Algeria remains heavily dependent on the hydrocarbon sector and still maintains a sizable and inefficient state-owned enterprise sector. Against this background, the paper addresses two different issues with important implications for macroeconomic stability in Algeria. The paper proposes the replacement of directed credit to large loss-making public enterprises with temporary and explicit budget subsidies. It also shows that money, volume of imports, and weather conditions have a strong impact on price movements in the short term, whereas the exchange rate has none.


Algeria remains heavily dependent on the hydrocarbon sector and still maintains a sizable and inefficient state-owned enterprise sector. Against this background, the paper addresses two different issues with important implications for macroeconomic stability in Algeria. The paper proposes the replacement of directed credit to large loss-making public enterprises with temporary and explicit budget subsidies. It also shows that money, volume of imports, and weather conditions have a strong impact on price movements in the short term, whereas the exchange rate has none.

II. Replacing Bank Credit to Loss-Making Public Enterprises with Temporary Budget Subsidies in the Context of a Restructuring Program1

The main objective of this proposal is to remove from public banks the burden of being the financier of last resort for some large loss-making enterprises in order to facilitate the privatization of public banks and the implementation of banking reform. Freeing public banks from their quasi-fiscal activities will at the same time increase transparency of fiscal policy, improve governance, and provide an incentive for subsequent public enterprise restructuring).2

A. Overview

6. After more than ten years into the economic transition process to a market economy, Algeria still maintains a sizable and inefficient state-owned enterprise sector. Continued financial support to public enterprises through directed credit has been the main factor of the fragility of the Algerian banking system.3 Large loss-making public enterprises have been resistant to productivity enhancing reforms. Furthermore, the needs of state-owned enterprises for credit have reduced, everything being the same, limited financial resources available for private sector development. Repeated attempts at public enterprise restructuring as well as several bailouts and recapitalizations of public banks posed a growing financial burden on government finances. The fiscal costs of the current system are disguised by the implicit nature of public enterprise support through the quasi-fiscal activities of public banks. This lack of transparency obstructs an accurate evaluation of the problem’s magnitude, perpetuates soft budget constraints facing public enterprises, impedes effective public enterprise reform, and, more importantly, hinders the development of a sound, growth-enhancing financial system.

7. Reforms at the enterprise level have proved to be inherently more difficult than macroeconomic reforms, such as price and trade liberalization. This is particularly the case given that numerous state-owned enterprises may not be viable under internationally competitive conditions.4 Restructuring takes time, so that the option of temporary financial support to these enterprises should not be outright rejected. To reduce the political and social costs of adjustment, the budget constraints facing public enterprises should be hardened gradually.5

8. Removing from public banks the burden of being the financier of last resort for some large loss making-enterprises would be a crucial step to facilitate the implementation of banking reform and free financial resources for allocation to the emerging private sector.6 In order to also increase transparency, and provide time to absorb the social costs of adjustment, IMF staff proposes the replacement of directed bank credit to loss-making public enterprises with temporary and explicit budget subsidies in the context of a restructuring program. This process must be transparent, credible, and follow a pre-announced action plan for phasing out subsidies over time. During the transition phase, commercial bank lending to public enterprises, as well as inter-enterprise credit, should be strictly controlled. Fiscal transparency would make a major contribution to the cause of good governance. It would increase the pressure on firms to improve efficiency, foster closer government supervision of the firm’s activities, and lead to a better-informed public debate about the need of reforms, as well as to enhanced public acceptance of such reform.

B. The Development of the Current System

9. During the first decades following independence, Algeria pursued a socialist growth model based on centralized planning and reliance on state-owned enterprises (SOE) to deal with externalities, natural monopolies, regional development, and vulnerability of the economy to external shocks. This model, in the context of abundant hydrocarbon revenues accruing to the state, initially generated a rapid rise in production and employment. However, by the late 1980s, this policy stance showed its limitations. Most public companies were then heavily undercapitalized and incurred continuing and increasing losses. They suffered from inefficient resource and capacity utilization, excessive capital intensity, increasingly obsolete technologies, inadequate management, and lack of ownership and governance. The state-owned enterprises’ losses imposed a growing burden on public finances.

10. Several attempts were made in the 1990s to restructure the public enterprise sector in the context of Algeria’s transition to a market-oriented private sector-led economy.7 The initial strategy of comprehensive restructuring and financial rehabilitation of public enterprises, combined with partial market liberalization, proved to be costly and ineffective. In the mid-1990s, the Algerian authorities then embarked on a new strategy that was geared toward privatization and financial sector development. While considerable advancement was reached with regard to the group of small local public enterprises (EPLs), success has been limited until now, in terms of confronting the restructuring needs of, or privatizing, the large public companies (EPEs), with the exception of the construction and steel sectors. While some initial progress had been achieved with the grouping of EPEs in sectoral holdings and the introduction of the bank-enterprise mechanism in 1996, restructuring and privatization efforts slowed down considerably after the end of the Fund-supported program in spring 1998.

