ECONOMIC REFORMS IN THE MEDITERRANEAN REGION

EURO - MEDITERRANEAN ECOFIN MINISTERIAL MEETING (TUNIS, 25-26 JUNE 2006) ECONOMIC REFORMS IN THE MEDITERRANEAN REGION AN OVERVIEW OF PROGRESS IN THE FOUR PRIORITY AREAS AGREED BY THE EURO-MED ECOFIN IN RABAT-SKHIRAT (JUNE 2005) BACKGROUND NOTE EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRS Table of contents Background and summary...2 I. Overall situation in the region... 3 II. Improving the business climate to enable firms to invest, create jobs and expand... 3 III. Further liberalizing trade and opening the economy, while simultaneously protecting the most vulnerable groups of population, to increase competitiveness, efficiency and productivity... 5 IV. Upgrading public institutions and governance systems... 7 V. Consolidating macroeconomic stability and public finance management... 7 VI. Concluding remarks... 9 1

Background and summary This background note has been prepared by the European Commission as a contribution to the discussions at the second Euro-Mediterranean ECOFIN Ministerial meeting (Tunis, 25-26 June 2006). It aims to offer an overview of progress in the four priority areas for reforms agreed upon at the first Euro-Mediterranean ECOFIN Ministerial meeting (Skhirat-Rabat, June 2005). One of the goals of the first Euro-Med ECOFIN meeting was to jointly take stock of recent economic developments in the Mediterranean region, assess the main economic policy issues confronting the EU Mediterranean partners, and discuss the value added to be expected from the reinvigorated Euro-Mediterranean Partnership and the European Neighbourhood Policy. Ministers agreed that, in order to lift obstacles to growth and job creation, an acceleration of economic reforms will be necessary in four inter-related priority areas: (i) improving the business climate to enable firms to invest, create jobs and expand; (ii) further liberalizing trade and opening the economy, while simultaneously protecting the most vulnerable groups of the population, to increase competitiveness, efficiency and productivity; (iii) upgrading public institutions and governance systems to improve public service delivery, particularly in education, and raise transparency and accountability; while, at the same time, (iv) consolidating macroeconomic stability and public finance management through further fiscal consolidation in countries with high debt ratios and high quasi-fiscal deficits, and maintaining prudent monetary policies. The five-year work programme agreed by the leaders of the Euro-Mediterranean Partnership on the Summit for the 10 th anniversary of the Barcelona Declaration reflects the Skhirat four priority areas for reforms. In agreement with the conclusions of June 2005, this second ECOFIN Ministerial meeting provides an occasion to Ministers of Finance and Economy to ensure peer review of, and peer support to, the reform process. Therefore, Ministers are invited to review progress made in each of the four agreed priority areas briefly described in this background note. Overall, over the last couple of years, the MED countries achieved considerable progress in improving the business climate but they still score below the world average with respect to an index measuring the current business environment in 2005. Trade reforms have advanced strongly largely in connection with recent bilateral and multilateral agreements and the implementation of the Association Agreements with the EU; but the region continues to be among the most trade-restrictive worldwide. In the area of governance, the MED countries continued progress in improving public sector accountability and the quality of administration, but these reforms need to be accelerated as they are particularly important for progress in other areas. The region consolidated macroeconomic stability but remains vulnerable to external shocks. Robust economic performance experienced in recent years continued in 2005 but came under pressure on account of increasing oil prices. The note concludes that Mediterranean countries should seize the opportunity of the current macroeconomic stability, promising global outlook and picking up economic activity in the EU to vigorously address their economic development challenges and accelerate progress in the four inter-related priority areas. In this respect, the enhanced policy dialogue with the EU in the context of the European Neighbourhood Policy, the objectives jointly agreed in the Action Plans, as well as the increasing support mobilised by the EU provide a useful framework for accelerating reforms. 2

