Algeria: Selected Issues

International Monetary Fund. Middle East and Central Asia Dept.

doi:10.5089/9781484302675.002.A003

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Algeria: Selected Issues

Author: International Monetary Fund. Middle East and Central Asia Dept.

Publication Date:: 01 Jun 2017

eISBN:: 9781484302675

ISBN:: 9781484302675

Language:: English

Keywords:: ISCR; CR; bank; growth model; export company; government redistribution; private sector development; evidence of the transmission channels; Structural reforms; Commodity markets; Competition; Productivity; Global; potential GDP

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Selected Issues

Abstract

Selected Issues

Structural Reforms: Strategies and Possible Payoffs¹

Algeria needs to implement wide-ranging structural reforms to improve the investment climate, support the diversification of the economy, and facilitate the emergence of a dynamic private sector. A strengthened institutional and legal framework would help accelerate much-needed product market, labor market, and financial sector reforms. Effective reform implementation will require careful sequencing and should take into consideration preconditions, complementarities, and the short-term costs of reforms. The public sector could contribute to enabling private sector growth, including by restructuring and gradually privatizing non-strategic state-owned enterprises. Macroeconomic policies should support reforms, notably by using some of the available fiscal space to cushion transitory costs. If well implemented, such a reform package could significantly improve Algeria’s potential growth and promote more inclusive growth.

A. Introduction

1. The collapse in oil prices has exposed the shortcomings of Algeria’s growth model. Historically, the role of the state has been central in the economy, which has relied heavily on government redistribution of hydrocarbon revenues. Even when oil prices were high, this model was unsustainable considering that Algeria’s proven hydrocarbon reserves are projected to be exhausted in 1–2 generations’ time.² With prolonged lower oil prices, it has become even more evident that the government no longer has sufficient resources to sustain high levels of spending and continue creating jobs for a young and fast-growing population.

2. In response to the oil price shock, the authorities are working on a strategy to reshape the country’s growth model. Algeria adopted a new constitution in 2016, which establishes as an explicit objective the promotion of a diversified and more market-based economy. Accordingly, the government started working on a strategy to reshape the country’s growth model, with World Bank support. The aim is to reduce the dependence on hydrocarbons and foster the emergence of high value-added tradable sectors. The authorities acknowledge that successfully transitioning to this new model hinges on the emergence of a dynamic private sector that would become the main engine of growth and job creation.

3. The structural impediments to private sector development are multiple and intertwined. In addition to undertaking fiscal consolidation to restore macroeconomic balances, Algeria needs to pursue a mix of reforms that complement and reinforce each other to relax the multiple structural constraints that impede private sector growth. Notable structural issues include a restrictive business environment, difficult access to finance, weak governance, insufficient transparency and competition, high barriers to entry, rigid labor markets, jobs-skills mismatches, and excessive growth in wages with respect to productivity.

4. This paper aims to inform the discussion on the design and possible payoff of a structural reform strategy that would help achieve the authorities’ objectives. Building on a diagnostic of key structural issues (Section B), the objective of this paper is twofold: outline some important considerations for a successful reform strategy based on a review of relevant literature and cross-country examples, in light of the specifics of Algeria’s situation (Section C); and estimate the likely impact of structural reforms on potential growth (Section D). Section E concludes.

B. A Snapshot of the Economy

5. Algeria lags its peers and competitors on indicators of competitiveness and productivity. Algeria has traditionally ranked low in survey-based measures of competitiveness.³ In the World Economic Forum’s Global Competitiveness Report 2016–17, Algeria ranked 87 out of 138 economies. In 2015, Algeria’s productivity (i.e., output per capita) ranked in the bottom third of 104 countries and was the lowest among MENA oil exporters. Low productivity coincided with low overall competitiveness, as assessed by the World Economic Forum.

6. The economy is dominated by the state and heavily reliant on hydrocarbons. Following independence in 1962, Algeria pursued a socialist, centrally-planned growth model. The economy today remains dominated by the state, with a large share of activity conducted by the public sector and based directly or indirectly on hydrocarbons. Over the past decade, a large share of new job creation has been either in the public sector, which today is very large by international standards, or in the construction sector, which is driven largely by public investment. In 2016, the broader public sector (i.e., the civil service and public enterprises) was the largest employer, providing jobs for nearly 40 percent of the working population (ONS, 2016a).

7. Algeria’s nonhydrocarbon exports are minimal and lack sophistication. More than 60 percent of bilateral nonhydrocarbon exports are within five product categories, a share that has remained broadly stable over the past decade. Furthermore, most indicators of economic complexity, diversity, and export quality are low compared to many peers and competitors in the MENA region and oil exporters in other regions. Available data suggest that the export quality index for Algeria, which was relatively high at the start of the 1990s, has been declining since. This trend was largely driven by developments in mineral fuel exports, while the quality of nonhydrocarbon exports declined compared to oil and non-oil exporters.⁴

8. State-owned enterprises (SOEs) dominate the economy, and many rely heavily on government support. SOEs accounted for about third of overall value-added in the economy in 2015 (ONS, 2016b). They are widespread, and some are dominant players in their sector. For instance, 87 percent of banking assets are held by public banks. Many SOEs encounter problems of inefficiency related to their social mandate, governance challenges, and low performance incentives. As a result, many are loss-making and often rely on government support, in the form of direct transfers, guaranteed debt buybacks, bank recapitalizations, and financial support to cover price subsidies.⁵ Although SOEs are subject to the same taxation policies as their private sector competitors, the favorable treatment they receive from the government can create an unlevel playing field between public and private enterprises (Oxford BG, 2015).

C. Constraints to Private Sector Development

9. The private sector has been affected by Dutch disease.⁶ Over the past 20 years, Algeria has experienced a significant reduction in industrial activity, with manufacturing falling from 15 percent of GDP in the 1980s to 5 percent in 2015. The private sector is dominated by low-productivity activities. Construction and services represent more than two-third of the private sector’s total value-added, while manufacturing represents only 5 percent. Moreover, while the private sector employs about 50 percent of the labor force (including in the informal sector), formal private sector firms tend to be rather small, with 98 percent employing less than 9 employees in 2011 (ONS, economic census of 2011).