11. Algerian public banks continue to finance the deficits of inefficient and loss-making state-owned enterprises by providing credit under noncommercial conditions. Some public enterprises appear being considered “too big to fail” and have more or less unlimited access to loans to cover operating losses. When public banks lend money to persistently loss-making enterprises which are unlikely to pay back, they are performing essentially a fiscal function.8 Consequently, nonperforming claims of public banks have been repeatedly assumed by the treasury to preserve public banks’ solvability. IMF staff estimates that quasi-fiscal expenditures of that nature amount on average to a minimum of US$500 million (1 percent of GDP) each year.

C. Effects of the Current System

12. The current practice has severe effects on the management of public enterprises, undermining their financial discipline. Soft bank credits create soft budget constraints which negatively affect state-owned firms’ allocative and operational efficiency as well as their dynamic adjustment capabilities. Incentive forces are disabled, inefficiencies conserved, painful restructuring measures postponed. Enterprises are insufficiently motivated to avoid losses by raising efficiency. Management resources are being distracted from enterprise restructuring to lobbying and rent-seeking activities.9

13. Directed bank credit serves as a transparency-reducing quasi-fiscal instrument. Loans from public banks to loss-making state-owned enterprises frequently become nonperforming, and are later taken over by the treasury. Technically, these loans are fiscal subsidies. By being made through the banking system, they do not directly affect the fiscal deficit and, thus, distort the fiscal accounts and disguise the actual fiscal policy stance. The quasi-fiscal activities of the state banks also create increasing contingent liabilities. The size and timing of their impact on the cash income position of the treasury is highly uncertain, which makes them especially difficult to monitor and control. The macroeconomic effects of directed bank credits (higher public expenditure in the medium term, negative implications on inflation and interest rates) are thus both hidden and delayed.10 Hence, it is important to note that even in the current situation (with directed credit), the government is, in principal, footing the cost of financing the loss-making public enterprises.

14. The continued financial support to loss-making public enterprises has been the main factor of banking system fragility in Algeria. The accumulation of bad loans implies that it is difficult to assess the real value of the banks’ capital assets, as well as their profitability and basic soundness.11 Among other things, this has a negative effect on the privatization prospects of public banks.

15. To the extent that lending to public enterprises absorbs much of the financial funds available, new private enterprises face greater difficulties and higher costs in getting credit,12 Entry of new firms and the development of a dynamic private sector is impeded by the disproportionate share of bank credit being allocated as refinancing to the state-owned incumbents. Commercial banks behave generally passively with regard to changing the persisting loan allocation. This lender passivity can be due to lack of experience in risk management as well as insufficient information about the quality of new investment projects, or it can be explained by lack of financial resources (undercapitalization). As a consequence, refinancing of old loans crowds out new finance, giving rise to credit crunches on new loans.13

D. Changing the Incentive System

16. Implementing successful and sustainable reforms in the Algerian banking and state-owned enterprise sectors requires changing the incentives of all economic agents involved. The government has to commit credibly to impose hard budget constraints on public enterprises. Public banks must be encouraged to enforce existing debt contracts as well as to discontinue refinancing unprofitable investments of state-owned enterprises and instead allocate credit resources to promising projects initiated by the private sector. Managers of loss-making public companies, finally, must be persuaded to tackle in depth enterprise restructuring instead of lobbying for a continuation of subsidies and speculating for bailouts by commercial banks or the government.

17. Strong political will in favor of change is a precondition for successful banking and state-owned enterprise sector reform.14 The government faces a trade-off between long-run efficiency gains and immediate adjustment costs in terms of production, job and security losses, as well as political resistance. In addition, the state has to deal with the legacy of central planning: Because the state was responsible for past decisions and failures, public enterprises can now bargain for compensation in form of continued financial support.15 Furthermore, close relationships between commercial banks and the government may also cause soft budget constraints, when banks exploit the ‘softness’ of the ‘paternalistic’ government, refinancing unprofitable or high risk loans in a gamble for a collective bailout.16 This problem is not restricted to lending to state-owned enterprises, and emphasizes the great importance of well-designed banking sector reform.