I. Overall situation in the region The economic performance of the region in 2005 was shaped by two major external factors: increasing oil prices (from an average of USD 38 a barrel over 2004 to more than USD 53 over 2005 an increase of more than 40% year on year) and the expiry of the WTO multifibre agreement. The adverse impact of higher oil prices on the fiscal and current accounts was mitigated to a certain extent through a range of transmission channels from the oil producers, including intra-regional tourism, portfolio equity flows and labour remittances. Excess capital liquidity in the region has been recycled through direct investment projects in industry, finance and real estate, as well as on the stock exchange markets, particularly in the Mashreq countries. Region-wide, security remains an issue of concern and appears to have had an effect on economic performance. Long-term growth prospects throughout the region continue to depend, however, on progress in building sustainable conditions for stronger economic growth and job creation through implementing broad-based structural reform. The sections below review recent developments in each of the four priority areas of reform agreed by Ministers. 1 II. Improving the business climate to enable firms to invest, create jobs and expand Mediterranean countries achieved considerable progress in improving the business climate but they still score below the world average with respect to an index measuring the current business environment in 2005. Evidence from country surveys shows that countries having complex regulations often show higher rates of unemployment and are more likely to nurture growing informal sectors. Indeed, cumbersome procedures push entrepreneurs into the informal economy, where businesses pay no taxes, workers lack health insurance and pension benefits, and businesses do not benefit from credit to expand their activities. Therefore, there is a major incentive for countries to continue making progress with reforms. Easing the business environment will pay in terms of higher government revenues, lower unemployment rates, and better standard of living for workers, all of which is badly needed in the MED region. Some countries have made commitments in the ENP Action Plans and by endorsing the Euro- Mediterranean Charter for Enterprise to improve the business environment and the investment climate. However, further efforts should be undertaken in the region to overcome current regulatory constraints, particularly in the areas in which regional performance is below world average such as, for instance, contract enforcement, access to credit, hiring and firing workers, and procedures to start a business. Most recent data available confirm that, on average, Mediterranean countries score below the world average with respect to an index measuring the current business environment in 2005. 2 However, during the last three years, the region's progress in improving the business climate has been considerably above world average. The greatest progress occurred in Jordan, Morocco and Tunisia, all ranking among top reformers; noticeably, Jordan has been in the top 1 Indicators of reform used in sections 1 and 2 on business climate and trade liberalisation are mainly based on the World Bank (2006), MENA Economic Developments and Prospects. Channelling Petro-dollars into the Real Economy: MENA's Financial Markets. 2 The current business environment index reflects country's current placement in a worldwide ordering of countries based on a variety of business indicators with 100 reflecting the country with the most friendly business policies and 0 representing the country with the most unfriendly business policies. 3

list of reformers not only among the MED countries but also worldwide. In contrast, limited progress has been achieved by Syria. Egypt has accelerated reforms since 2004. With regards to contract enforcement, the region ranks on average below the world average. These countries wait on average 430 days for a commercial contract to be enforced, about twice as long as OECD countries. The region contains extreme cases such as Lebanon and Syria with 721 and 672 days on average, respectively. On the other side of the spectrum, Tunisia takes only 27 days, the best result region-wide. Private sector's access to credit remains limited due to the fact that, in many Mediterranean countries, the financial sector is under-developed, credit is largely directed towards state-owned enterprises and requires high collaterals, and financial institutions face difficulties in obtaining their claims or collateral through the judiciary system. Within the region, some countries like Jordan have taken measures to liberalize the banking sector and modify taxation regimes, resulting in an increased private sector participation in the economy. Morocco and Tunisia have also made progress in strengthening the legal, regulatory, and supervisory framework of the financial sector, although in the case of the former, further efforts are needed to improve the access of small and medium-sized enterprises to credit. Private sector access to credit is bound to benefit from the consolidation of the privatization trend permeating the region, although with uneven impetus at a country level. During 2005, Algeria started the liberalization of the hydrocarbon and telecommunications sectors and Egypt and Jordan made progress with the sale of the 70-80% share of the Bank of Alexandria (one of the four largest state-owned banks in Egypt) and plans to privatize Jordan Telecom and the Jordan Phosphate Mines Company. In contrast, progress stalled in Lebanon as a result of numerous political deadlocks, and in Syria. Rigid labour regulations have prevented Mediterranean countries from reaping the benefits of flexible labour policies. Overall, Mediterranean countries are proceeding slowly with reforms in labour regulations and performing very differently: while Morocco adopted in 2004 a new labour code which is expected to improve labour relations and flexibility in the