My authorities thank staff for the well-focused report and helpful Selected Issues (SI) paper. They appreciate the high-quality Fund policy dialogue, advice, and technical assistance, and highly value management and the Executive Board's support for Algeria's sustained reform efforts. They broadly agree with staff's assessment of the recent economic developments, challenges ahead, and policies required for growth acceleration.

Prudent macroeconomic policies and continued structural reforms, supported by higher oil prices and improved political and security situations, have underpinned recent favorable economic developments. Following high growth rates, low inflation, and strong fiscal and external positions in 2001–05, the economy continued to perform well in 2006. While hydrocarbon output declined due to the need to improve maintenance and upgrade production facilities, nonhydrocarbon sector continued to expand at a healthy rate, underpinned by strong activity in the construction sector, nongovernment services, and agriculture, leading to a reduction in unemployment. Prudent monetary policy kept inflation under control, fiscal position strengthened further, with the overall surplus reaching 12 percent of GDP on account of higher revenues, and the external position improved significantly, with the current account surplus exceeding 24 percent of GDP, allowing for further accumulation of international reserves. As indicated in the staff report (Box 2), with the settlement of the Russian debt issue, the government accelerated the early repayment of the external obligations, including to Paris Club and London Club creditors, bringing the debt-to-GDP ratio down to less than 4.5 percent from 34 percent at end-2003.

The authorities remain strongly committed to their reform agenda to strengthen private sector participation in the economy, further reduce unemployment, and improve the living conditions of the population while maintaining macroeconomic stability. Priority actions include continued implementation of the 2005–09 Growth Consolidation Plan (GCP), strengthening financial intermediation, and improving the business climate. Fiscal sustainability remains the anchor of the authorities' strategy. The substantial accumulation of savings in the hydrocarbon stabilization fund over the past years reflects the prudent management of oil revenue and provides room for investment in infrastructure and social spending. The former is set to increase over the medium term, in line with the GCP's objectives while the latter will focus on housing, education, and health. The authorities are determined to enhance the quality of public investment, therefore, they are carefully considering the recommendations of the public expenditure review recently conducted with the assistance of the World Bank. Particular attention is paid to keeping the pace of implementation in line with the economy's absorptive capacity. Sustained efforts will also be devoted to contain current spending. As staff note, the recent wage increase was meant largely to compensate for past large compression of real wages. Looking forward, the principles set forth in the National Economic and Social Pact (NESP), recently concluded between the government, employers, and trade unions, will govern wage setting policy. In addition to supporting efforts to improve the business climate, enhance productivity, and privatize public enterprises, the NESP ensures that wage increases are linked to productivity and economic performance in the nonhydrocarbon sector. Furthermore, the trade unions have indicated that no general wage increase will be requested over the next four years.

The authorities intend to continue to enhance nonhydrocarbon revenue. Building on progress achieved thus far in improving tax administration, including the establishment of a Large Taxpayers Unit, the restructuring and modernization of the regional and local tax agencies are progressing. In addition, the authorities plan to simplify the tax and incentive system and to modernize customs administration and have requested Fund technical assistance in these areas. They also intend to gradually increase domestic energy prices while mitigating the impact on vulnerable segments of the population.

Progress is being made in modernizing budget management and strengthening fiscal transparency. In this regard, a new budget classification, in line with the Government Finance Statistics guidelines, has been prepared and a draft organic law will be submitted soon to the Parliament. The rules governing the use of the hydrocarbon stabilization fund have been amended to allow for direct financing of the nonhydrocarbon deficit, in line with staff's advice. The authorities intend to proceed with implementation of the remaining recommendations of the 2004 fiscal ROSC, including the introduction of a medium-term budget framework by 2009.

Prudent monetary policy has kept inflation under control. In view of the potential inflationary pressures stemming from higher external flows as well as additional spending, the central bank will continue to absorb excess liquidity in the banking system, while keeping its policy interest rate positive in real terms. At the same time, it will maintain its flexible exchange rate policy. In line with staff's recommendations, the authorities have prepared a draft new unified regulatory framework to improve the exchange and payments systems, which will be issued shortly.

Financial sector reforms are advancing, in line with the FSAP recommendations. Banking supervision continues to be strengthened with Fund technical assistance, mainly through enhanced on-site inspections. Tighter bank licensing requirements are contributing to improving the soundness of the sector. With strong political support, the role of the Banking Commission has been strengthened. Governance of the public banks is being improved, with close monitoring of the performance contracts and elimination of quasi-fiscal deficits. Efforts are also focused on improving risk management and internal controls, and plans are being developed to address the nonperforming loans issue. Competition in the sector will be further enhanced with the privatization of a first public bank, expected to be completed in early 2007 with the assistance of a reputable foreign investment bank. Significant progress has been made in modernizing the payment system with the launch in 2006 of the Real Time Gross Settlement and the Retail Payments systems. The authorities are determined to sustain these efforts to further strengthen and deepen financial intermediation. The upcoming FSAP update should contribute to identifying helpful directions in this regard.

The SI paper on growth prospects in Algeria provides useful advice on improving the country's growth potential. The paper concludes that “[the] results support the authorities' reform priorities,” including modernizing the banking and financial system, further liberalizing trade, and improving the business climate. Sustained efforts are being made to improve governance, prevent corruption, strengthen the judiciary system, and reduce the cost of doing business. A number of measures have already been taken, including lowering employers' social contributions, facilitating the issuance of property titles, and streamlining the procedures for establishing businesses. Improved financial intermediation, along with strengthened confidence, should allow raising the quality and the level of credit to the private sector. The authorities are also advancing the agenda of restructuring and privatization of public enterprises and have taken important strides in recent years to liberalize trade. They remain focused on the steadfast implementation of the Association Agreement with the European Union and making continued progress toward accession to the World Trade Organization. Ongoing efforts to promote regional cooperation within the Maghreb countries, including in the areas of trade and finance, should also help improve economic prospects. In this context, the authorities appreciate highly the Managing Director's efforts in this process.