transfers could be reduced as local taxsystems are strengthened.

76. Local tax system reform is one component in a much-needed comprehensive tax reformplan. The plan's objectives must be twofold: to provide more incentives for economic activity, andto increase fiscal revenue--a prerequisite for adequate public savings. Reform must be gearedtoward a value added tax as a primary source of revenue, while direct taxation must be reduced asmuch as possible. The main reason the tax system is unfair is that tax evasion and tax exemptionsare significant. By waging an effective campaign against tax evasion, the government would see itstax revenues rise and dispel the sense of injustice felt by those who actually pay their taxes.

A legal and regulatory system conducive to the development of the private sector

77. The legal and regulatory framework. Private investment in Madagascar can developonly insofar as potential investors are confident they can operate under well-defined, stableconditions. Furthermore, the legal system must be effective in enforcing contract compliance. Atpresent, this is far from the case. There are many contradictions between statutes that are still inforce, between statutes and their corresponding regulations, and even among internal governmentdirectives which are not legally binding but have a significant impact on decision making within thegovernment. Businesses already operating in Madagascar have often succeeded in overcominggovernment-imposed constraints, but they represent a major obstacle to new entrants.

78. The commercial, industrial, and agricultural activities of individuals and groups are inprinciple still governed by the Commercial Code (Code de Commerce), enacted in 1960. It is nolonger appropriate to the demands of modern business, and has been amended many times. Its

32

application is frequently complicated by the large number of decrees and circulars that at timescomplement it, but at others contradict it. Bankruptcy laws make it very difficult for a failingbusiness to terminate its activities. Property rights must be better defined and easier to verify.There is no mechanism for settling civil liability conflicts in the absence of a contract. A series ofnew statutes was enacted during the recent period of economic liberalization. Foremost amongstthese is the new Constitution adopted in 1992. It is a liberal document, very different in naturefrom the dirigiste approach of the Socialist period. But the practice remains, from the dirigisteperiod, where an administrative note may supersede the implementation of new legislation. Forexample, foreigners are now legally permitted to purchase buildings in Madagascar, but suchtransactions cannot take place because a memo exists prohibiting them. Foreigners' inability toacquire real estate constitutes a major obstacle to both the privatization of public enterprises andthe development of direct foreign investment.

79. These examples show how necessary it is to review the legal and regulatory frameworkgoveming economic activity. Existing contradictions between statutes, the regulationsimplementing them, decrees and internal directives, and memoranda must be eliminated. Theremust be no conflict between the commercial code, business code, mining code, and legislationgoverning competition, real estate ownership, the free trade zones, and other areas. Collectivelythese instruments must be consistent and reflect the government's liberal approach, as set forth inthe Constitution of August 1992. Furthermore they must be enforced through an effective legalsystem, which requires profound restructuring. The possibility of establishing arbitrationprocedures should also be studied. It is not enough for private investors to know the rules of thegame, instead the rules must be such that compliance does not require a huge investment in timeand effort to wade through the bureaucracy. Incorporation procedures should be simplified, givingall entrepreneurs access to the one-stop facility implemented to deal with certification applicationsunder the investment code. To ensure that certification mechanisms are open to scrutiny, arecourse procedure could be instituted for cases that were denied certification, or had received noresponse within two months of submitting the application. Mexico has enacted such legislation.The one-stop facility must serve as the single decision-making entity: sector ministers should notbe responsible for approving applications as they were under the Second Republic's interventionistapproach.

80. Pursuing the course of liberalization. The expansion of external trade will requireimproved air transport and cheaper shipping, and telecommunications facilities. The high cost ofair transport is a significant obstacle to tourism. Air Madagascar has a monopoly on bothdomesticl and intemational routes. Since domestic airfares for residents are set by the companyat far below cost, Air Madagascar's international flights subsidize domestic flights. Oninternational flights pooled with Air France and Air Mauritius, rates are higher than they would bein a more cornpetitive regime. The end result is that capacity for domestic flights is far belowdemand, in spite of the higher domestic fares paid by nonresidents. Capacity on internationalflights is artificially limited to ensure full occupancy. Thus tourism and exports are penalized intwo ways: by fares that are too high, and by the inadequate transportation capacity. The best wayof eliminating these constraints would be to deregulate domestic flights and open the internationalroutes to other carriers. The later would involve entering into an agreement with Air France.

t° In 1992, domestic flights for aircraft carrying less than 10 passengers were liberalized.