18. To commit credibly to hardening public enterprises’ budget constraints, the government needs to build a reputation for toughness by sticking to preannounced support limits and ensuring transparency by full publicity and public scrutiny. Privatization of state-owned enterprises is the most powerful commitment device by government to cut back financial support.17 As a first step, the greater transparency of explicit budget subsidies, and the need to consider all subsidy claims simultaneously in framing budget projections, is likely to stiffen fiscal resistance compared with a situation in which individual credit deals can be done with public banks in circumstances which are much harder to monitor.18

19. Commercial banks may have strong incentives not to enforce debt contracts. The costs of enforcing bankruptcy can be high, or there maybe some option value in waiting, which would justify rescheduling of nonperforming loans. Also, taking action against debtors may signal solvency problems due to high bad loan exposure. Furthermore, the higher the share of nonperforming loans in the banking system, the higher is the temptation to gamble for a general government bailout.19 Finally, because of the existence of sunken costs, projects that turn out to have been ex ante unprofitable, may still be refinanced and completed because they are ex post profitable.20 In the latter case, a decentralization of credit (multiparty financing) can discourage refinancing of credit. Promoting investment by banks in screening and monitoring technology is a promising instrument to curb creditor passivity, since banks can improve the relative profitability of potential new lending by screening and monitoring firms. Alternatively, increasing capita] requirements raises the cost of funds to banks, making it less attractive for them to refinance bad loans. The authorities can also increase the costs of passivity by engaging in closer monitoring of bank behavior. Finally, if the lack of a functioning market for liquidated assets limits financing based on collateral, the government could replicate collateral by providing partial loan guarantees—which would increase liquidation values and thus the credibility of the creditor’s threat to foreclose.21

20. Public enterprises usually have multiple principals, multiple objectives, and operate under a number of variable constraints. This regularly causes distorted incentives for managers due to information asymmetries, moral hazard, and significant benefits associated with managerial control rights. Corrective measures should aim at (a) reducing managers’ information advantages, (b) improving incentives by specifying and enforcing rewards and penalties, and (c) proving commitment on the part of the government to public enterprise reform. The problem of information asymmetries can be best tackled by introducing competition and improving transparency (e.g., making explicit subsidies or monitoring firm behavior). Rewards and penalties include bonus schemes, contracting fees, price adjustments, conditional transfers etc. To ensure commitment, performance goals, rewards, penalties, and government actions should be stated clearly in contracts between the government and the management of public enterprises.22

E. Implementing Reform

21. Replacing the current practice of directed bank credit to loss-making public enterprises with explicit budget subsidies requires a careful case-by-case approach. With the bulk of nonperforming loans being concentrated within a small group of problem cases, the program should focus on the large loss-making public enterprises.23 In the view of limited administrative capacities, smaller beneficiaries are not addressed in this framework. Public banks could deal with these debtors themselves. Therefore, program implementation should start with the identification of the public enterprises which take the greatest share of credit. This could be accomplished by an auditing of public bank loan portfolios, preferably by independent auditors.

22. Public enterprise accounts and operations should be analyzed to take stock of the extent of their current implicit subsidization. The authorities might want to consider technical assistance needs in this regard. Independent auditing of public enterprises should be ensured. When estimating the amount of implicit subsidies comprised in nonperforming bank loans, both market interest rates and the value of retrievable collateral have to be considered.24

23. Differentiation of objectives in financial support should be made early on in the process. To the extent that the state decides to assign social responsibilities to public enterprises, this puts constraints on profit-maximization and necessitates financial compensation. Official support as compensation for such purposes (such as price controls, supply of merit goods, and other public service requirements) will still be needed after public enterprise restructuring, and is, therefore, not addressed in the current subsidization scheme. Financial support for public enterprises deriving from these objectives should, therefore, be separated from the purely loss-financing transfers considered here.25

24. The government has to project the amount of direct government financial aid that is likely to be needed and, equally important, available in exchange for the elimination of credit by public banks. Financing needs have to be specified case-by-case, taking into account the potential long-term viability of the company subunits, in addition to the consolidated balance sheets. Nonviable operations can be characterized by negative value added at world market prices, or more generally by the relation between costs of restructuring and its expected benefits. The medium-term financing needs of the loss-making public enterprises can be quantified using balance sheet projections and profit simulations.26

25. The subsidization scheme has to specify the amount of individual transfers, the conditions for granting financial support, routines for monitoring, and corrective measures. The size of the subsidy follows from the identified financing needs for maintaining operations of the enterprise in question. Subsidies should be fixed annually in advance, fully budgeted, and subject to strict conditionality and full accountability. Since any subsidization scheme is vulnerable to rent-seeking and makes heavy demands on the government and public officials, full transparency and publicity are of the highest importance.27 Conditions for granting subsidies, as well as corrective measures in case of noncompliance, should be specified in explicit agreements between the government and the management of public enterprises. Contracts should specify clear performance criteria, benchmarks, managerial incentives, automatic trigger mechanisms for sanctions, as well as corresponding rewards and penalties linked to performance.28 The program should ensure close monitoring of public enterprises, including strengthened accounting and reporting regulations, independent auditing, and an annual reassessment of performance agreements.

