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33651 Republic of Senegal Private Sector Adjustment Credit (Cr. 3875-SE) Public Disclosure Authorized Release of the First Floating Tranche - Full Compliance I. BACKGROUND 1. Senegal is located on the West Coast of Afnca and is part of the West African Economic and Monetary Union (WAEMU). With a population estimated at about 10 million, its economy is dominated by a few strategic sectors, including groundnut, fisheries, and services. The informal sector accounts for about 60 percent of its economy. Its rural economy frequently suffers from drought and lacks access to basic services and infrastructure, leading to low productivity, high emigration and higher poverty rates in rural areas. About half ofthe population lives in cities, including 30 percent in Dakar. Public Disclosure Authorized 2. Over the past years, Senegal has enjoyed a stable political climate, and has remained largely unaffected by regional instability. A peace agreement was signed in the Casamance at the end of 2004, generating donor support for the construction effort, including the World Bank. In April 2000, Mr. Abdoulaye Wade, third President of the Republic of Senegal, and the new Government assumed office, representing the first transition to another political party since independence. A new Constitution, approved in January 2001, reduced the length of the presidential term from seven to five years and the unlimited number of terms to two. Legislative elections were concluded on April 2001, and municipal elections in May 2002 saw a majority of seats won by the President’s Party (Senegalese Democratic Party). 3. The next two years will see an increase in political activities since legislative and Public Disclosure Authorized presidential elections are scheduled to take place in 2006 and 2007, respectively. This political cycle may influence the pace of economic reforms and fiscal policy. Such risks became apparent with some governmental spending irregularities in 2003 (which came to light in June 2004), and could appear again over the coming months in spite ofthe recent remedial actions taken by the authorities. 4. Over the past few years, Senegal’s macroeconomic performance has been encouraging with GDP growth averaging over 5 percent and the absence ofmajor disequilibrium in its fiscal and extemal balances. Sustained and relatively rapid economic growth has reduced the level of absolute poverty, from 65 percent in 1994 to 57 percent in 2001, a significant achievement by both historical and regional standards. However, Senegal remains a poor country with a GNI per capita ofUS$690 in 2004, and also remains a dual economy, with two thirds ofthe poor living in rural areas. Public Disclosure Authorized 5. While the picture of a stable, low inflation, growing economy, poised to substantially reduce poverty is accurate, there are constraints that the Government will need to address in order to increase economic performance in line with its new Accelerated Growth Strategy (AGS). Since 1994, GDP growth seems to have been driven mostly by internal demand, recovering from 1 stagnation preceding the devaluation, rather than being based on external competitiveness stemming from growth in productivity, a more favorable exchange rate and an improved investment climate. Analysis conducted for the Country Economic Memorandum for Senegal issued in 2003 shows that despite strong GDP growth, the response ofexports to the devaluation has been lackluster, sustainability of commodity exports such as fish and groundnuts is fragile, and the long-term trend in manufacturing productivity (both labor and total factor productivity) has been one ofstagnation and even decline. In addition, the formal sector provides no new net employment opportunities. About 200,000 new job seekers enter the labor market each year and many end up underemployed or engaged in subsistence jobs. The recently completed Investment Climate Survey highlights a number of institutional and transversal constraints that need to be removed before private investment will take off. 6. Senegal thus faces a series of developmental challenges to sustain economic growth and achieve poverty alleviation. The Government and other Senegalese stakeholders have recognized these challenges, which are addressed in the Government’s medium-term poverty reduction strategy and the work now being done to develop the AGS. The Government has given a clear leading role to enhancing private sector development in these strategy initiatives. Encouraging private activities is a prerequisite to reduce unemployment and under-employment, which remain important, especially in remote areas and for young adults in urban areas. 7. The Government has started to improve the quality of the investment climate and strengthened structural reforms in strategic sectors. Based on recent studies, surveys and analysis [Investment Climate Assessment, Financial Sector Assessment Program (FSAP), Doing Business, FIAS survey] several constraints continue to limit the expansion and competitiveness of Senegal’s private sector. Over the next few years, the Government needs to pursue its efforts and achieve significant improvements in the provision of infrastructure, the quality of the investment climate and the gradual diversification ofproduction away from traditional resources such as vegetable oil. In terms of the investment climate, key obstacles to private sector development include limited access to finance for small- and medium-sized enterprises; the poor functioning ofthe judiciary; remaining administrative barriers, with access to land being a major issue; and the complex tax regime. 8. Other significant developmental challenges that have been identified include improving the transparency and efficiency of budgetary and financial procedures of the State, increasing delivery of basic social services in the regions, improving the performance of health and education, and increasing protection of vulnerable groups. IDA’S Board approved the First Poverty Reduction Support Credit (PRSC I)in December 2004, which has focused on three crosscutting and institutional areas: (i)fiduciary reforms, by strengthening budgetary and financial procedures and procurement; (ii)decentralization, by securing financial transfers to local governments as well as disseminating and implementing the Poverty Reduction Strategy at the local level; and (iii)health services. This agenda has subsequently been expanded under the planned Second PRSC, to also include wealth creation and social protection. 2 11. RECENT ECONOMIC PERFORMANCE 9. In 2004, real GDP growth reached 6.4 percent with inflation below 1 percent, despite the impact of a locust infestation. Although the real effective exchange rate (REER) appreciated by about 12 percent during November 2000-October 2004, reflecting mainly the appreciation ofthe euro (to which the CFA franc is pegged) against the U.S. dollar, it has remained depreciated by about 8 percent since 1994, compared to an appreciation of the REER in almost all other countries of the West African Economic and Monetary Union (WAEMU). On the monetary front, the BCEAO lowered its key lending rates by two percentage points in an effort to stimulate further credit growth to the private sector, but this measure failed to translate into a decline in commercial interest rates because of excess reserves in Senegalese banks. 10. In 2004, the fiscal performance continued to be satisfactory since the overall fiscal deficit (including grants) remained below the IMF program ceiling of 2.7 percent ofGDP, and the basic fiscal balance was also better than programmed. The over-performance reflected larger-than- expected revenue and grants, accumulation of deposits of public entities at the treasury, and a decline in current expenditures.’ These developments offset a sharp increase in capital expenditures caused by a faster-than-expected rate ofproject implementation, notably in projects funded by external resources. 11. The recent economic growth has been associated with a widening of the current account deficit from 5.9 percent of GDP in 2002 to 6.2 percent of GDP in 2004. This deterioration was driven by strong domestic demand, mainly from the public sector, and lackluster export performance. However, substantial private capital inflows, combined with debt relief, led to an increase of 36 percent in the net international reserves of the central bank, reaching about 4 months of imports at the end of2004. 12. Over the past few years, private sector performance has been mixed since the overall private investment rate declined from 12.3 percent of GDP in 2000 to 11.8 percent of GDP in 2004. This decline reflects the volatility of the agricultural sector to extemal shocks and the unequal performance ofthe industrial and service sectors. A few sectors such as construction (up by 12.4 percent in 2002 and 10.5 percent in 2003) and mining have expanded faster than the overall economy through access to new financing (e. g., remittances) and the arrival of a few new foreign investors, but others, such as fisheries and transports, have suffered over the past few years. This absence of dynamism is partly the result of lack of significant progress in the investment climate.* The recent Bank’s hvestment Climate Assessment concluded that labor productivity declined in Senegal over the last two decades, emphasizing the need to reverse this trend if Senegal wants to be in a position to achieve stronger and more equitable growth. 13. The macroeconomic objectives for 2005 include real GDP growth