33

Domestic shipping should be officially liberalized. This would allow expansion in trade with

Madagascar's isolated areas, and make it easier to dispatch goods, particularly agricultural

products, for export. The telecommunications monopoly is shared between the Ministry of Post

and Telecommunications for domestic services, and a public enterprise STIMAD for international

services. The ministry has proven unable to maintain the equipment properly, and to manage what

is essentially a technical and commercial enterprise. STIMAD has better management than the

ministry but its monopoly status has resulted in high prices. The government's current

restructuring process should quickly lead to the privatization of telecommunications, and for some

services open the doors to competition. The process must meet two conditions. First, it must be

transparent, with privatization occurring in a context of open competition. Second, there must be

an adequate regulatory framework governing the rules of access to competing telecommunications

services.

81. Support for the private sector. To meet private sector needs, the government must

have some means of conducting an ongoing dialogue with representative, private sector

organizations. In most countries this is achieved through the Chamber of Commerce, and

professional or interprofessional associations whose spokesmen are selected by members. In

Madagascar, such organizations are not always completely separate from the government, and the

private sector consider them neither representative nor particularly useful. Perhaps these

organizations should be replaced by new ones, which are entirely managed and led by the private

sector. The new organizations should be financed mainly by membership fees, forcing members to

monitor that the fees were put to proper use. Such organizations should play a fundamental role in

organizing technical training, determining quality control procedures for export products, and

promoting exports. It has been demonstrated in many developing countries that such organizations

can provide a common footing for a variety of programs financed through foreign aid.

82. Professional organizations in rural areas should be decentralized. In particular, the water

users' associations could take over the management and maintenance of irrigation networks, with

support from government representatives. The latter could provide training for local managers and

ensure they were taught new farming methods. The government could continue general

supervision of the irrigation system. In many countries the empowerment of local associations has

proved to be a remarkably effective way of boosting agricultural productivity.

83. Another productivity issue for Madagascar is the distribution and marketing systems.

Many public enterprises are not efficient at distributing inputs or marketing products. In order to

get rid of the inefficient public enterprises and encourage further development, a new system

should be developed which does not give advantages to the public enterprises.

84. The changes envisaged in the above spheres will frequently require that the new

government examine the options and decide on policies that can best fulfill the people's desire for

social and economic change. The legislature will have to amend existing laws or enact new ones,

covering a wide range of applications including air transport and telecommunications, the

incorporation of new companies, professional organizations, and supply and marketing

organizations. The government's policy options will have to be formulated before this is done, so

that all statutes and regulatory instruments form a coherent whole.

34

Macroeconomic policy

85. Government finances. Reform of government finances is the keystone tomacroeconomic equilibrium, rapid growth cannot take place without it. In order for GDP growthto reach 6 percent by the year 2000, a sufficiently high investment rate will have to be achievedwithout either undue inflationary pressures, or depriving the private sector of the resources it needsfor development. This means that the government must generate positive public savings. Toreduce the budget deficit revenue must be raised. While Madagascar's revenue is less than 10percent of GDP, African countries with a similar per capita income have revenues at about 15percent of GDP 1 Though not yet implemented, some measures have already been designed toraise customs revenue. However export taxes on vanilla and other products, will have to beabolished following the liberalization of vanilla marketing. Along with other tax reforms, the levyof a single tax on petroleum products should increase revenue. However before deciding to raisetaxes, an action that could have a negative impact on the economy, the government shouldconsider whether a broader tax base and improved recovery rates can significantly increaserevenue. Increasing user participation in cost recovery programs along with rate adjustmentshould contribute to higher revenues and a controlled demand for public services.

86. Spending cuts would help immensely in reducing the budget deficit. These cuts can beachieved by cutting nondebt-related spending, and by rescheduling and reducing the external debtservice load. The latter should be done with an accompanying impact on interest rates. Sincespending on education and basic health must be increased, even to maintain the current service percapita, other forms of spending will have to be decreased in real terms. Specifically, this includesspending on defense, embassies, universities, and intervention in the economy. A review of allactivities that generate spending is required so that cuts can be made in all nonpriority areas.