labour market, other countries such as Syria still have a very rigid labour market, including measures limiting the employer s right to lay off workers for economic reasons, and large non-wage benefits in the public sector that discourage mobility. Egypt also faces particularly rigid regulations to fire a worker ranking 80 th in an index measuring the difficulty of firing although Tunisia remains the hardest place to fire a worker (ranking 100 in the same index). In 2005, the Tunisian authorities started active policies to make it easier to hire new staff, notably by creating new types of temporary contracts; however, to be completely effective, this policy will need to be flanked by measures to ease the rigid regulations and procedures governing dismissals. Reforming labour markets should be accompanied by measures improving the efficiency and coverage of social safety nets. Region-wide, starting a business remains the most cumbersome procedure, with Mediterranean countries on average ranking in the bottom third of countries worldwide with respect to time, cost, and number of procedures necessary to start a business. However, progress has been recorded in Morocco, which reduced the number of procedures from 11 to 5 from 2003 to 2005; Tunisia, which reduced by more than 90% the minimum capital requirement to start a business in 2005; and Egypt, which reduced from 43 to 34 the number of days to start a business. In addition, Egyptian customs procedures were significantly eased by establishing a single window for trade documentation and merging 26 approvals into 5, all of which made Egypt the world's top performer in customs reform. Mediterranean countries also face dense regulations with respect to other indicators influencing the region's business environment as, for instance, securing the rights to 4

property, complying with licenses and permit requirements, and paying taxes. With respect to the latter, the region performs slightly over the world average in terms of number of payments, time, and percentage of gross profit firms have to pay. However, at country level large differences emerge; for example, Algeria performs poorly not only in the region but also worldwide as regards paying taxes: firms must make 63 payments, spend 504 hours, and pay 58.5% of gross profit in taxes. In contrast, firms in Jordan make on average 10 payments, spend 101 hours and pay 39.8% of their gross profit, all of which places Jordan at the top ten world performers on this indicator. Some progress has taken place in 2005 in Egypt with the signature of a simplified income tax law resulting in substantial personal and corporate tax rates cuts. Egypt also cut the fees for registering commercial property by a third, from 4.5% to 3% of the property value. III. Further liberalizing trade and opening the economy, while simultaneously protecting the most vulnerable groups of population, to increase competitiveness, efficiency and productivity Trade reforms have advanced strongly led by deep tariff reductions, especially in Egypt. Reforms were pursued largely in connection with recent bilateral and multilateral agreements and the implementation of the Association Agreements and the Action Plans with the EU. The Euro-Med Trade Ministerial Conference in Marrakesh has launched the process of liberalisation of trade in services and investments. Although the region has made considerable progress with tariff reform over the last years, MED countries continue to be among the most trade-restrictive worldwide. Much of the region's trade-restrictiveness stems from continuing high tariff protection. Most countries in the region Algeria, Jordan, Morocco, Syria and Tunisia maintain simple average tariffs 10% above the world average 3. But the region also suffers from proliferation of non-tariff barriers, as well as lengthy processes for both importing and exporting. Trade protection is especially acute in Syria not only in terms of tariff protection (average tariffs close to 20%), but also in terms of cumbersome processes for both exporting and importing. On the contrary, achievements have been made on the trade facilitation front by countries which had not yet undertaken deep reform. Tunisian and Moroccan customs carried out reforms to simplify import procedures. FDI flows, mainly from the Gulf countries, continued to rise remarkably for some countries (Jordan, Tunisia and Egypt) but decreased in some others (Morocco, Algeria). The Barcelona+10 anniversary Summit in November 2005 re-confirmed the 2010 free-trade agreement objective of the Euro-Mediterranean Partnership. The policy is now pursued through the implementation of an ambitious trade roadmap, which is part of the five-year work programme adopted at the Barcelona Summit last year. It revolves around creating and implementing all possible instruments for tariff dismantling, market access, trade-related and regulatory policies between the EU and its partners and among the partners themselves, on the one hand, and extending and deepening trade liberalisation in agriculture and in the services sector, on the other. Over 2005, many MED countries made further progress with implementing the Association Agreements with the EU by continuing to dismantle tariffs for industrial goods (e.g. Egypt, Morocco, and Tunisia) and adopting the new Pan-Euro-Med Protocol on rules of origin 3 This reflects MFN rates. For most countries, however, average tariffs applied to imports from the EU are lower. 5