10. Longstanding and multiple structural obstacles hinder private sector development. Over the past years, the creation of new private firms in Algeria was relatively low compared to regional peers and emerging market countries. Structural impediments to private sector development are multiple and intertwined. Indeed, Algeria ranks behind regional peers and other resource-rich countries in almost all key structural areas in international surveys. Notable structural issues include a restrictive business environment, difficult access to finance, weak governance and corruption controls, insufficient transparency and competition, high barriers to entry, a rigid labor market, jobs-skills mismatches, and excessive growth in wages with respect to productivity.

11. The business climate does not promote entrepreneurship, partly due to complex regulations and red tape. In 2017, Algeria ranked 156 out of 190 on the World Bank’s Ease of Doing Business Index. Not only are regulations heavy and complex, but their application is also described as problematic. Private sector entrepreneurs report that bureaucracy is pervasive and administrative procedures are cumbersome. They also consider poor governance and corruption to be significant obstacles to doing business, with negative implications for private sector investment and growth.

12. There are potential gaps in the institutional and legal frameworks that could hurt private sector activity. Several indicators suggest that Algeria’s frameworks are weaker than in other MENA oil exporters and advanced economies. Algeria’s legal and institutional frameworks do not seem to adequately ensure the rule of law and property and contractual rights, or to ensure a quick settlement of contract disputes and bankruptcy proceedings.

13. The market for goods and services is inefficient. In 2016, Algeria scored below the average of the MENA region and lagged significantly behind peers and competitors in the pillar on goods-market efficiency of the World Economic Forum’s Global Competitiveness Report. Survey respondents considered that local competition is practically nonexistent (Algeria ranked 138th in the sample of 140 countries). They expressed concerns about markets being dominated by very few companies (109^th), had little trust in the ability of anti-monopoly policy to address the issue in an efficient way (110^th), and considered both tariff and non-tariff barriers as major impediments to market entry (130^th).

14. Inadequate access to finance is another factor inhibiting private sector development. The financial system is small and shallow, and the banking system is dominated by state-owned banks. Credit to the private sector, particularly to small and medium-sized enterprises (SMEs) and firms operating in the tradable sectors, remains relatively low by international comparison (23 percent of GDP). This reflects the small size of the private sector; insufficient financial infrastructure, including substantial collateral requirements for lending to SMEs and lengthy bankruptcy settlement proceedings; and the prevalence of state-directed lending.⁷ Moreover, Algerian capital markets are nascent, and market capitalization amounts to less than 1 percent of GDP. Several factors thwart the development of financial markets, including lengthy administrative procedures and subsidized bank lending that make market financing unattractive.

15. Several issues impede the functioning of labor market and hinder the effective allocation of labor. The unemployment rate remained high at 10.5 percent in 2016, while the labor force participation rate—at 41.8 percent— was low by international standards. In addition, the private sector has created only 141,000 new formal jobs since 2013—less than 2 percent of the working population in 2016. Jobs in the informal sector accounted for about 38 percent of total employment in 2016. These facts reflect: (1) the lack of labor market flexibility due to costly hiring and firing regulations; (2) large labor costs driven by high payroll taxes and excessive wage hikes relative to productivity gains; (3) mismatches between skills offered by job seekers and those sought by firms, and (4) strict eligibility requirements that limit access to the unemployment insurance system, contributing to a large informal sector. ⁸ These issues have prevented private firms from hiring high-skilled workers and, in turn, from engaging in high-value-added tradable sectors. They have also contributed to the exclusion of important parts of the population—especially women and youth, whose participation rates remain very low compared to regional peers (16.6 and 26.7 percent respectively, in 2016).

D. Important Considerations for a Successful Reform Strategy

What are the key areas for reforms?

16. Algeria suffers from structural deficiencies in many areas, calling for an ambitious reform agenda. Structural reforms should aim to increase productivity by reducing barriers to efficient investment, employment, and competition (Box 1). Reforms are needed to revamp the business environment, strengthen institutional and legal frameworks, reinforce competition in product markets, ensure adequate access to financing for businesses, enhance the functioning of labor markets, and improve the outcomes and standards of the education system.⁹

17. Continued efforts are needed to reduce bureaucracy and strengthen the institutional and legal frameworks. Reducing unnecessary red tape and accelerating the transition to a digital economy would help enhance the competitiveness and efficiency of private sector firms, while building strong institutions and legal frameworks would contribute to the success of the reform program. International experience suggests that where the rule of law is lacking and corruption is a concern, resistance to reforms is likely to be stronger. In recent years, the authorities have started reforming the regulatory and institutional frameworks by modernizing public administration and strengthening economic and financial governance (AfDB, 2011). Further efforts are needed to better secure property and contractual rights, ensure more transparency, and prevent corruption and rentseeking behaviors. The judicial system should be geared to the norms of a market economy to ensure quicker settlement of contract disputes and bankruptcy proceedings.

18. Greater competition should be promoted in product markets. Strengthening competition requires reducing barriers to the entry of new investment projects and the exit of obsolete ones. Restructuring SOEs and privatizing nonstrategic ones would help alleviate implicit barriers to entry posed by some SOEs. Further reducing price restrictions by deepening subsidy reform can create incentives for private enterprises to emerge.¹⁰ Strengthening the powers of the competition authority would help ensure an adequate enforcement of competition rules.¹¹

19. Algeria’s transition to a private sector-led growth model would benefit from increased openness to trade and foreign investment. Promoting more regional trade integration, including with the Maghreb and European countries, pursuing WTO accession, and relaxing the requirement of a minimum 51 percent Algerian ownership in foreign investments (“51-49 rule”), for instance for investments in tradable sectors, would help lower the cost of inputs, attract foreign investors, promote technology transfers, increase competition in the domestic market, and make Algerian businesses more competitive.

20. Financial sector reforms would help mobilize savings and improve the allocation of resources. Revisiting the strategic positioning of public banks and channeling their activities either towards non-commercial development activities or direct competition with private banks on similar terms would promote competition in the banking sector, stimulate innovation, and reduce the cost of financial intermediation.¹² Strengthening creditors’ rights and modernizing the bankruptcy framework would increase bank incentives to increase credit supply to SMEs. Promoting modern payment technologies could help reduce transaction costs, increase financial inclusion, and attract unbanked agents to the financial system. Strengthening prudential frameworks would help prevent excessive risk-taking behaviors and promote banking sector soundness. Restructuring existing public programs that support young entrepreneurs and reviewing current legal and regulatory frameworks would help eliminate constraints to the development of capital venture firms and microcredit.¹³ Reducing widespread interest rate subsidies, lifting the restrictions on foreign investors to access domestic bond markets, and attracting domestic investors through the partial divestment of some loans to public enterprises would increase the attractiveness of capital markets and promote better self-selection of investment projects.