87. The required increase in the investment ratio as a percentage of GDP should result fromexpanded private investment. If public investment ratios remain at or around their 1992 levels, thePublic Investment Program (PIP) will have to be comprehensively restructured in line with priorityneeds in the transportation, communication, energy, and human resources sectors, and complementprivate investment in providing the infrastructure needed for growth. The PIP includes a numberof projects financed by external resources, for which loans or grants have been committed but notpaid out. The total amount of financing remaining unused at the end of 1993, is estimated at $1billion. Since only a small portion (on average 15 percent) of the available financing is used eachyear, old projects are carried over from year to year. This is done despite the fact that they may nolonger fit with government strategy: many of the more than 300 projects in the current portfoliowill have to be reviewed and restructured on the basis of their cost-effectiveness, priority, and typeof financing. Implementation for projects that meet the criteria should be expedited. Theseprojects often move very slowly because the local counterpart is frequently unavailable or isavailable too late. One way to circumvent this problem would be to consolidate all counterpartfunds obtained from donors and apply the consolidated fund to priority projects withoutearmarking. As a whole, the PIP lacks the capacity to be implemented at the administrative leve .Such institutional barriers must be eliminated, otherwise, they will constitute a major obstacle to

In comparison, budget revenue is 20 percent of GDP in Thailand, 31 percent in Chile, 24 percent in Mauritius, 29 percent inMalaysia and 18 percent in Indonesia

35

the investment effort needed for growth. In line with the decentralization program, the

government will have to devise mechanisms to define and fund regional and local public investment

programs.

88. Restructuring the public enterprises sector should help lighten the load on the budget.

Direct subsidies to public enterprises are fairly low, but the state carries the full burden of servicing

their external debt. In fact, public enterprises receive almost one-third of foreign public loans

through the relending mechanism, but their service payments represent only 5 percent of total

external debt service payments. Of the 170 public enterprises which existed in 1987, 50 have been

privatized or liquidated since 1988. However many of these either carried no economic weight or

had ceased to operate, so most of the work has yet to be done. The immediate impact on public

finances will be limited; the state will continue to assume the full external debt of liquidated

enterprises, and a major share for privatized enterprises, while buyers' contributions will be low.

However, there may be a considerable impact in the medium term, since the sector's financial

hemorrhage will have been stopped and private enterprises will begin contributing to economic

development. To date, the government's withdrawal strategy has been focused on small

enterprises. With more sweeping privatization in the textile, cotton, sugar, mining, shipbuilding,

air transport, telecommunications, and petroleum sectors, the government will make it very clear

that it is indeed withdrawing from public enterprises and making way for the private sector and a

market-driven economy. That course offers the best prospects for a rehabilitated budget and

greater economic efficiency.

89. Money and credit. To achieve the macroeconomic stability required to create a climate

of confidence, the Central Bank will have to pursue a prudent monetary policy designed to

maintain foreign exchange reserves at an adequate level, and gradually bring down inflation to the

world rate. At the same time, it will have to ensure that the banking system operates properly, and

financial intermediation improves. This framework is crucial to private sector development, and

can be achieved only insofar as public finances are rehabilitated as described above.

90. The most urgent measure, which is already underway, is tc, restructure the financial

sector and privatize the two state banks (BTM and BFV). It seems that the Central Bank will be

unable to exercise effective control over credit unless the two banks are restructured and the

financial sector can be made independent, efficient, and competitive; the establishment of new

private banks tied to market demand will help. Central Bank policy should promote monetary

market development and market-determined interest rates. The policy would be complemented by

mechanisms enabling indirect credit control.

91. To mobilize private savings, real interest rates must be kept positive and there must be

satisfactory competition among banks. At present, few of the loans extended are medium- or long-

term; in part, this can be attributed to the low investment demand caused by uncertainty in the

future Malagasy economy. However, demand should rise quickly once confidence is restored.

The government will then have to ensure that banks have the capacity to finance the private

investment essential to growth. To achieve this a bank could be required to deposit at the Central

Bank a percentage of deposits. These mandatory reserves could be calculated to provide

maximum incentives for banks to mobilize a larger part of their resources in the form of long-term

deposits. The Central Bank could also institute rediscounting to encourage long-term loans.

Moreover, additional forms of private investment financing, and long-term loan refinancing, should

36

be examined. In addition to postal orders and Post Office savings, the nonbanking financial systemincludes a social security fund, and two state insurance companies. Due to the relative stability oftheir commitments, these contractual savings institutions represent an important source of medium-and long-term financing in many countries, and should be studied to see how they could make amore effective contribution to investment financing in Madagascar.