26. The financial support granted to public enterprises has to avoid any open-ended character. Only temporary financial assistance that follows a clear, pre-announced and credible action plan for gradually ending loss-financing subsidies is acceptable. To guarantee that the granting of budgetary subsidies does not degenerate into permanent financial support, the subsidization scheme has to be credibly coupled with a rigorous restructuring and privatization of public enterprises. Depending on viability, measures can be introduced in combination with the subsidization program to prepare enterprises for privatization, restructuring, or liquidation. In order to contain the fiscal costs of the support program, some unviable lines of production might need to be closed at an early stage of the program. Maintaining and restructuring production units with negative value added at world prices will, in general, not be worthwhile. In these cases, it will be preferable to end production and instead use budget transfers to compensate employees in full.29 Generally, private investors have a comparative advantage in restructuring loss-making enterprises. Therefore, potentially viable public companies should be privatized as soon as possible to relieve the government from the fiscal burden of the enterprises’ losses, as in the case of the steel sector (ISPAT). However, the public companies with the greatest need for financial support are presumably those which cannot quickly be privatized. For these cases, cash limiting and transparent subsidization with a view to eventual liquidation remains the best policy option in the short run.30

27. The authorities should concomitantly move ahead with gradually privatizing and steadfastly restructuring public banks. Pending successful implementation of financial sector reforms, the authorities should rule out new lending to loss-making public enterprises receiving loss-financing transfers (all new credit, including overdrafts, should be ruled out). This will ensure that the gradual hardening of public enterprise budget constraints is not undermined by the granting of additional soft credits. In view of the current situation of abundant liquidity, however, crowding out of credit to the private sector seems not to be a major risk at the moment. Therefore, credit ceilings on bank lending to public enterprises, in general, are not needed under the present circumstances. However, the authorities should ensure an early strengthening of bank monitoring and supervision in order to minimize imprudent lending by public banks. As long as public ownership remains dominant in the banking sector, public banks will not operate under fully commercial conditions, and a moral hazard problem in the form of general bailout expectations will prevail.


Implementation of Reforms

Citation: IMF Staff Country Reports 2004, 031; 10.5089/9781451811391.002.A002


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Prepared by Holger Flörkemeier (ext. 38322), who is available to answer questions.


Public enterprise restructuring per se is not discussed in this note.


Smaller public enterprises generally face a harder budget constraint than the large loss-making companies.


Dhar, S., 1992; Algeria FSAP Main Report, 2003.


Koraai, J. 1986, 1998, 2001.


Although there is currently excess systemic liquidity, in a situation of exceptionally high oil prices, it is concentrated in the public bank that holds the account of the state oil and gas company. See Algeria FSAP Main Report 2003. Due to the high volatility of hydrocarbon export earnings and the expectation of lower oil prices in the medium term, the possibility of private sector crowding out can, however, not be ruled out.


Lin, J. and G. Tan, 1999; Bai, C. and Y. Wang, 1997.


Maskin, E. and C. Xu, 2001; Kornai, J., 2001. The devolution of fiscal authority from central to local government (fiscal federalism), as well as the upward devolution of domestic economic policies to supranational authorities {e.g. WTO or EU association agreement) have been discussed as other possible instruments to harden budget constraints. Maskin, E., 1999; Bertero, E. and L. Rondi, 2002.


Schaffer, M. 1998; Komai, J., 1986; Bregg, D. and R. Portes, 1993. This includes non-performing loans both to public and private enterprises.


It may be ex post optimal for the bank to refinance a loan instead of liquidating the borrower’s activity since any prior funds invested in the enterprise are sunk costs, and hence irrelevant for any further profitability considerations; Dewatripont, M. and E. Maskin, 1995.


The recent FSAP report indicates that 22 of the 38 largest state-owned enterprises (SOEs) are loss-making (there are twelve very large SOEs). Relatively viable SOEs are found in the chemicals and plastics, construction materials, and food processing sectors, while many SOEs in the metallurgy and machinery, textiles, leather and footwear industries are distressed. According to the Ministry of Industry, 380 out of a total of 1120 SOEs are salvageable, of which 320 will be privatized within the next three years.