(Egypt, Israel, Jordan, Morocco and Tunisia). In 2005, Association Agreements with the EU entered into force in Algeria and Lebanon. Also, 2005 saw the formal entry into force of the Action Plans drawn up under the European Neighbourhood Policy with a number of MED countries and the start of preparations of the Action Plans for some of the others. The Action Plans provide for a much broader agenda of policy dialogue with the EU in a vastly expanded set of economic, social and sector issues. Tackling the remaining obstacles to trade at the borders and starting the structural and regulatory reforms that will reduce behind the borders obstacles to trade and investments are among the key objectives of the Action Plans. The 5 th Euro-Med Trade Ministerial Conference, held in Marrakech on 24 March 2006, provided the political impulse to start the process of the liberalisation of trade in services and investments (right of establishment). Furthermore, insofar as it will cover investments, liberalisation will tackle establishment of companies in the agricultural, manufacturing and services sectors. Ministers pointed out that the economic benefits in terms of market integration, attraction of foreign direct investment, employment and growth resulting from a substantial liberalisation of services and investment could significantly contribute to economic development by enhancing regional economic integration. Negotiations on services and right of establishment were launched in Marrakech with Morocco, Tunisia, Israel, Jordan, Lebanon, Egypt and the Palestinian Authority. Other Mediterranean partners will join the negotiations process in due course. These negotiations will have a regional dimension insofar as they will encourage South-South liberalisation for the sake of the regional FTA in an attempt to avoid market segmentation. Liberalisation of trade in agricultural, processed agricultural and fisheries products is the other major work in progress towards the establishment of a genuine FTA by 2010. In Marrakech, Ministers confirmed the plan to deepen agricultural trade liberalisation on the basis of the Rabat roadmap and the principles of the Barcelona declaration, as indicated in the five-year work programme. In parallel, non-trade aspects such as sustainable rural development, geographical indications and quality of production, all integral part of the Rabat roadmap, will be addressed as a complement to market access negotiations. Such negotiations have already started, or are about to be launched, with a number of MED partners since the beginning of 2006. Finally, Ministers noted that the increase in trade in goods and services resulting from the implementation of a number of Association Agreements will require the adoption of a clear and streamlined mechanism to resolve trade disputes. To this end, they agreed to strengthen the rules of procedures in the Association Agreements by negotiating an efficient and proportionate dispute settlement mechanism specifically applicable to the trade domain. Ministers agreed to launch negotiations between the EU and the Mediterranean partners on this mechanism with the objective of concluding the first bilateral protocols by the end of 2007. There is some evidence indicating that the expiry of the WTO Multi-Fibre Agreement (MFA) at the beginning of 2005, and the increased competitive pressure mainly from Asia, has had a negative impact on exports of some Mediterranean countries highly dependent on the textile and clothing sector (Tunisia, Morocco, Jordan and Egypt). Textile exports in Morocco and Tunisia, which are concentrated in the EU markets, suffered the most. Egypt, whose exports are well diversified geographically between the EU and the US markets, has managed to maintain textile exports to date in part by cushioning the impact with a December 2004 agreement on qualifying industrial zones (QIZs) with the US and Israel. Morocco signed an important agreement with Turkey, which will allow it to take advantage of cheaper Turkish inputs in the production of its own textiles to European markets. The implementation of the free-trade agreement with the United States, in force since January 2006, will also enhance 6

trade flows. The weakening export market in Tunisia affected jobs in the sector which decreased by 9% from employment values in 2004. IV. Upgrading public institutions and governance systems In the area of governance, the MED countries continued progress in improving public sector accountability and the quality of administration. These reforms are particularly important for a successful implementation of other areas of the reform agenda. Issues that need to be addressed as a matter of urgency include re-focusing the role of the state on the priority areas for sustainable development - education, health care and infrastructure - raising the efficiency and impact of public interventions and the quality of public services, ensuring the independence of the judiciary and increasing transparency and accountability of public actions. Weak government effectiveness, low quality of administration and a lack of accountability remain fundamental challenges in many