92. The banking sector will be responsible for recycling to the private sector any publicsavings not applied to public investment, and a considerable share of balance of paymentsassistance. This is officially allocated to the government but the state will not need it if the publicsavings target can be reached. This function underlines the importance of having an efficientfinancial sector, with the capacity to manage a substantial flow of private sector financing.

93. External trade. The sustained growth scenario rests on the expansion of exports, asdiscussed in detail in Chapter III. In part, exports will be made possible through joint ventureswith foreign firms. This requires substantial direct investment, financed on the basis of externalresources. In other words, the Malagasy Franc must be convertible for current accounttransactions. Also required are external debt relief and nonproject financial assistance high enoughto allow the immediate liberalization of imports--a measure crucial to the promotion of exports.The liberalization program should cover all goods and services, as well as repatriation of investedcapital. The government might also authorize residents to hold foreign exchange accounts undercertain circumstances, and conduct transactions in foreign currency witl the ultimate objective ofliberalizing capital account transactions when conditions permit.

94. The liberalization of external transactions will require a realistic exchange rate, one thatenables the economy to become, and ultimately remain, competitive. Once a satisfactory rate hasbeen established, the government will have to decide how to manage currency exchange. Twoalternatives are possible: a floating, administered exchange rate, or a market-determinedmechanism where the rate adjusts automatically in response to economic fluctuations. Somepractical considerations will have to be explored, for example whether foreign exchange should besold at auction or through an interbank market set up.'2 Though a consistently appropriateexchange rate is a prerequisite for the expansion of exports, it alone does not suffice. The tariffand regulatory framework should not penalize exporters, nor should it engender distortions leadingto inefficient resource allocation. The system has been improved over the past few years, but moreprogress is needed.

95. While most export taxes have been eliminated, the tax on vanilla has not, Both domesticand international sales and purchases of vanilla are still under stringent state control. The stocksbuilt up to keep prices from falling now represent 18 months of world consumption. Thismonopolistic approach has led importers to seek supplies elsewhere: Indonesia and other countrieshave been more than ready to oblige. Madagascar risks losing its market for high quality vanilla,for which it had undeniable comparative advantages. In order to prevent this from happening, thevanilla market will need to be liberalized, and associated research, quality control, and exportpromotion activities entrusted to an interprofessional organization. In place of the current ta.system, which is largely hidden and provides few incentives, the government could institute a

12 As of May 1994, a floating exchange rate system, based on an interbank market, has been put in place.

37

proportional tax, which is reviewed annually. A vanilla market collapse would increasing poverty,since over 60,000 small farmers are involved in vanilla.

96. Debt relief. Madagascar has a very serious debt problem. Though much of it isconcessional, the accumulated foreign debt nonetheless stands at 120 percent of GDP. In spite ofseven Paris Club reschedulings and the cancellation of some of France's loans in 1990, service fordebt due in 1991 and 1992 represented 70 percent of exports of goods and services. Externalarrears had accumulated to $700 million by the end of 1993. The debt service burden has becomeone of the main obstacles to the restoration of a liberal exchange allocation system and a viablebudget. For the 1993-2000 period, gross financing needs, corresponding to the shortfall in thecurrent account balance plus depreciation of the public debt, total some $6.3 billion, of which $2.9billion will be required to service the debt. After direct investment, aid-in-kind and projectfinancing are deducted, a residual gap of $3.4 billion in new financing will be required. Thisresidual gap should be covered by restructuring the debt and balance of payments support.

97. Some 90 percent of the residual financing represents external debt service payments.Whether the gaps entailed in the sustained growth scenario can be financed or not will depend onthe debt's restructuring conditions. Under Paris Club rules, only a portion of the debt due in 1990was rescheduled at the last session. In 1990, only 46 percent of the debt service due that year wasrescheduled, a relatively low figure because 70 percent of Madagascar's debt had already beenrescheduled. However the debt rescheduling agreements relate largely to onerous loans made in1978-80, the period of "all-out investment," during which the economy declined alarmingly.Average interest rates in the agreements are high, which is why the current annual interest burdenhas reached 5.5 percent of the amount outstanding in 1990, even though new loans have been onhighly concessional terms. Obviously traditional rescheduling alone cannot solve the debt problem,and the government will have to formulate a specific strategy to reduce the burden.