21. The functioning of the labor market can also be improved. Relaxing hiring procedures and reviewing the currently stringent layoff rules would lower hiring and firing costs. Allowing for more flexible working hours would facilitate higher employment rates for women and youth. Ensuring that labor regulations are fully enforceable and removing room for discretionary enforcement would reduce uncertainty for firms and increase labor demand. Incentives to work in the informal sector could be reduced by reforming the existing unemployment benefit scheme. Moreover, the effectiveness of current active labor market policies (i.e., wage subsidies and entrepreneurial schemes) should be assessed to ensure that they are targeted to the most vulnerable groups, e.g., unskilled women and youth.

22. Stepping up reform of the education system can help form future generations that are adaptable to private sector needs. In the most recent OECD PISA global education survey, Algeria’s performance was one of the lowest among PISA-participating countries and economies (it ranked 68 out of 69). The education and vocational system needs to be reviewed to improve the quality of education, which in turn would help attract foreign investors who seek a skilled labor force. Furthermore, to ensure that students acquire the right skills to find jobs, revisions to the curriculum should be made, with input from the private sector.

23. The authorities are seeking to address structural issues. Encouraging steps in the right direction have been taken, indicating that reform momentum is building. Last year the government adopted a broad strategy to reshape the country’s growth model, which it is now fleshing out with World Bank support.¹⁴ The objectives of the new model are to reduce dependence on hydrocarbons and move towards a private sector-led growth model. The authorities also took steps to enhance the business environment, which resulted in an improvement in the World Bank’s Doing Business ranking from 163^rd in 2016 to 156^th in 2017. A new investment code was promulgated, and the 51-49 rule was removed from its scope. The rule can now be amended through budget laws, which is easier. The authorities should seize this opportunity to relax the rule, at least for nonstrategic sectors, in future budget laws. New laws to foster the development of small and medium-sized enterprises were adopted, and regulations for using foreign currency were eased for export companies. There is an ongoing dialogue between trade unions, employers, and the government to review the labor code, which offers an opportunity to increase labor market flexibility while ensuring adequate protection for workers.

Box 1:

What Reforms? A Selected Literature Review

A large existing literature provides aggregate, sector, and firm-level evidence of the transmission channels through which structural reforms can boost productivity and growth.

Institutional and legal reforms. Property rights and the ability to enforce contracts are the two critical elements of a country’s institutional and legal frameworks (Dabla-Norris et al., 2013). When property and contract rights are insecure, entrepreneurs have high private discount rates, and therefore avoid investments characterized by long time horizons and up-front fixed costs (Richards and Waterbury, 1996). Evidence suggests that strong institutions that secure these rights can promote private investment and entrepreneurship (Dabla-Norris, Ho, and Kyobe, 2016) and have a first-order effect on long-term economic growth (Acemoglu, Johnson and Robinson, 2005).
Product market reforms. When firm renewal is obstructed either by regulatory or institutional barriers, the economy’s ability to adopt new technologies can be severely handicapped, with negative consequences for long-run income. Regulations limiting market entry may also hinder the adoption of existing technologies by reducing competitive pressures, constraining technology spillovers, and discouraging the entry of new high technology firms. For instance, low product market competition is found to impair productivity growth, inhibit new firm creation and business investment, and reduce the speed of diffusion of new technologies and production techniques (Conway et al., 2006). Reduction in productivity resulting from entry costs is found to be larger when labor markets are not competitive (Poschke, 2010). In contrast, product market reforms are found to improve competition, contributing to boosting aggregate productivity by raising the capacity of the economy to allocate capital and labor resources to fast-growing sectors.
Financial sector reforms. Theoretical and empirical studies find that developed financial markets help improve productivity by lowering the cost of capital. Cross-country empirical evidence suggests that productivity payoffs from undertaking banking system reforms (including privatization and the strengthening of supervision) are higher for countries that tend to have more bank-based financial systems (Dabla-Norris et al., 2013). Also, reducing financial repression and restrictions on the price or quantity of credit can facilitate the reallocation of resources to more productive uses, both across and within sectors (Larrain and Stumpner, 2013). Policies that encourage the formation and development of securities markets can be particularly effective for a more efficient allocation of capital across firms and industries (Rajan and Zingales, 2001; Tressel, 2008), thus increasing private investment and spurring innovation (Levine, 2005).
Labor market reforms. The combination of rigid hiring and firing practices and weak income protection systems encourage informality, making it costly for labor to move to more productive sectors (Dabla-Norris, Ho, and Kyobe, 2016). Firm-level evidence suggests that less stringent labor market regulations facilitate the movement of labor to more productive firms, and foster firm entry and exit (Henrekson and Johansson, 2010). Labor market reforms typically include the strengthening of unemployment benefit systems, which appears to boost employment relatively quickly since it improves job search and hiring without significantly affecting layoffs. Reforms to unemployment benefits are also found to be associated with stronger investment and output growth (Bouis et al., 2012).

How to sequence and package reforms?¹⁵

24. Algeria is designing a strategy for implementing structural reforms. Based on international experience, structural reforms can be implemented all at once, piecemeal, or somewhere in between.

Under the so-called “big-bang” approach, also known as “shock therapy” in its Eastern European incarnation, a government implements as many reforms as possible across many areas (labor market, product market, financial sector, etc.) in a very short period.
Under the “piecemeal” approach, a government implements reforms within a given area before moving to another area, without regard to the possible interdependence among reforms in different areas (Wei, 2004).
Under a gradualist approach, a government implements reforms in different areas simultaneously over an extended period, taking into account reform preconditions and complementarities. This approach is more cautious than the big-bang approach but more pragmatic than the piecemeal approach.

