A. Economic activity and inflation:

Economic activity continued to improve in 2002 and 2003. Growth was strong, with real GDP further picking up from 4.1 percent in 2002 to 6.8 percent in 2003—the highest rate over the past two decades—reflecting strong performance in the agriculture, hydrocarbon, construction, and non-government services sectors. Excluding hydrocarbons, GDP growth reached 4.2 percent in 2002, and 6.0 percent in 2003. As a result, unemployment, though still high, has declined. Inflation remained subdued, mainly on account of low food prices and gradual reduction in the external tariff. The external position continued to strengthen, underpinned by higher hydrocarbon exports. The current account surplus rose from 7.8 percent of GDP in 2002 to 11.5 percent of GDP in 2003, and official reserves reached $32.9 billion by end-December 2003, representing two years of imports of goods and nonfactor services, and significantly exceeding total external debt.

B. Fiscal performance and policy:

Fiscal policy in 2002 and 2003 reflected the authorities’ determination to stimulate growth in view of the still insufficient contribution of the private sector to growth-oriented economic activity, while maintaining a sustainable fiscal position. Additional fiscal expenditure has focused on promoting labor-intensive activities, construction, local development projects, and rehabilitation and development of infrastructure to foster growth, employment, and private-sector development. At the same time, the authorities, with World Bank assistance, have paid due attention to expenditure efficiency by cutting non-priority outlays, while preserving social spending, notably in education, health, and housing. However, additional expenditure pressures arose following the May 2003 devastating earthquake, which led to losses of 2500 lives and damages estimated at $5 billion. Consequently, a supplemental Budget Law provided for earthquake-related appropriations in 2003, and additional funding was provided in the 2004 Budget Law. Despite these pressures, the overall fiscal balance has recorded an estimated surplus close to 4 percent of GDP in 2003, up from near balance in 2002, as a result of higher revenues, tight current spending, and rationalized capital expenditure. As part of their prudent approach to fiscal management, the authorities continued to build up sizable deposits at the central bank, which increased to 600 billion dinars by end-December 2003 (11.7 percent of GDP) from 430 billion dinars by end-2002 (9.7 percent of GDP).

C. Monetary developments and policy:

The continued increase in net external assets in 2002 and 2003, which represented the major source of monetary creation, resulted in significant monetary expansion, as measured by the increase in M2. However, this did not translate into higher inflation. As reflected in the Selected Issues paper, real factors have played a role in dampening inflation. Moreover, a significant part of the hydrocarbon revenues was sterilized in the form of increased Treasury deposits at the central bank. The central bank also regularly intervened to mop up excess liquidity in the banking system. To this end, it increased reserve requirements from 4.25 percent to 6.25 percent, as well as the amounts of central bank deposit auctions. As recommended by staff, the central bank is committed to further strengthening the latter instrument to contain inflation pressures. It also welcomes staff advice on relinquishing its role as broker on the interbank market, and is moving in this direction. As staff noted, credit to the economy has increased substantially, with a significant part directed to the private sector. The authorities note staff concerns regarding its possible impact on inflation and bank soundness, and will address these risks through increased liquidity absorption, enhanced supervision, and strengthened monitoring of banks’ credit provisioning, in line with FSAP recommendations.

The exchange rate continued to be managed flexibly, with the objective of maintaining real effective exchange rate (REER) stability. As staff noted, the central bank intervened during the second half of 2003 to correct an initial depreciation during the first half of the year resulting from the low inflation rate and the continued depreciation of the dollar against the euro. As indicated in the staff report, by end-2003 the REER returned to its level at end-2002 and was 8 percent below the level of end-2001. The authorities do not target further effective real appreciation of the dinar and remain committed to their present exchange rate policy, paying particular attention to avoiding substantial misalignment of the REER. They thank staff for their recommendations on further liberalizing the exchange system and will proceed gradually with their implementation.

D. Progress with structural reforms:

Progress continue to be achieved in trade liberalization, with modernization of the legislative framework following issuance of new ordinances addressing issues on international trade, organization of free trade zones, protection of intellectual rights, and competition in line with World Trade Organization (WTO) rules. In addition, implementation of the tariff reform has continued as scheduled, with the temporary additional duty progressively reduced to 36 percent as of January 1, 2003, and to 24 percent as of January 1, 2004, to be eliminated totally by January 2006. Discussions on Algeria’s WTO accession are well advanced, while the Association Agreement with the European Union should be ratified by the European partners in the course of 2004.

Important strides have been taken in the public enterprises restructuring/privatization process. The authorities have adopted a pragmatic approach consisting of privatizing any public enterprise ready for privatization and for which there is a reasonable interest from private local or foreign investors. Concurrently, the authorities are continuing to restructure the remaining enterprises to enhance their attractiveness. Moreover, public enterprises are encouraged to seek private partnership through joint-ventures, and foreign direct investment is further facilitated through more expeditious and streamlined, yet transparent procedures. In this context, the Council of State Participations (CPE) has approved, over the last six months, 19 privatization operations, including seven brickyards. The privatization process of three cement factories has been re-launched, building on the lessons of the earlier unsuccessful attempt, and discussions are being held with 10 international bidders. New bids are also being envisaged for the transfer of the management of the airport to the private sector. The privatization of the major beverage group is also at an advanced stage. In addition, the telecommunication sector was further opened to the private sector through the recent sale, for an amount of $421 million, of a third GSM license to a foreign investor. Along with privatization and restructuring actions, seven joint-ventures have been recently created in different sectors, including the pharmaceutical, textile and leather, water management, electronics, and construction materials sectors.

In the banking sector, efforts are still ongoing to privatize one public bank and measures are taken to increase the market share of quality private banks, while improving the sector’s operating framework, in line with FSAP recommendations. Modernization of the payment system is given high priority and is being closely monitored by an inter-ministerial council, chaired by the head of the government. Bids for modernization of the real time gross settlements component are being examined at the Bank of Algeria, under a World Bank-financed project, while the modernization of the small payments component is under preparation.

Following the recent fraudulent bankruptcy of two small private banks, the authorities have focused on improving the quality of potential new entrants in the banking sector. In this context, a new ordinance on money and credit has been issued, tightening bank licensing requirements. Supervision has been significantly enhanced over the past years, and further strengthening is proceeding with Fund assistance. The authorities agree with staff on the need to replace bank credit to loss-making public enterprises with explicit budget subsidies. Initial measures have been taken in the 2004 Budget Law involving, in particular, the national airline company. The authorities are committed to further significant progress in this area, within a comprehensive restructuring program.

As staff noted, the authorities share the thrust of FSAP conclusions and are working toward early adoption of an action plan to implement the recommendations, including further strengthening the AML/CFT framework. Regarding the FSAP recommendation to privatize all public banks in the medium term, the authorities consider that soundness and efficiency, not ownership, should be the overriding criteria. While they agree that a greater role of private banks would be more consistent with a market economy, they believe that a more prudent and gradual approach in privatization is warranted and are moving in this direction.