A growth-oriented human resource development strategy

98. Education. In the years of the Second Republic, Madagascar made a considerable efforttowards universal education. Between 1975 and 1985, the number of children attending primaryschool rose by 60 percent, while the number of students in higher education more than quadrupled.However, this dramatic increase in numbers was accompanied by a serious decline in the quality ofeducation. With many students repeating grades or dropping out altogether, the domesticperformance of the education system is one of the weakest in the world. The average studenttakes eleven years to complete five grades of primary school. The government must find a way toimprove the quality of education and to adapt it more effectively to the country's needs.

99. Primary school attendance has fallen from 95 to 92 percent of school-age children since1975, though this figure is still fairly high compared to other African countries. Since teachers'salaries absorb almost all the available resources, students are handicapped by a lack of textbooks,notebooks, blackboards, and other equipment. Steps must be taken to improve the quality ofeducation, including a rise in the cost per student of education, and improved management--thiscould result in immense savings. If the current student failure rate was reduced, the increaseddemand from population growth might not result in a net increase in students in the primaryschools until 2000. However, even though new schools may not be needed, a great many existingschools will have to be brought up to an acceptable standard. The new government needs to

38

decide whether local communities will assume full liability for rehabilitating the schools, or whetherthe state will pay part of the cost. The government will also decide if the lion's share of the budgetshould be allocated to the primary school system, forcing a reduction in the budgets of lowerpnority services.

100. Another difficult decision is the language in which students should be taught. In 1975Malagasy replaced French in both primary and secondary schools, though courses at the universitylevel were still given in French. Ten years later, French was gradually reintroduced at thesecondary level, and recently the authorities considered bringing it back at the primary level aswell. Switching from one language to another inevitably causes problems for both students andteachers, and partially explains the lamentable state of education today. One short-term option isto upgrade the teaching of French in the primary and junior high schools. However, since studentscannot be taught if their teachers are not taught first, long-term objectives need to be clarified.

101. As in most African countries, secondary education in Madagascar is iil-suited to thecountry's needs. Junior high school should adequately prepare students for direct entry into thelabor market or senior high. Similarly, senior high should prepare graduates for immediateemployment or higher education. A secondary school diploma should not guarantee automaticadmission to university. Higher education institutions should admit students on the basis ofinstitutional capacity and selection criteria. One step in this direction was the creation of officialtechnical training; however, it had problems with high cost and a negative reaction from privatesector employers. New efforts are being made to adapt technical training to the labor market, byinvolving employers in course development. These efforts must be pursued vigorously, or exportdevelopment will be impeded by a shortage of qualified labor. To avoid placing an extra burden onthe state, the technical training programs envisioned provide for partial cost recovery, and involvemajor participation by private business schools, NGOs, and churches. Churches today play animportant role in education at the primary, and especially at the secondary, level. The newgovernment will have to decide on the relative roles of public and private schools, as well asinstitute quality control mechanisms.

102. University related spending13 is clearly out of proportion to academic results. Due to thefact that many students drop out of the university, and repeat courses or even full years, eachmaster's degree represents an investment of about 120 student-years. Spending for highereducation stands at 25 to 30 percent of total spending on education. The universities' missionshould be to offer quality education at a reasonable cost; it should not exist to provide a living forunemployed graduates. The government will be faced with the challenge of re-establishing theuniversities' priorities, in spite of the inevitable resistance.

103. Health and family planning. When measured by traditional indices such as lifeexpectancy and infant mortality, the health situation in Madagascar is demonstrably below theaverage of low-income countries. In addition, the incidence of such diseases as malaria andtuberculosis has tended to rise in recent years. This is largely the result of inadequate facilities atprimary health care centers and a general lack of drugs, especially outside the cities, In some rura.areas, essential health services are provided by NGOs, especially churches. In spite of a recent

13 A variety of scholarships and benerits cover more than half of total cxpenses. Since the actual spending always exceedsallocated funding, arrears have accumulated and are causing substantial problems.