25. A big-bang approach is unlikely to succeed in Algeria. Although many researchers consider the big-bang approach to be less prone to time inconsistency and therefore more credible, such an approach seems to be neither desirable nor possible for Algeria for the following reasons:¹⁶

Algeria’s institutional and legal frameworks are relatively weak. International experience suggests that the institutional and legal frameworks need to be sound for sweeping reforms to succeed (Dabla-Norris, Ho, and Kyobe, 2016). Algeria’s still-developing institutional and legal frameworks do not adequately ensure the rule of law or guarantee contractual and property rights. In this environment, firms are less likely to engage in complex activities and undertake long-term investments. A big-bang approach to structural reforms could exacerbate this situation by creating even higher uncertainty for firms.
Algeria’s technical capacity may be insufficient. Cross-country experience suggests that it may not be practical to introduce many reforms simultaneously when the government lacks technical capacity (Gelb and Fisher, 1991). Indeed, insufficient technical capacity can prevent a government from addressing the distributional effects of certain reforms, leading to public resistance and causing the government to shy away from critical reforms. The distributional effects of reforms can be especially high in economies such as Algeria that have large distortions (OECD, 2008). As reform fatigue sets in, reform gains risk being delayed or even forgone, further intensifying public resistance and eventually leading to reform reversal.

26. A piecemeal approach may fail in Algeria due to the interrelated nature of the multiple binding constraints to private sector development. Focusing on one area at a time would leave intact constraints present in other areas. Therefore, proceeding in an excessively incremental manner would not address the multiple distortions that hinder Algeria’s private sector development. Furthermore, a piecemeal approach ignores the fact that reforms are interrelated, and that the success of certain reforms depends on action in other areas. For example, Brazil in the early 1990s lowered barriers to trade. Contrary to economic theory, however, there was little movement of workers across industries due to labor market rigidities. Moreover, many workers were laid off and ended up in the informal sector (McMillan, 2004). The lesson from this experience is that trade reforms should have been coupled with labor market reforms.

27. A gradual but sustained approach seems best suited for Algeria. Such an approach implies that Algeria would implement reforms progressively but across several areas at the same time. Where reform preconditions exist, certain reforms should precede others. For example, strengthening the legal and governance framework would facilitate the privatization of SOEs. Where complementarities exist, reforms should be implemented together. For example, product market reforms and reforms to open the economy to more FDI would reinforce each other. Such an approach would have the following advantages in the Algerian context:

Spreads out adjustment costs. Structural reforms can have short-term negative effects as the economy adjusts to policy changes.¹⁷ These adjustment costs tend to be higher in economies, such as Algeria, with large distortions (Little, Scitovsky and Scott, 1970). A gradualist approach that spreads out the adjustment costs is less likely to encounter public resistance (Agenor and Montiel, 1999).¹⁸
Gives the government more time to strengthen the institutional and legal frameworks. Resource-dependent economies such as Algeria are particularly exposed to the so-called “institutional trap” (Guriev et al., 2009), whereby vested interests take advantage of weak institutions to extract rents during the reform process (including from the privatization of state assets), thus slowing or even reversing the development of institutions and increasing resistance to reforms.
Creates incentives for an acceleration of reforms. Cross-country experience shows that successful implementation of certain reform can sometimes set the conditions for “an avalanche” of reforms down the road. For example, product market reforms can increase the pressure for reform in other areas such as labor market reforms (e.g., New Zealand in 1980s). Also, trade liberalization can create a need for supply chain improvements (e.g., India in the mid-1990s).
Adapts to existing technical capacity. Given Algeria’s limited technical capacity, a gradualist approach would be preferable as it would allow for trial and error, mid-course adjustment, and room to retreat if necessary (World Bank, 1991).

28. Although reforms should be implemented gradually, implementation should occur in a reasonably short time frame. Gradualism implies a deliberate choice of extending the time needed to implement the reform package to ease the cost of transition and build support for reforms. However, too long a time lag between reforms might not be desirable (OCDE, 2016). For example, New Zealand took about five years between the liberalization of product markets and labor market reforms in the 1980s, which mitigated the potential overall gains from reforms (Caldera Sánchez, de Serres, and Yashiro, 2016). Too slow a pace of reform also increases uncertainty, which in turn can lead private investors to adopt a wait-and-see attitude and delay the expected benefits of reforms.¹⁹ Furthermore, cross-country experience suggests that a slow pace of reform implementation is associated with more intense resistance by vested interests, which can ultimately lead to reform reversal. This risk is especially acute in Algeria, where the population still has vivid memories of the costs associated with the structural reforms of the 1990s.

29. Effective implementation requires careful sequencing. Under a gradualist approach, the sequencing of reforms is especially important. This paper does intend to prescribe specific rules for the sequencing of reforms in Algeria but there is a broad consensus in the literature about key considerations:

Compatibility with macroeconomic stability. Structural reforms need to be introduced in a manner compatible with macroeconomic stability. The overall reform package should include reforms that support short-term growth—for example, legal reforms to improve the investment climate, trade and FDI liberalization to help with diversification and ease balance of payments pressures, and financial deepening to facilitate credit flows.
Complementarity. The complementarity of policies should determine the timing of actions. For example, product market reforms can lower the resistance to labor market reforms by reducing rents (Blanchard and Giavazzi, 2003). Product market reforms reduce barriers to market entry, thereby strengthening competition, creating new jobs, and reducing the incentive for workers to capture a proportion of overall rents. Moreover, product market reforms tend to reduce the price of goods, resulting in higher real wages. These combined effects facilitate labor market reforms.
Lead time. Structural reforms should be phased in, considering the time needed for the requisite preparatory work and, where applicable, the gestation period. For example, the phasing in of capital market reforms should consider the time required to put in place a functioning institutional structure (stock market authority and other self-regulating private organizations), recruit and/or train the requisite personnel, and prepare and adopt the legislation.
Distributional effects. Although structural reforms improve growth prospects in the long run, they can affect income distribution and even increase inequality in the short run, leading to social tensions that can derail reform efforts (IMF, 2016). As reforms are phased in, they should include compensatory measures, such as conditional targeted cash transfers and unemployment benefits, that address these distributional effects. Structural reforms should also be complemented by a regional perspective to ensure that the growth impact of reforms is inclusive (OECD, 2016).²⁰ Moreover, as discussed below, well-targeted safety nets can help mitigate the distributional effects of some structural reforms.

How do SOEs fit in the overall reform strategy?

