Economic Overview

Algeria’s economy has had a timid recovery since the onset of the decline in oil and gas prices in mid-2014. The initial policy response of a significant fiscal tightening and exchange rate depreciation dampened non-hydrocarbon activity, particularly in 2015–16, while oil production restraint in effect since 2016, in compliance with the OPEC agreement, limited hydrocarbon GDP growth. The impact of declining oil and gas prices and oil production restraint was more visible in the twin deficits: despite the REER depreciation, the current account deteriorated by 12 percent of GDP and hydrocarbon revenue fell by 10 percent of GDP between 2014 and 2016. By 2017, there was a significant erosion of internal and external buffers, growth had remained anemic, and unemployment was on the rise. Fiscal adjustment continued in 2017, albeit at a slower pace, essentially through spending cuts, and the deficit was financed by depleting the savings in the oil stabilization fund (FRR) and, late in the year, by borrowing from the Bank of Algeria (BA). Fiscal restraint has continued under the 2018 budget by capping nominal current expenditure and raising taxes and cutting subsidies, even though the headline deficit increased. The recent firming of energy prices is providing welcome space. Non-hydrocarbon (NHC) GDP growth and inflation are expected to tick up in 2018.

Staff policy discussion center on what they see as Algeria’s “new economic strategy”. The policy approach adopted this year, combining limited exchange rate flexibility; higher capital spending and improved control of current spending; no external borrowing; are in fact continuation of standing policies and do not signify a material shift in policy approach. Import ban on some products to preserve foreign reserves and the resort to central bank financing, following the depletion of FRR resources, are exceptional and temporary measures.

The Algerian authorities are fully aware of risks ahead, some of which are reflected in staff’s Risk Assessment Matrix. However, the authorities believe that the staff presentation is too alarmist in its tone. They agree with staff that the relative likelihood of a prolonged period of weak energy prices is low and its likely impact on the Algerian economy is high. However, staff attaches a high likelihood to weaker-than-expected growth in advanced economies and to security and geopolitical risks, with both factors having a high but probably opposite impact on the Algerian economy through oil prices. In fact, three of the five risk factors essentially work through the same channel: oil prices. The oil market channel is the main source of potential direct and indirect external risks to the Algerian economy, but it is important to remember that Algeria has faced periods of oil market volatility and geopolitical risks before, and has always managed to pull through, thanks to the authorities’ pragmatic policies and the support of citizens and international partners. Algeria’s large public sector, its low public debt, its virtually non-existent external debt, and its still sizable large external buffers provide extra layers of protection against external shocks.

Fiscal Policy and Transparency

The authorities are of the view that in assessing the underlying fiscal policy stance in 2018, one-off and exceptional factors should be taken into consideration. On the revenue side, the drop in non-tax revenue in 2018 is entirely due to lower dividend transfers from BA to the budget (by 1.6 percentage points of overall GDP). NHC tax revenues in 2018 are in fact likely to exceed budget estimates (unchanged from 2017 at 17.4 percent NHC GDP) due to tax hikes—in line with past staff recommendations (Annex I)—on mass consumption items such as fuel, electricity, tobacco and alcohol, as well as higher tariffs on imported goods. Further, the import ban is likely to be lifted during the course of the year and replaced by high import tariffs, and some government fees (on passports, ID cards, court procedures) are planned to be raised by 40–50 percent. On the expenditure side, current spending is cut by 1 percent of NHC GDP, despite a significant one-off transfer to a pension fund (CNR) to repay part of its debt. Personnel expenditures were frozen in nominal terms, and the increase in capital expenditure, equivalent to 1.7 percent of NHC GDP, in part reflects repayment of government arrears to suppliers. As such, the NHC deficit (excluding BA dividend transfers) is expected to fall by 1.3 percent of NHC GDP in 2018, continuing a trend that started in 2014 with a cumulative decline of 7.8 percent of NHC GDP over 2014–18. If account is taken of one-off factors (transfer to CNR and repayment of arrears), the underlying NHC deficit would be even lower.

The authorities intend to accelerate fiscal consolidation in 2019, while anchoring fiscal policy on a zero balance in 2023—corresponding to a 20 percent reduction in NHC deficit as a share of NHC GDP. Indeed, tight financing conditions demand strong fiscal tightening in the near term. The fiscal consolidation plans will be based on reducing tax exemptions and strengthening tax collection; containing discretionary current spending; increasing the efficiency of public expenditures and improving PFM; while providing enough fiscal space to accommodate higher social and infrastructure spending, all within a rolling medium-term framework.

The authorities are making every effort to enhance budget clarity and transparency and were surprised to see reference to Algeria scoring an Open Budget Index of 3 out of 100 in 2017 (footnote 13, page 17 of the Staff Report. Comparisons of this nature based on third-party indicators with limited or no independence or credibility are questionable at best, and damaging at worst.