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increase in the health services budget, the public health care systeml4 remains inefl.icient. The newgovernment will have to determine how the system could be improved as part of thedecentralization effort. Already extensive social problems are exacerbated by rapid populationgrowth, which is currently estimated at 2.75 percent a year. Some NGOs have set up limitedfamily planning programs, but to date the state has failed to take an active role15. The governmentwill have to revitalize the program as one element in the battle against poverty. All countries thathave succeeded in bringing down the number of poor people have lowered population growth, byimplementing measures needed to encourage families to wait longer between children. Should thegovernment decide to take an active role in family planning, it should concurrently introducemeasures to prevent sexually-transmitted diseases (STDs), with special emphasis on AIDS. So farMadagascar has a relatively low incidence of AIDS, but the high incidence of STDs shows AIDScould spread rapidly. Without an immediate and dynamic prevention program, AIDS-relatedmorbidity and mortality could become a major problem by 2000. Foreign aid to finance theseactivities should not be difficult to obtain.

POPULATION, POVERTY, AND THE ENVIRONMENT

104. In spite of its abundant natural and human resources, Madagascar is one of the countrieswhere poverty has escalated most rapidly in recent years. Exacerbated poverty has led toenvironmental degradation, a decline in production potential, and a deterioration in the quality ofsocial services. The challenge facing the new government will be to break the vicious circle bysimultaneously tackling problems in education, health, family planning, and the environment. Higheconomic growth rates in conjunction with environmental protection, are the best way to fightpoverty. Many areas will require more specific intervention, especially through public spending forcarefully targeted programs. In Madagascar, as in many other countries, population pressures havebeen the major cause of environmental degradation. Cutting trees to clear new farmland, and forfuel, has led to shrinking forests and intensified erosion, particularly on slopes. Poor soils, silt-clogged drainage systems and ports, flood damage, and other negative effects of erosion have ledto an estimated loss of 10 percent of potential GDP. In addition, if Madagascar fails to protect itsexceptionally rich biotic resources, it would lose its foundation for ecological tourism and allchances of exploiting its unique gene pool.

105. In 1990, Madagascar launched a massive environmental protection program known as theNational Environmental Action Plan (NEAP). The plan carried the principal message thatenvironmental protection and economic development are not conflicting aims, but that a series ofsuitable protection measures can actually foster economic growth. The first component of theprogram is to improve the security of land tenure by giving farmers title to land. It has beendemonstrated in Thailand and other countries that farmers who own their land strive for bettermanagement methods to increase its long-term value. Furthermore, many farmers are actually, ifnot legally, sharecroppers--officially sanctioning the practice would give them far greater security.A second component of the plan focuses on the sound exploitation of forest resources. One

14 Hlealth spending now represents 1.5 percent of GDP, compared to I percent in 1990.

15 The population control policy enacted by parliament in 1990 is aimed at bringing down the birth rate by encouraging parentsto wait longer between children. However, the measures have not been implemented yet.

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objective is to ensure the regeneration of fuelwood species, requiring foresters to hold ownershiptitle. Another is to increase overall energy crop yields by reducing the BTU loss at various pointsin the fuelwood chain, from the manufacture of charcoal to heating and cooking devices. A thirdcomponent is to preserve species unique to Madagascar through the creation of protected reserves,with cost recovery from the expanded ecological tourism industry. However, this can be achievedonly to the extent that the first two components of the plan can be implemented, and populationgrowth contained.

106. Population growth has resulted in rapid environmental degradation. If that trend is to bereversed, family planning measures must be viewed as an essential adjunct to environmentalprotection programs. But the environment cannot be effectively protected unless poverty isreduced. Those who have the least also have the fewest options when it comes to subsistence.For them the problem is not the state of the environment ten years from now, but feeding theirfamilies today.

107. The last two decades have shown that among developing countries, only those whichachieved rapid economic growth were able to reduce poverty. Since most of the poor live offagriculture, subsidizing the consumption of staple foods has not proved an effective means ofimproving their situation in a sustainable fashion. Like many other developing countries,Madagascar can achieve high growth by making full use of its most abundant resource. labor.This implies that the poor must have access to education and basic health services, without whichthey will have fewer oppoitunities than others to break into the market economy. The expansionof an export-oriented manufacturing industry and growth in tourism and related services willgenerate a considerable demand for employment in the medium term. However the real impact ofsuch growth will be felt only in the long term. In the immediate future, public sector reforms willhave a negative impact on the number of job seekers in the informal sector. Therefore, specificshort-term poverty reduction and job creation measures will be necessary, as will a public spendingprogram to create a targeted social safety net for those whose plight is most serious.