30. SOEs enjoy a variety of privileges that give them a competitive advantage over private sector firms. SOEs create implicit barriers to product market competition. Despite incurring frequent losses, they appear to have almost no bankruptcy risk given the support they receive from the government. Some have preferential access to resources, for instance credit, putting private sector firms at a disadvantage. Easy access to resources reduces incentives to increase productivity and innovate, negating possible spillovers to the private sector. SOE reform is therefore needed to provide economic space for the private sector to emerge.

31. Reforming SOEs, if not managed properly, risks blocking other economic reforms. Among those who stand to lose from reforms most directly are the SOEs’ employees, since they enjoy more protections than their private sector counterparts. When Algeria attempted to restructure and privatize SOEs in the 1990s, public sector unions conducted several waves of strikes (Werenfels, 2002). Prior engagement with unions is therefore important to gain support for reforms and build trust in the government’s commitment to offset the possible distributional effects.

32. The privatization of SOEs should be gradual. The privatization of SOEs often occurs alongside deregulation (Chang, 2007). International experience suggests that unless legal and institutional frameworks are strong enough to ensure a transparent and competitive environment, privatization should be gradual. The experiences of Hungary and Russia in the early 1990s are instructive (IMF, 2014):

Hungary: The government opened the sale of state-owned firms to strategic investors, including foreign investors. In parallel, the government set up a strong and transparent privatization agency, which concentrated all ownership rights of the state, making it easy for potential buyers to negotiate with the authorities in good faith. New laws on banking, insurance, state asset management, accounting and reporting, bankruptcy, and liquidation contributed to a rapid and sweeping transformation of the corporate sector. Allowing foreign investors to participate in the privatization process resulted in an inflow of foreign capital, which led to technological improvements and increased competition.
Russia: By contrast, Russia’s attempt to implement a rapid privatization program sparked massive popular opposition, ultimately prompting the government to reverse course in nearly all sectors. Under the initial privatization program, the government distributed vouchers that could be sold or exchanged for shares in institutions being privatized. Although a large percentage of state-owned enterprises were privatized in a short period, the process led to the transfer of ownership of several SOEs to oligarchs, causing a public outcry. A weak institutional framework and lagging banking sector reforms contributed to the failure of the privatization process.

33. SOEs that would remain under state ownership may need to be restructured. Based on cross-country experience (Vietnam, China, and Kazakhstan, among others), Algeria may wish to first classify SOEs into one of two broad categories. The first would include firms dedicated to public welfare, whereas the second would encompass those that carry commercial activities. The latter would include public enterprises operating in the industrial and services sectors. Boosting market competitiveness and improving profitability should be a top priority for commercial SOEs. Reforms are also needed to improve the incentive system for employees and managers.

How to overcome resistance to reforms?

34. Resistance to reforms is likely to mount. Algeria is in a better shape to initiate reforms now than in the 1990s, when it faced a previous oil price shock, as it has since built human and physical capital, reduced poverty and inequality, and has more fiscal space. Notwithstanding these improved conditions, resistance to reforms is likely to be high, because of the trauma associated with the reforms of the 1990s during a period of civil strife, and the expected resistance of stakeholders who may lose out in the short term.

35. To overcome resistance to reform, Algeria needs the sustain the current reform momentum. International experience suggests some clear patterns correlated with reform success. Among the key institutional and design factors that can contribute to building and sustaining reform momentum are:

Identifying and exploiting the drivers of reforms. Evidence suggests that the strongest reform momentum tends to coincide with periods of stress and turbulence (IMF, 2015) and that countries that successfully sustained reforms had developed strong drivers of reforms. For example, the desire to join the European Union was an important driver of reforms in some post-communist Eastern European countries. In Algeria, the authorities are appropriately seizing the difficult macroeconomic context as an opportunity to reshape the country’s growth model.
Building results-based monitoring and evaluation systems, and publicizing results. Such systems help track tangible progress on reforms, and demonstrate their impact. Evaluation of reforms helps create feedback loops among players, allowing for revisions and improvement over time. Publicizing reform results is essential for sustaining reform in the face of resistance.
Engaging the opponents of reform. International experience shows the benefits of engaging those who will be most directly affected by a reform. Inclusive consultations are no guarantee against conflict when sensitive reforms are under consideration. Over time, however, they can create greater trust among the parties involved and make reform opponents more willing to rely on commitments to mitigate the cost of the reform for them.
Communicating effectively. If reform advocates can build a broad consensus among experts and the public on the merits of reform, they are likely to be in a stronger position when engaging with the reform’s opponents. Communicating the reform’s objectives, expected benefits, and process can help reduce anxiety about expected changes. It can also prepare civil servants for their role in implementing the reform.

How can macroeconomic policies support reforms?

36. Long-term gains of structural reforms come with transition costs. The short-term costs of structural reforms can be caused for instance by the closing of incumbent firms and associated costs (e.g., loss of capital) or by the time lags in adjusting to the new equilibrium.²¹ Some structural reforms might even be contractionary in the short term, for instance if they increase perceived income insecurity and precautionary savings. Possible transitional costs and distributional effects of reforms can raise political and public resistance. Macroeconomic policies can help mitigate these effects.

Implementing fiscal reforms. Fiscal reforms can promote greater equity in sharing the potential costs of the adjustment. For example, energy subsidies, which are costly and highly regressive, should be gradually replaced with targeted monetary transfers. Eliminating tax exemptions and strengthening tax administration can help make the tax system more inclusive while increasing nonhydrocarbon revenues, allowing for compensatory spending.
Conducting a gradual fiscal adjustment. One difficulty in Algeria at the current juncture is that it must conduct simultaneously a critical mass of structural reforms and a sustained fiscal consolidation that reduces the means to support the structural changes. All available space should be used to conduct fiscal consolidation gradually to offset the short-term costs of structural reforms. Strengthening the efficiency of public investment would also help reduce the impact of capital spending cuts on growth.
Strengthening the monetary policy transmission mechanisms. Some reforms may create inflationary pressures in the short run. The central bank should continue to strengthen monetary policy transmission channels to help anchor inflation expectations around the inflation target.
Allowing further exchange rate depreciation and taking measures to unify the exchange rate system. Further exchange rate depreciation would contribute to eliminating real exchange rate overvaluation and, hence, mitigating the effects of Dutch disease. It would also inflate oil revenue in local currency and help reduce pressure on the budget. Measures are also needed to unify the foreign exchange market to eliminate arbitrage opportunities and allow the country to benefit from a more efficient allocation of resources.