countries. Governance reform continued in the MED countries in 2005. On the administrative side, there have been various achievements in Jordan and Morocco, which embarked on ambitious programs of civil service management reform. In Egypt, civil service reform was advanced in December 2005. There has been additional progress by the region in attacking corruption, including in Algeria, Jordan and Egypt. A major achievement in enhancing public sector accountability has occurred with Morocco s recent adoption of the Law on Political Parties, which helps consolidate the credibility and efficiency of political parties and institutions. In particular, the law aims, first, at enabling the political parties to take more responsibility and be more accountable to their constituencies. Second, the law seeks to improve the efficiency of the parliamentary work. V. Consolidating macroeconomic stability and public finance management The region consolidated macroeconomic stability while remaining vulnerable to external shocks. Robust economic performance experienced in recent years continued in 2005 but came under pressure on account of increasing oil prices. Without further progress in structural reforms, the economic situation is likely to deteriorate in the medium-term. Following an economic upswing in 2004 and an average real growth rate of 5%, the region continued to grow in 2005 at a comparable pace (4.8%). Although robust, the region growth rates still lagged behind growth of 7.2% observed in other emerging markets and developing countries. On a per capita basis, the MED countries continued to grow at lower rates than the developing countries as a whole (3% in MED compared to 4.7%). 4 In general, output growth was again mainly influenced by external factors. Although exerting pressure on their external and fiscal accounts, high oil prices benefited some oil-importing countries in the region via close economic linkages with major Arab oil producers. Oil revenues have been recycled through direct investment projects in industry, finance and real estate, as well as on the stock exchange markets, particularly in the Mashreq countries. A 4 However, the pace of improvement of their living standards becomes comparable to other developing countries if China and India are excluded. 7

sharp increase in the stock prices in several Mediterranean countries, mainly due to capital inflows from Arab countries, continued to mark the developments in the financial sector in 2005. However, the net impact of the increasing oil prices on growth may become negative without further progress in structural reforms. Lebanon and Morocco were exceptions to the positive regional trends. In Lebanon, following the political turmoil at the beginning of the year, GDP stagnated in real terms in 2005 after a 10-year record of 6% GDP growth in 2004. Morocco experienced a considerable economic slowdown from 4.2% in 2004 to 1.8% in 2005 on the back of a severe drought, high oil prices and the abolition of textile quotas. In Syria, relatively meagre growth rates of 3.5% reflect among other things depleting oil reserves and a shortage of refinery capacity. Unemployment remains high in most countries. Officially-reported unemployment rates range from 9.1% in Israel and 9.5% in Egypt up to 23% in West Bank and Gaza. Despite robust economic performance, unemployment increased in Jordan (from 12.5% in 2004 to 15.7% in 2005) and in Syria (from 16% in 2004 to 20% in 2005). Considerable improvement was observed, however, in Algeria, Israel and WB&G. In 2005, overall inflationary pressures remained contained at 2.8% (2004: 2.9%) with inflation rates ranging in the region from 0.3% in Lebanon and 1% in Morocco to 3.8% in Egypt. The marked increase in oil prices has thus not led to a significant increase in inflation rates on account of price regulations and/or oil subsidies. Upward pressures emerged, however, in Syria where the average inflation rate went up to 10% in 2005 from 4.6% in 2004 on account of important currency depreciation. The fiscal situation remains a challenge in many countries, notwithstanding efforts to consolidate public budgets. High oil prices exerted additional pressure on governments' budgets in those oil-importing countries where energy is subsidised to a significant extent in a regressive and untargeted way. Several countries have implemented short-term adjustments to oil prices (e.g. Jordan) although the concerns of potential poverty impacts have held back more ambitious reforms. Some others (Morocco and Tunisia) are working to put in place longer-term measures to reduce consumption and dependence upon oil. On the back of high growth rates, the slight improvement in fiscal balances observed in 2004 continued also in 2005 and the regional average central government deficit decreased from 2.1% of GDP in 2004 to 1.2% in 2005. Algeria and Syria showed an improvement in the overall fiscal balance but their non-oil deficit to non-oil GDP ratios remained high. Egypt, Morocco, Jordan and WB&G experienced acute deteriorations in their fiscal deficits compared to 2004. Along with rising oil subsidies (amounting for example in Jordan to 5.8% of GDP in 2005 compared to 3.1% in 2004), increases in public sector wages in various countries resulted in a total expenditure increase of almost 13% over 