108. With the Development Action Fund, Madagascar has launched a program that so far hasworked well in several West African countries. It involves a flexible system, established outsidecurrent administrative structures, which would enable small private firms to execute labor-intensiveinfrastructure projects with NGOs and local community assistance. The aim is to improve the foodsecurity of vulnerable groups by paying them for their labor, and at the same time performing workwhich local communities consider necessary. The government should make this a priority, anddevise ways to create jobs by stimulating the creation of small private firms.

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V. MANAGING THE TRANSITION

109. Overall, the formulation of economic policies needed to restore the 1971 living standardin a decade and double per capita income within one generation presents a formidable challenge.Can Madagascar succeed? For the answer to be yes, the government will have to delineateworking methods and a program that are in line with management capacity. The mobilization offoreign investment and private sector activity is critical to the achievement of sustained growthengendered by rapid export development. A climate of confidence must be established toencourage entrepreneurs to invest and foreigners to locate activities in Madagascar. As East Asiahas demonstrated, essential principles are to fulfill any comrnitments made and to carry declaredreforms through to the end. The country cannot afford any backsliding. The government will haveto state its priorities clearly, set up an economic management team and the means to direct thetransition, and encourage the people to participate. Two factors crucial to success will be theMalagasy people's confidence and the extent to which they understand and accept the measuresproposed. With a new government, their expectations are high. One theme that should underliethe entire process is restoring confidence.

PRIORITIES

110. The NIEs which have successfully managed the transition to high growth rates focusedon restoring macroeconomic stability, eliminating barriers to economic activity, and making use ofthe private sector's demonstrated ability to be an engine for growth. In defining the first stage ofthe reform program, the government should consider its priorities, and what it can achieve in theimmediate term. Measures with only a long-term impact should be implemented without delay.Obviously, high priority reforms already underway or implemented in the past should initially bemaintained. The principal themes to be considered fall under the five broad headings below:

Macroeconomic stability

111. This is essential to growth, efficient utilization of resources, and long-term private sectorinvestment decisions. It means moderate inflation, access to foreign exchange, and a stableexchange rate, none of which can be achieved without appropriate policies.

(a) A prudent monetary policy, based on gaining control over private and public credit.Credit must be extended to the private sector (as this is essential to growth), at th.eexpense of government borrowing.

(b) Reinforcing budgetary discipline is a concomitant measure. The budget deficitmust be reduced to prevent public sector borrowing from the banks. This meansraising tax revenue and bringing down public spending, while continuing to protecthigh-priority sectors.

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International trade and finance policies

112. To enable the private investment necessary to growth, an international trade policy mustaim for a convertible current account, the first stage in total convertibility. This requires arealistic exchange rate determined by a market-based mechanism, such as an interbank foreignexchange market, if the financial sector can support one. A possible transitional measure could beto reintroduce the Liberalized Import Regime (LIR), though an appropriate exchange rate wouldhave to be achieved first."6 Prudent monetary and budgetary policies in concert with realisticmanagement of the exchange rate should enable Madagascar to keep the exchange rate fairlystable:

(a) Rigorous management of budgetary and monetary matters will be needed to permitthe liberalization of imports. Moreover, some relief for the external debt will haveto be found, along with substantial assistance for the balance of payments.

(b) The financial system must be reformed. The interbank exchange market cannotfunction unless bank operations are sound. The financial sector must rapidly beplaced on a solid footing, and the BTM and BFV privatized. Market-determinedinterest rates are needed to halt the flight of capital. A treasury bond market,managed by the Central Bank, will make it possible to establish competitive interestrates, which will in turn stimulate savings.

Eliminating the barriers to economic activity

113. The government must declare explicitly that entrepreneurs are welcome and ensure thatits administrative requirements do not hamper the establishment of businesses, investment, thepurchase of goods, and the flow of goods and funds.

114. An unambiguous directive on the acquisition of real estate by foreigners could be veryhelpful in stimulating the creation of business and foreign investment. The one-stop shoppingapproach should be implemented and serve as the only requirement for admission to the free tradezone system and approval under the investment code,

115. Liberalization of certain industries could be pursued to make the economy morecompetitive. This could improve the telecommunications infrastructure. The vanilla sector isequally urgent, if Madagascar's share of the world market is to be protected. Negotiations withforeign partners are needed to open up international air transport to more companies and givetourism an opportunity to develop. The petroleum sector also needs to be liberalized.