Monetary and Exchange Rate Policy

Government’s unconventional financing through BA since late 2017, as indicated earlier, was prompted by the depletion of FRR savings, but also by the need to finance government buyback of public enterprise debt and make a transfer of DZD 500 billion to the National Investment Fund (FNI) for financing two turnkey projects (harbor expansion and a phosphate plant). The authorities are aware of risks associated with central bank financing, especially at below market rates. While such financing was used in Q4 2017 and in January 2018, no additional exceptional borrowing has been made since then, while at the same time the BA doubled the reserve requirement ratio to 8 percent and began mopping up operations to tighten liquidity conditions.

Staff is of the view that if unconventional financing were to continue, it should be subject to strict quantitative and time limits, and be at market pricing. In fact, Law No 17–10 of October 2017 on exceptional financing stipulates that exceptional financing should be limited to 5 years and undertaken solely for the purpose of financing the treasury (within the confines of annual budget laws), paying down public debt, and funding the FNI (the DZD 500 billion transfer to FNI mentioned earlier was in this context). The Law, however, falls short of imposing a quantitative limit on borrowing. The authorities prefer to move towards market rates at a measured pace and as a part of a broader plan to modernize the monetary framework, including establishing an effective monetary transmission mechanism.

As regards the potential inflationary impact of unconventional financing and liquidity growth, staff study¹ has shown that external factors are the most important driving forces of inflation in the long run. Liquidity growth is also an important contributing factor in the long run, but the impact is muted by the extent of price controls in the economy and the fairly slow speed of adjustment of inflation to its long run rate following a shock. The latest data indicate an average annual inflation rate of 3.4 percent during Q1 2018 (the immediate period following the liquidity injection), less than half the 7.6 percent in Q1 2017.

As regards exchange rate policy, staff recommends more flexibility leading to eventual unification of the official and the parallel rates once capital transactions are sufficiently liberalized. The authorities are of the view that the degree of the exchange rate flexibility should be calibrated with other policy moves, particularly fiscal consolidation, and liquidity conditions. Additionally, with non-hydrocarbon exports accounting for a mere 5 percent of total exports, and being almost entirely foreign currency based, the authorities feel that there are only limited gains in export competitiveness from greater exchange rate flexibility under the current export structure, until diversification takes stronger hold through structural policies. There is also little evidence of a robust exchange rate pass-through to domestic prices, at least in the short run: despite the significant nominal depreciation of the dinar in 2015–2016, CPI inflation in 2017 remained broadly unchanged. The authorities are determined to curb the informal sector of the economy that has been the main source of supply and demand of foreign exchange to the illegal parallel market.

Financial Sector

Algeria’s banking system is well capitalized and profitable despite the low interest rate environment. NPLs are moderate and well-provisioned, and are expected to decline as the government continues to clear its arrears to suppliers. Risk-based bank supervision and tighter bank governance have improved banking sector resilience, as indicated by staff. Cognizant of risks to financial sector stability, the authorities are monitoring the liquidity conditions closely and stand ready to act promptly and appropriately.

Structural Reforms

The authorities agree with staff that Algeria is facing important policy challenges in reducing the economy’s exposure to the vagaries of the energy market through diversification. They also realize that the private sector has to play a greater role in income generation and wealth distribution going forward. With that in mind, using the window of opportunity offered by the recovery of the energy market, and in close collaboration with the World Bank, they are designing a long-term strategy to reshape Algeria’s growth model that has been reliant for decades on a dominant public sector. The process is expected to be well sequenced and its pace measured; some of the reform areas have been already announced in a recent decree.² The key areas include: simplifying business regulations and improving business climate in general; opening new areas of activity to the private sector; rationalizing subsidies; improving the functioning of the labor market; strengthening PFM; modernizing the banking system; and investing in infrastructure—all with the longer-term aim of rebalancing the economy in favor of the private sector and diversifying the economic structure away from hydrocarbons.

Conclusions

The Algerian economy is in a state of transition. The authorities’ near- to medium-term objectives are to restore macroeconomic stability, revive non-hydrocarbon GDP growth, and create jobs, particularly for women and youth. In the longer run, the primary goal is to diversify the economy with greater private sector participation. There are major headwinds, but the authorities are committed to advancing their reform agenda in a well-sequenced and moderately-paced manner. Fiscal consolidation is central in the authorities’ strategy to reduce the economy’s reliance on hydrocarbon revenue. The process started in 2015, is ongoing, and is expected to be the lynchpin of macroeconomic policies going forward. Structural reforms will lend support to encourage private sector activity, improve business climate, modernize the monetary policy framework, and improve the efficiency of the labor market. The thrust of the authorities’ reform program is consistent with staff views and the authorities will continue to count on staff policy and technical advice.