2005. Most countries remain characterised by a relatively weak tax base. Substantial gains were, however, observed in both income and sales tax revenue across the region over 2005 (increase by 6% over 2005, up from a 3% growth in 2004 in the oil-importing MED countries). Reducing high public debt remains a key medium-term challenge for Lebanon, Egypt, Israel and Jordan; however remarkable progress was achieved by these countries in 2005 except in Lebanon. In Algeria, sizeable surpluses in the balance of payments have allowed to continue the process of external debt pay-off initiated in 2002. The vast majority of Mediterranean countries, albeit to different degrees, are taking steps to improve budget and fiscal management systems. The early reformers have already been successful in putting in place the main basic elements of a sound public finance management system. Nevertheless, many countries still display major weaknesses in the degree of transparency and comprehensiveness of their budgets, in the rules and practices applied to 8

budget planning, preparation and execution, as well as in the level of external accountability. Addressing these challenges through active public finance management reforms is crucial, both to maximize the effectiveness of public spending and to ensure better fiscal outcomes in terms of stability, sustainability and resilience to shocks. A high degree of current account volatility and vulnerability to external shocks continues to characterise the region. On account of high oil prices, which have led to a sharp increase in the oil import bills for the net oil-importing countries, current account balances deteriorated in most countries of the region in 2005. The combination of high oil prices and a sharp reduction in oil grants has been most severe in Jordan where the current account, in balance in 2004, turned drastically to a deficit of 17.8% of GDP in 2005. The deficit remained severe in West Bank & Gaza (22% of GDP). The regional surplus of 3.0% of GDP (2004: 3.5%) remained, however, strong, thanks to an improvement in Algeria from 16.8% to 21.1% of GDP on account of high oil revenues. Remittances continued to be a strong source of external financing in 2005 alleviating pressures on the current account stemming from relatively large trade deficits in non-oil exporting countries. Important factors affecting external performance and its volatility include limited export diversification, particularly in Algeria and Syria, highly fluctuating agricultural production depending on weather conditions, as well as security risks which can have severe repercussions on tourism receipts. VI. Concluding remarks Creating jobs and reducing unemployment, especially among the young, remains the main development challenge faced by the MED region. Building conditions for higher, domestic and broad-based economic growth rates over a sustained period of time is crucial in this context. Mediterranean countries should seize the opportunity of the current macroeconomic stability, promising global outlook and picking up economic activity in the EU, their main regional trading partner, to vigorously address these economic development challenges. Oil prices are expected to remain at high levels exerting continuing pressure on the external and fiscal accounts in the oil importing countries. Only part of this negative impact may be compensated with higher capital and tourism inflows from the oil-producing countries in the region. In the absence of significant fiscal consolidation and structural reforms, the economic situation is likely to deteriorate in the medium-term. For the oil-exporting countries, the challenge is to manage efficiently the large fiscal receipts, while avoiding their potentially destabilising macroeconomic consequences. Growth prospects will be driven by changes in the policy environment. Overall, over the last couple of years, the MED countries achieved considerable progress in improving the business climate but they still score below the world average with respect to an index measuring the current business environment in 2005. Trade reforms have advanced strongly largely in connection with recent bilateral and multilateral agreements and the implementation of the Association Agreements with the EU; but the region continues to be among the most traderestrictive worldwide. In the area of governance, the MED countries continued progress in improving public sector accountability and the quality of administration, but these reforms need to be accelerated as they are particularly important for the successful implementation of other areas of the reform agenda. The region consolidated macroeconomic stability but remains vulnerable to external shocks. Robust economic performance experienced in recent years continued in 2005 but came under pressure on account of increasing oil prices. 9

Therefore, further progress is required in the four inter-related priority areas: (i) improving the business climate; (ii) further liberalizing trade and opening the economy; (iii) upgrading public institutions and governance systems; while, at the same time, (iv) consolidating macroeconomic stability and public finance management. The European Neighbourhood Policy will continue to provide a comprehensive policy support to the reforms in the MED countries. 10