E. Quantifying Possible Payoffs of Structural Reforms in Algeria

37. To quantify the impact of structural reforms on potential growth, two different methodologies are used. One approach is to estimate the long-run correlation between structural change and growth across countries. This methodology can help identify important reforms based on a country’s distance from the frontier on a given indicator and the expected payoff from improvement. Another approach is to create a ‘synthetic’ control (i.e., estimate a counterfactual without reform). This technique can help estimate the impact of reforms in specific country cases.

Distance-to-frontier analysis

38. Distance-to-frontier analysis is based on the long-term, cross-country association between growth and a set of structural indicators. The impact of reform is simulated as:

g_{i}^{A} = β_{i} (I^{A} - I^{B})

where $g_{i}^{A}$ is the growth impact of reforms in policy area i; β_i is the parameter for improving in that policy area, which is estimated from a cross-country panel; and, I^A and I^B are the values of that indicator for Algeria and for a chosen benchmark. Generally, the included indicators measure the quantity or quality of the regulations, infrastructure, technologies, and institutions that shape economic activity.

39. For robustness, we estimate the impact of reforms in Algeria using two different datasets and analyses. Since neither dataset is comprehensive, we use both IMF (2008) and Mitra (2016) to quantify the impact of different areas of reforms:

IMF (2008) includes annual indicators of enacted reforms in international trade, FDI, and the financial and agricultural sectors.²² The data coverage is 1973-2005 and includes most emerging and developed economies. As Algeria has not improved significantly in most structural areas, since 2005, the database may still be indicative of its current levels, although its relative standing has likely changed.
Mitra (2016) draws on structural indicators from several sources, including the Fraser Institute’s Economic Freedom of the World Index, International Financial Statistics, the International Labor Organization, the PRS Group, World Bank Doing Business, World Bank Education Statistics, the World Economic Forum’s Global Competitiveness Report, the World Economic Outlook, and the World Governance Indicators.

40. The analysis from IMF (2008) suggests that gains in potential growth from structural reforms could be large.²³ If Algeria were to progress on structural indicators in different areas halfway between its current levels and the highest attainment observed for an emerging market, potential GDP growth could increase by: (i) 0.5 percentage points from product market reforms; (ii) 0.3 percentage points from current account reforms ; (iii) 0.3 percentage points from labor reforms (following Bouis and Duval, 2012); (iv) 0.2 percentage points from financial sector reforms, and (v) 0.1 percentage points from capital account reforms. The overall potential output gains from undertaking the full range of reforms might come close to 1.4 percentage points over the medium term.

41. Applying the estimates from Mitra (2016) also points to potentially larger gains from reforms, mostly from improvements to productivity. In Mitra et al. (2016), the authors first decompose growth into three main factors—capital, labor, and productivity—using a standard Cobb-Douglas production function. They then regress the average growth over 2007–14 of each factor against a set of relevant indicators to estimate β_i. Assuming Algeria converges halfway to EMDC levels across indicators, the results show that reforms could increase potential growth by 2.7 percentage points. The main channel would be the impact on productivity, which could alone account for 2.1 percentage points of additional growth. The impact of reforms on capital would be 0.4 percentage points and the impact on labor 0.15 percentage points.

42. The results from Mitra (2016) indicate potential productivity growth is associated following elements, as described below:

Worker talent—represented in the paper by the quality and quantity of education as well as diaspora support. An improvement in the quality of education (by 1 unit for instance in the Global Competitiveness Report, where 1 is poorest and 7 is highest) would raise productivity growth by 0.7 percentage points. Making better use of diaspora support has a significant influence on productivity growth—increasing it by 0.6 percentage points.
A competitive business environment—where the government delivers basic services efficiently, promotes the rule of law, reduces corruption and fraud, and streamlines business regulations— significantly influences productivity. An improvement in this area (for example, enough to move up one place in the Global Competitiveness Report rankings, where 1 is poorest and 7 is highest) would raise productivity growth by 1.4 percentage points.
Modern production methods—the application of technologies and management techniques that help firms efficiently use energy, capital, and worker talent, while instituting policies that encourage innovation. Technology transfer through FDI serves as a proxy.

43. It is important to highlight some limitations of the approach. First, the distance-to-frontier methodology implicitly assumes that reform impacts are homogenous across countries. Second, it assumes that it is possible to isolate the effects of specific reforms, and abstracts from the complementarity of these reforms and the appropriate sequence of implementation. Thus, the results may be biased because the impacts are not necessarily additive.

Synthetic Control Method (SCM)

44. The synthetic control method seeks to approximate a counterfactual without reforms. If the counterfactual GDP without reforms could be observed for countries that undertook reforms, then the difference between their actual GDP and the counterfactual would be attributable to the impact of reforms. Trying to approximate this counterfactual through SCM is a useful alternative to regression techniques since it can be applied to individual cases and avoids correlations between the dependent and explanatory variables.

45. The synthetic control method works by combining a set of countries into a single unit based on their similarity to the country of interest. If country A were to implement reforms, it may be difficult to find a relevant comparator because each country has many unique characteristics. One way to address this limitation is to combine multiple countries (country B, C, D, etc.) into a single entity (fictional country) that closely mimics country A’s key characteristics or economic behavior over time. Additionally, if we select the comparator countries (B, C, D, etc.) that did not implement reforms, while country A did, we can attribute the difference in outcomes between country A and the synthetic unit to reforms. Our analysis uses a matching period of 15 years to estimate each country’s synthetic GDP. During this period, neither the country of interest nor its comparators initiated reforms. Once reforms are initiated in the country of interest, we observe the divergence between actual and synthetic GDP over the following 10 years. A detailed description of SCM is provided in Box 2.

46. We estimate the GDP impact of comprehensive economic reforms using the IMF structural reforms dataset (IMF, 2008). Comprehensive structural reform is defined as an improvement in the percentile rank of a country by 15 or more points on at least four indicators in a five-year timespan. By this definition, there were 12 cases of comprehensive structural reforms.²⁴ The pool of “no-reform” countries for the synthetic GDP excludes countries that improved their percentile rank by 15 or more points on two or more indicators during the pre- and post-treatment periods. Countries were matched based on the similarity of the evolution of their PPP GDP per capita.

