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 of about 5.5 percent and consumer price inflation of about 2 percent, barring any major supply-side shocks. The overall fiscal deficit (including grants) is expected to increase slightly to about 3 percent ofGDP,

The latest evolution of Senegal’s public finances is analyzed in the recent Public Expenditure Review, June 2005.

The indicators listed in Doing Business have not improved markedly between 2003 and 2004 in Senegal. but it should be almost entirely financed by external resources. This increase will be principally explained by the surge in capital expenditures, with a doubling of the allocated public resources toward infra~tructure.~The extemal current account (including official transfers) deficit is projected to increase to 7.5 percent of GDP in 2005, as the result of the larger than expected increase in oil prices and the lack of impetus in new exports. As discussed in the next section, given the favorable macro-economic conditions, low debt levels, absence of central bank financing, and little risk of crowding out the private sector from the credit market, such a level of fiscal and extemal deficits should be accommodated without undermining macroeconomic stability.

111. PROGRESS IN IMPLEMENTING THE REFORM PROGRAM

14. The Private Sector Adjustment Credit (PSAC) is an integral part ofthe Bank Strategy set forth in the Country Assistance Strategy (CAS) for Senegal presented to the Board on April 17, 2003. The objective of the Credit is to support the Government in the implementation of sub- sector reforms aimed at improving the investment climate and accelerating private sector growth and employment. The PSAC supports the Government’s Poverty Reduction Strategy through improving the investment climate and implementing key sector reforms by: (i)restructuring the edible oil sector by improving the competitive environment in which it operates, through the elimination or reduction of policy distortions associated with non-tariff barriers and other domestic protection mechanisms, and of public interventions; (ii)supporting the implementation of a private enterprise tax regime that stimulates investments through a level playing field and lower taxes, and allocates user fees for private sector purposes for which they are levied; (iii) reforming postal services by introducing greater competition in the sector, restructuring the postal enterprise so as to enhance its sustainability and to create an autonomous financial subsidiary that would provide savings and payment and transfer services; and (iv) bringing changes to the pensions system to make it financially sustainable and improve its corporate governance.

Edible Oil Sector Reform 15. About 30 percent of the Senegalese population directly or indirectly derives part of its livelihood from the groundnut sector. The overall liberalization efforts pursued by the Senegalese Government in the 199Os, and more recently in 2001 with the divestiture ofthe seeds distribution subsidiary of the monopolistic groundnut processing public enterprise (SONACOS), have encouraged some efficiency gains. A major further step was taken with the successful privatization of SONACOS in February 2005.

16. A sector reform strategy, outlined in the Government’s Edible Oil Sector Policy Letter, calls for the following broad actions to be taken: (i)elimination of trade policy, and other regulatory and financial sector distortions; (ii)divestiture of SONACOS; (iii)complementary sector reforms, involving diversification of production in groundnut producing areas as well as

For a discussion on public investment spending and its effectiveness, see recent Public Expenditure Review, June 2005.

4 possible downstream measures to meet untapped demand; and (iv) clearance of accumulated liabilities, estimated at under CFAF 10 billion, through a one-time financial restructuring of the sector.

17. The PSAC focuses on the elimination of the most serious trade policy and domestic distortions which are seen as key to the effective development and diversification of the sector. The following condition of effectiveness was substantially met in December 2004, after three extensions, when the President signed the law eliminating the taxes that provided protection to domestic groundnut producers: “the Borrower has implemented the agreed action plan for the edible oil sector reform regarding the elimination or reduction, as the case may be, of the economic distortions in the areas of trade, domestic market and Jinancial sector policy, inter alia, through the elimination of the TCI and Taxe SpkciJique on edible oils. ’’

18. The Government first suspended the application of the TCI (Taxe Conjoncturelle d’Importation) benefit to the edible oils through administrative action camed out at the level of the Director General of Customs. This action was then complemented by the passage, on December 14, 2004 of Law No. 2004-34, which involved the abrogation and replacement of article 360 of the tax law (Code Ge‘ne‘ral des Impdts) with a revision that eliminates the protective tax imposed on both processed and unprocessed edible oils. This law will go into effect on December 31,2005, the closing date of the PSAC. Signing the law also allowed for the PRSC Ito go to the Board in December, after the Country Director indicated that the PRSC could not be presented to the Board with PSAC effectiveness outstanding. There are no floating tranche conditions related to the edible oil sector reform.

Tax Reform 19. The Government decision to proceed with a tax reform initiative arose out of in-depth diagnostic work undertaken in collaboration with FIAS. Investment in Senegal was being deterred by excessively high tax rates, hrther complicated by a multitude of taxes and user fees and heavy administrative arrangements. The system was recognized to lack transparency and encourage rent-seeking.