Private sector development

116. The private sector's role in the economy should be clearly recognized. By withdrawingfrom public enterprises and redirecting public sector activities and investment towarcis establishedpriorities, the state will clearly demonstrate that its economic policy is irreversible and will createthe climate of confidence needed for growth. The state must withdraw from activities in which it

" See the preface, and footnote 12.

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has no comparative advantage. At the same time, it must be more efficient in discharging itsresponsibilities.

(a) The government must make it clear how, and on what basis, it intends to withdraw frompublic enterprises, and it must start that withdrawal quickly. In the secondary sector, thegovernment needs to withdraw from textiles, sugar, cotton, oilseeds, mines, and meatpreparation. Privatization should continue on the I I small- and medium-sized business,and started on the remaining 100. Finally, the prospects for privatizing large enterprisessuch as banking, oil, telecommunications, electric power, water, and port activities,should be evaluated. The mechanisms established should aim primarily at making theeconomy more efficient and promoting competition. The state must begin by establishingthe same rules for everyone to ensure that public enterprises do not receive preferentialtreatment in any industry.

(b) Enough work has been done to enable the Public Investment Program (PIP) to be quicklyrestructured. With a new focus on infrastructure and human resources, it will helpsupport economic growth. Production-oriented government projects, particularly inagriculture, as well as all projects with nonconcessional financing or requiring too high acontribution from the state, should be halted or suspended. Resources should be appliedto expediting the implementation and follow-up of priority target sector projects relatingto infrastructure, human resources, and the social assistance safety net. Implementationof other projects should be phased in according to the priorities, strategies, and localresource availability. With the help of donors, part of the project portfolio should berestructured to reflect sectoral strategies.

(c) Reorganizing the civil service to serve as an instrument of support for the country'sdevelopment is a long process. In the immediate term, the action plan for civil servicereform adopted in 1992 requires the state to reflect upon its essential functions and thebest means of discharging them in the context of a move towards decentralization and anenhanced role for the private sector.

Human resources policies

117. Though their impact will be felt only in the long-term, efforts to tackle demographic,educational, and health care problems will play a major role in helping Madagascar achieve itsgoals in 15 to 20 years. The family planning support program could be strengthened. Mostpressing--indeed the key to long-term development--are improvements in the primary educationand technical education systems.

THE STEERING GROUP

118. The success of the reform program will depend on the people who carry it through. Thegovernment will have to form a team of politicians and economists--a steering group--with acoherent vision of the overall strategy and the abilities needed to guide the reform process. Theteam must draw on the country's best intellects and be given all the technical resources it may need.Although the examples of South Korea, Malaysia, Thailand, and Mauritius may provide a basis forreflection, Madagascar will have to find its own way of achieving sustained growth and reducing

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poverty. Policies will be dictated largely by economic realities; however, the steering group cantailor implementation schedules and transition management approaches to take into account

Mvadagascar's specific needs and the Malagasy people's particular aspirations.

PARTICIPATION BY THE PEOPLE

l19. The reform program is very broad in scope and cannot succeed without the Malagasy

people's confidence and acceptance. There must be a broad consensus on economic policies, and

politicians must take great care to keep economic issues untainted by political controversy.

Confidence will also be restored if the government complies rigorously with its laws andregulations, ceases to act arbitrarily, and strongly supports an independent, revised judiciary. To

gain the people's acceptance, the government's economic program must be widely disseminated,

explained, and discussed. The stakes are very high, knowledge of the program's objectives and

rationale cannot be confined to a limited group of technocrats, but must be shared with all citizens.

This is the only way the people can be made to understand that everyone must make sacrifices, sothat everyone can eventually share in the benefits of growth and attain a better standard of living.

120. This report began by noting the incredible contrast between Madagascar's potential and

its current economic plight. The report shows that it is possible, albeit difficult, for the country to

regain hope in its economic future. If all goes well, the next generation will inherit a democratic

society based on a market economy, one in which living conditions have significantly improved.

By that time, there should be a competitive economy, with the state playing its proper role.

Investment in human resources will have paid off These assets will then enable Madagascar to

close the gap with the countries that showed it the way. The Big Island will no longer be a dim

economic candle, but a beacon of growth in the region.