47. The results show that comprehensive structural reforms increased GDP per capita significantly in many, but not all cases. The largest impact of reforms is observed in Albania, Hungary, Portugal, and El Salvador. Conspicuously, two of these countries implemented reforms to gain EU entrance, which entailed new trade, financial, and monetary arrangements and supporting structural and investment funds. While EU accession may be an exceptional case, the impact of comprehensive reforms is demonstrated to be large: on average, GDP per capita is 20 percentage points higher after 10 years. The results for EU accession countries underscores that structural reform strategies work when complemented with increased access to trade and significant external technical and financial support.

48. Over the 10-year post-treatment timespan, only one country performed worse than its synthetic control. In Chile during the 1980s, radical reforms combined with an overvalued currency and a banking crisis resulted in a severe GDP contraction, highlighting how reforms, when not adequately conceived, sequenced, and/or implemented, can lead to negative outcomes.

49. Had Algeria implemented comprehensive reforms in 2006, it may have achieved a GDP capita of around US$ 1,140 above its current level in PPP terms. SCM indicates half of the countries in sample that implemented comprehensive reforms realized per capita GDP growth 10 percentage points higher than their counterfactuals after a decade. Taking the median impact estimated through SCM, Algeria would have achieved a PPP per capita GDP of around US$16,170 in 2016, i.e. an increase of 41 percent from 2006 levels (as opposed to the 31 percent increase realized).

Box 2.

The Synthetic Control Method

Developed by Abadie and Gardeazabal (2003), the synthetic control method works by combining a set of countries into a single unit based on their similarity to the country of interest. The underlying insight of SCM is that a combination of countries might produce a better comparator than an individual one, and thus provide a better approximation of the counterfactual. With time-series data containing J + 1 number of countries, the first unit (i = 1) undergoes treatment at time T0: all other countries remain untreated over the sample period and constitute the “donor pool” and serve as controls.

$Y_{i t}^{N}$ is the value of Y in country i without policy intervention and $Y_{i t}^{I}$ is its equivalent when an intervention occurs. The impact of the intervention on the treated country is then:

\begin{matrix} (1) & α_{1 t} = Y_{1 t}^{I} - Y_{1 t}^{N}, t \geq T_{0} \end{matrix}

The counterfactual $Y_{1 t}^{N}$ cannot be observed. SCM starts by specifying a factor model for the unobserved $Y_{1 t}^{N}$ . Then, the counterfactual is estimated as a linear combination of realized outcomes in the donor pool of countries:

{\begin{matrix} (2) & \hat{Y} \end{matrix}}_{1 t}^{N} = Σ_{i = 2}^{J + 1} w_{i} Y_{i t}, t \geq T_{0}

The unit weights wi are selected such that the synthetic control unit matches certain characteristics of the treated unit as closely as possible. Below in (4), X1 is a vector containing the average values of pre-intervention variables for the treated unit. These “predictors” should not be affected by the policy intervention itself. The vector X0 collects the same variables for units in the donor pool. The goal now becomes to pick the weights wi such that the resulting synthetic control unit matches the pre-treatment characteristics of the treated unit (X1) as closely as possible. This will be achieved if the vector of weights W* solves the following equation:

\begin{matrix} (3) & \min_{W} | | X_{1} - X_{0} W | |_{V} = \sqrt{(X_{1} - X_{0} W)^{'} V (X_{1} - X_{0} W)} \\ s . t . w_{i}^{*} \geq 0 for i = 2, …, J + 1 \\ Σ_{i = 2}^{J + 1} w_{i}^{*} = 1 \end{matrix}

Once the weights have been obtained, the counterfactual can be constructed for any t ≥ T₀ by using equation (2). Subsequently, one can obtain an estimate of the treatment effect at time t ≥ T₀:

{\hat{α}}_{1 t} = Y_{1 t}^{I} - {\hat{Y}}_{1 t}^{N}

The resulting gap is attributed to the effect of the policy intervention.

F. Conclusion

50. Algeria needs to reshape its growth model, which is overly dependent on hydrocarbon revenues and related fiscal spending. Historically, the economy has relied heavily on government redistribution of hydrocarbon revenues, and the state has been the main engine of growth and job creation. This growth model was already unsustainable when oil prices were high. With oil prices durably lower, the need to move towards a private sector-led growth model has become even more pressing.

51. Structural impediments to the emergence of a dynamic private sector are multiple. Important structural issues curb firms’ incentives to invest and engage in high-value-added activities, and workers’ incentives to acquire the skills needed to obtain private sector employment. Notable shortcomings include a restrictive business environment, weak institutional frameworks, inadequate access to finance, and high barriers to entry. Other structural issues that hamper private sector employment and improvements in productivity include highly rigid labor markets, significant jobs-skills mismatches, and excessive growth in wages with respect to productivity.

52. Algeria should move forward on several structural fronts, building on recent progress in improving the business environment. To lift the multiple and intertwined impediments for private sector growth, Algeria should implement multifaceted reforms that complement and reinforce each other building on the growing reform momentum. The reform package should include product market, labor, and financial sector reforms, as well as legal reforms to improve the business climate and encourage private investment.

53. Actions should be implemented gradually and carefully sequenced to increase the effectiveness of the overall structural reform package. To maximize the chances of success, Algeria should carefully sequence reforms, accounting for the strength of institutions, reform pre-conditions, and short-term costs. While a sequenced approach implies that reforms should be implemented gradually rather than all at once (as in the “Big-bang” approach), action should not be delayed, and implementation should occur in a reasonably short time frame because structural reforms will take time to bear fruit.

54. Macroeconomic policies can support reforms by alleviating their short-term costs. Given the currently weak macroeconomic environment and the potential for reform resistance, macroeconomic policies can support reforms, including by using available fiscal space to offset the short-term costs of reforms.

55. The potential impact of reforms on growth can be substantial. Reducing the gap in each reform area between Algeria and top performers from the region and other emerging economies could significantly increase potential growth, mostly due to improved productivity.

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Prepared by Moez Souissi and Greg Auclair.

Algeria’s oil reserves are projected to be depleted in 21 years and its gas reserves in 54 years. See BP Statistical Review of World Energy 2016.

Caution is needed when comparing survey-based structural indicators across countries. Although these indicators are updated regularly and survey methodologies are revised frequently, they are partly constrained by the data that can realistically be collected. Nonetheless, the use of multiple indicators from a variety of sources provide comfort about the robustness of the key messages.