20. The tax reform process commenced in earnest with the prior Trade Reform and Competitiveness Credit (Cr. 3419) which assisted in the implementation of reforms covering VAT, tariffs and business taxation. The PSAC extends ths reform drive hrther with a program to reduce top rates and reduce a number of taxes, such that the Marginal Effective Tax Rate (METR) has decreased from 45 percent to 28 percent. Additionally, the reform package harmonizes the vocational training tax (Contribution Forfaitaire h la Charge de 1’Employeur - CFCE) treatment of national and foreign workers and allocates 30 percent of proceeds to the hnding of a matching grant facility being established under the PPP project (Private Investment Promotion Project, Cr. 3762). The reform also includes the rationalization of investment code waivers granted in regard to the consumption tax and import duties to bring these in line with the WAEMU Common External Tariff and the Value-Added Tax scheme.

2 1. This tax reform program has been widely supported by both the Senegalese Government and the private sector. The recent June 2005 meeting of the Presidential Investors’ Advisory Council that comprises both local and international business members highlighted the progress

5 Senegal has made in reducing the tax burden, both in terms of the overall level of taxation and the lack of transparency that exists in the system. The President also committed, during the course of the Council deliberations, to further reduce corporate tax to 25 percent. This will further reduce the METR to enterprises in Senegal.

Postal Services Reform 22. The objectives pursued by the Government are stated in the Letter ofPostal Sector Policy of April 17, 2003 and include: (i)improve overall performance through a progressive sector liberalization and increased private sector participation; (ii)modernize the legal and regulatory framework and strengthen sector regulation; (iii)safeguard the right to basic communications for all citizens through a funding mechanism to support the cost of universal postal services obligations; (iv) transform the historical postal operator into a modem and performing corporation through the definition and implementation of a new corporate strategy; and (v) promote the sustainable development of postal financial services in order to improve access of the population to basic financial and savings services, and channel these savings towards private investment funds.

23. The PSAC supports (i)ongoing reforms aimed at introducing more competition in postal services, strengthening corporate govemance, and restructuring the postal corporation so as to improve its sustainability and its service quality; and (ii)implementation ofthe required financial restructuring ofthe operator.

24. After a period of sustained progress, the postal services reform was slowed considerably in late 2004. Efforts are now being made by the Government to get the reform back on track and regain lost momentum. It is expected that two of the tranche conditions will be completed over the coming months, namely: (i)the effective transfer ofresponsibility for the regulation ofpostal services from SNP (Socie'te' Nationale de La Poste) to ART (Agence de re'gulation des te'le'communications); and (ii)performance-based agreement entered into between the Borrower and SNP for the operation ofpostal services.

25. The creation of the postal financial subsidiary and the problems arising out of staff indebtedness towards the company remain the most challenging aspects of the reform program. Agreement has been reached, taking into account the conclusions of the Financial Sector Assessment report completed in late 2004, to limit the initial round of financial subsidiary reform to the creation of a hlly public independent entity with a view to privatization at a later stage. The coming months will show whether the Government is able to complete this and hlfill the conditions for the release ofthe postal services reform floating tranche.

Pension Reform 26. The Government's pension reform strategy is described in the sector policy statement dated June 6, 2003. The first phase of reforms involves a series of parametric reforms and changes to the way the Institution de Pre'voyance Retraite du Se'ndgal (PRES) scheme is managed, in particular with regard to its investment policy and practices. The implementation of these policy changes requires a series of concrete steps including improvements to the existing information system, professional advice regarding investment policy, changes in accounting rules

6 and practices, as well as regular independent audits and training of Board, members and staff. These, along with other activities required to successfully implement the policy changes, are being supported under the pensions sub-component ofthe PIPP.

27. The second phase ofreform has two main components. The first area involves redefining pension policy that currently treats civil servants and private sector workers differently. There are clear arguments for the integration of the two existing formal schemes although this policy may be gradually applied. Integration would facilitate labor mobility, improve equity and would likely reduce overall administration costs. The second area involves the future role ofthe private sector in overall pension provision. As in the case of integration, the Government believes that systemic reforms must be constructed after the existing schemes are stabilized and credibility is restored. A systemic reform would require careful preparation, especially with regard to institutional design.

28. The PSAC supports an ongoing and multi-phase reform process that would completely restructure the existing pension system in Senegal. Specifically, the PSAC supports the shift to automatic indexation of key parameters of the pension scheme and an increase in the retirement age as immediate measures applied to the PRES scheme. This would be followed by the resolution of outstanding arrears in a way that restores pension rights to a significant group of workers and clarifies the status ofthe PRES balance sheet.