See ‘Fostering Export Diversification in Algeria,’ IMF Country Report No. 14/342.

In 2014, more than a third of SOEs incurred operational losses. For a detailed analysis of the situation of public enterprises, see accompanying Selected Issues Paper: “Fiscal Risks in Algeria.”

Dutch disease could be the outcome of market failures and defined as the crowding out of the non-tradable sector by the income generated from hydrocarbon exports (and redistributed by the government), which creates inadequate incentives for the private sector to engage in innovative activities and exports. See Cherif and Hasanov (2014).

While public banks have been subject to directed lending constraints, private banks in the past mostly focused on international trade finance, which generated the bulk of their revenues. Following the implementation of stricter prudential standards in 2014, private banks have increasingly reoriented their business model towards standard banking, but they have continued to refrain from lending to SMEs beyond government-sponsored lending programs. See “Financial System Stability Assessment – Algeria,” IMF Country Report No. 14/161.

Young people have an incentive to get an education that is suited to employment in the public sector, which offers higher wages than the private sector (this is true across sectors and most occupations, except in non-tradable sectors such as financial and personal services and real estate). Gaps between wages and productivity started increasing significantly in the wake of the Arab Spring when the Algerian authorities granted large wage increases in the public sector. See Dauphin et al (2016) and Callen et al (2014).

We draw on previous staff reports as well as FSAP and TA reports. See “The Financial Stability Implications of Lasting Low Oil Prices for Algeria,” IMF Country Report No. 16/128; “Fostering Private Sector Job Creation in Algeria,” IMF Country Report No. 14/342; “Price Competitiveness in Algeria,” IMF Country Report No. 14/34; “Promoting Faster Growth in Algeria,” IMF Country Report No. 13/48; “Fostering Export Diversification in Algeria,” IMF Country Report No. 14/342 and “Financial System Stability Assessment—Algeria,” IMF Country Report No. 14/161.

For example, international experience suggests that phasing out subsidies that reduce the domestic cost of imported agricultural products, such as milk, can support the emergence of domestic farmers.

A National Competition Council was created in 2013. It is an independent administrative authority endowed with investigative powers. Its objectives include monitoring markets in terms of free competition and fair pricing and steering and regulating the behavior of economic actors to promote more competition.

See “Financial System Stability Assessment – Algeria,” IMF Country Report No. 14/161.

The authorities have established a number of investment funds at both the national and regional level, but activity remains low and could be increased, and business selection models could be improved to ensure the most effective use of public resources. Furthermore, existing government programs that target microenterprises (ANGEM), young self-employed individuals (ANSEJ), and unemployed adults (CNAC) are all heavily subsidized and implemented in cooperation with public banks, leaving little space for conventional microfinance providers or private banks.

This strategy aims to promote economic diversification and develop private sector activities in high value-added sectors such as agribusiness, renewable energy, services, digital economy, mining processing, and other manufacturing industries. For a detailed discussion of Algeria’s untapped potential for diversification, see “Promoting Faster Growth in Algeria,” IMF Country Report No. 13/48.

To identify the most binding constraints to growth in an economy and, accordingly, determine the appropriate sequencing of reforms, researchers typically perform growth diagnostics using the well-known framework proposed in Hausmann, Rodrik, and Velasco (2005). Such diagnostics go beyond the scope of this paper, which instead tries to lay out guiding principles for implementing reforms considering that existing structural issues are complicated by their interrelated nature.

Time inconsistency refers to the fact that winners from early reforms will oppose later reforms which could hurt them. Knowing that, losers from early reforms will oppose the earlier measures. In countries with powerful interest groups and many distortionary policies, the big-bang approach resolves the time-inconsistency issue. See Martinelli and Tommasi (1995) and van Wijnbergen (1992).

For example, reforms aimed at increasing labor market flexibility may trigger immediate layoffs—especially in a weak economic environment—whereas hiring can take more time. Product market reforms may lead to rapid downsizing or the exit of incumbent firms but only gradual new firm entry. Financial sector reforms that reduce the costs of access to credit, but do not increase access to financial services for a broader part of the population, benefit mostly the better-off households and firms who can take advantage of cheaper credit and invest, leading in the short run to greater inequality.

With several major changes occurring simultaneously, firms face a turbulent environment in which it would be difficult for them to interpret the signals from policy changes. Firms must adapt to new conditions. In the absence of adequate innovation capabilities, which seems to be the case for Algeria’s private sector firms, adjustment costs could be high, fueling resistance to reforms (Dosi, 1988).

Countries that used gradualism took from four to fourteen years to implement their reform packages, with the average length being just over eight years (Popov, 2000; EBRD, 2001 and Staehr, 2003).

Certain structural reforms can benefit leading regions more than lagging regions. For example, labor market reforms could be of lesser benefit to lagging regions if there are no complementary measures to support better matching of workers to jobs or to facilitate physical access to jobs. Many of the labor market matching considerations, particularly for low-skilled workers, may involve efforts to tailor worker training to the needs of firms located in the area.

Blanchard and Giavazzi (2003); Everaert and Schule (2008); Cacciatore and Fiori, (2010); Cacciatore et al. (2012).

Domestic financial sector restrictions: the indicator includes measures of securities market and banking sector restrictions; Capital account restrictions: the index is based on a broad set of restrictions including, for example, controls on external borrowing between residents and nonresidents, as well as approval requirements for foreign direct investment (FDI); Current account restrictions: the indicator is measured along two dimensions: tariff restrictions, which measures average tariff rates; and a broader indicator of current account restrictions, which captures surrender requirements for export proceeds, and other items under Article VIII of the Articles of Agreement; Product market regulation: the indicator captures restrictions in the agricultural sector and in telecommunications and electricity markets; and Labor market regulation: the index is a measure of employment protection legislation (Aleksynska and Schindler, 2010).

Taken from Ostry (2008). The coefficients are estimated for low-middle income countries. Each regression includes as controls the lagged level of real GDP per capita, an indicator variable for democratic regimes, the level of terms of trade, and the level of tertiary school enrollment. All specifications were estimated by panel OLS with country and year fixed effects. The indicators in the structural reforms database are standardized between zero and one, with higher values of the indicator implying lower restrictions.

Not counting cases where countries undertook more than one reform wave over the 1973-2006 timespan of the database. In this case, only the first reform wave is used for estimates.

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