29. Several aspects of the pension reform are proceeding. A Supervision Commission was appointed in November 2004 and commenced full operations in June 2005. This is a key step in addressing the governance and management issues that are central to the reform agenda. The Government has also transferred approximately CFCA 8 billion in anears due to PRES who have advised that they are now making payments against these funds to pension recipients. Several key “tranche condition” studies are launched (selection of consultant done in July with start-up ofwork in August, 2005) including on the consolidation of existing pension schemes and on structural reform to introduce private pension funds. The investment policy report, the commission is working on a draft document transmitted by the new PRES Director, the report will be finalized and validated in October 2005. These will provide the analysis and recommendations critical to the next stage of the government’s institutional reform of the sector and subsequent policy decisions.

IV. PROGRESS AGAINST TRANCHE RELEASE CRITERIA

30. The first tranche was disbursed upon effectiveness. The conditions of release of the floating tranche listed in Part A of Schedule 2 ofthe Development Credit Agreement between the Borrower and IDA related to the Tax Reform Plan state that the following conditions must be fulfilled:

In accordance with the fiscal management plan referred to in paragraphs 22, 23 and 24 of the Letter of Sector Policy dated April 2003, the Borrower shall have furnished to the Association the evidence, in form and substance satisfactory to the Association, of the following:

7 1. reduction in the METR for the industry to 28percent or less - This condition has been met.

In conformity with the recommendation ofthe “Etude de l ‘Opportunitk de Baisse du Taux Effectifd ’Imposition (June 2003), a Fiscal Measure Action Plan was prepared which detailed the series ofmeasures that were required to reduce the METR.

This was achieved by the adoption ofLaw No. 2004-12 ofFebruary 12,2004 which modified the relevant sections ofthe General Tax Code. The World Bank has received, as part ofthe application package for this floating tranche release, copies ofthe original Fiscal Measure Action Plan, plus a copy ofthe new Tax Code with a summary table ofthe tax changes effected. This has been reviewed by Bank experts who have confirmed that the METR rate has been reduced to less than 28 percent.

2. elimination of specific exceptional tax regimes, including inconsistencies between the WAEMU Common External Tariff and the VAT, but excluding exceptional tax regimes for certain exporters, the extractive industry sector and the tourism sector, as agreed with the Association - This condition has been met.

The elimination ofthe specific, exceptional tax regimes was achieved with the adoption of the new Investment Code (Law 2004-06, February 6,2004), together with the new Mining Code (Law 2003-36, November 26,2003). The streamlining of consumption tax and import duty waivers in the Investment Code has achieved the desired consistency between the Investment Code and the WAEMU Common External Tariff and VAT codes. Also of particular note within the Mining Code is the elimination of any discretionary waiving ofthe annual mineral tax (see article 57).

The World Bank has received, as part of the application package for this floating tranche release, copies ofthe new Mining and Investment Codes.

3. harmonization of the rate of the CFCE to 3 percent and utilization of at least one- third of revenues collected in respect thereof tofund a matching grant facility - This condition has been substantially met.

Under Law 2004-34, adopted on December 14,2004, the differential vocational training tax CFCE rate (3 percent for national employees and 6 percent for foreign employees) was harmonized to 3 percent. This was achieved by abrogating the existing article 198 ofthe General Tax Code. Additionally the Government, in its letter ofApril 27, 2005, has committed to allocate one third of the value ofthe CFCE revenues to the matching grant scheme being developed under the associated PIPP project.

The World Bank has received, as part of the application for this floating tranche release, relevant correspondence confirming actions taken under Law No. 2004-34 and a letter from the Minister ofBudget confirming commitments and actions to be taken in fulfillment of the allocation to the matching grant scheme. The Government has further confirmed that changes are being made to the draft Budget Law for FY06 to give effect to this allocation of CFCE user charges. This proposed draft budget law will have been prepared and available by November 2005. Based on these assurances, the Bank is satisfied that at least one third ofthe revenues collected from the CFCE will be utilized to fund the matching grant facility.

31. The Borrower has therefore met the three conditions for the release of the Tax Reform Plan floating tranche as specified in Part A of Schedule 2 ofthe Development Credit Agreement.

V. CONCLUSION 32. In view of the overall performance and progress with the implementation of the Tax Reform Plan supported by the Credit, and in compliance with the specific conditions ofrelease as described in paragraphs 1-3 of Section IV above, the Association has informed the Borrower of the availability of the tax reform floating tranche in the amount of SDR 4.7 million.

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