Public Information Notice No. 05/138

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Syrian Arab Republic

October 3, 2005

On August 31, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Syrian Arab Republic.¹

Background

Following a slowdown in 2003, a mild recovery seems to have started since early 2004. The slowdown in 2003 reflected declining oil production and the impact of the conflict in Iraq on exports and investment. An expansionary fiscal stance cushioned the impact of these shocks and helped limit the slowdown in economic activity to 1¼ percent. The recovery in 2004 has been aided by a strong rebound in exports, especially tourism, and by a surge in private investment-reflecting the ongoing reforms. A 20 percent increase in public sector wages together with a good harvest contributed to the upturn. Inflation remains subdued for the moment, despite expansionary fiscal policies and the easing of credit. The external position is weakening as a result of a downward trend in oil exports and in unidentified inflows.

The recovery is likely to continue in 2005 supported by a further strengthening of private investment and exports. Notwithstanding the increase in oil prices, the current account is expected to weaken further, reflecting a decline in the volume of oil exports with a partial offset from tourism. Fiscal policies promise to be somewhat tighter in 2005, reflecting the introduction of the consumption tax, some adjustment in petroleum prices, and a planned curb on inefficient public investment. This, together with moderate credit expansion, would help keep inflation in check.

The medium-term prospects are worrisome given that oil, which presently contributes 20 percent of GDP, two-thirds of exports (about 14 percent of GDP), and half of government revenues (about 15 percent of GDP), is likely to be exhausted in the late 2020s and Syria may become a net oil importer within a few years.

The authorities have continued to make progress in addressing key structural rigidities to boost growth, and in strengthening the medium-term budgetary outlook to face the prospective decline in oil revenues. However, the supply response, so far, and the fiscal prospects suggest that the pace and the scope of reforms have fallen short of Syria's medium-term growth and employment challenges. If structural reforms and fiscal consolidation are not accelerated, there is a risk that oil reserves will be exhausted before the ongoing reforms have had time to generate new sources of growth and income. If this risk were to materialize, Syria may get locked in a cycle of financial volatility, fiscal deterioration, low growth, and rising unemployment.

Executive Board Assessment

Directors were encouraged by Syria's favorable performance in 2004 as reflected by the strong non-oil growth and the stable macroeconomic environment. They commended the Syrian authorities for the steady progress in pushing forward the structural reform agenda, notably the steps taken to further liberalize the trade and foreign exchange regimes, simplify and broaden the base of the tax system, strengthen budgetary procedures to improve the efficiency of public spending, grant greater autonomy and flexibility to public enterprises including public banks, and open the insurance industry to the private sector. However, noting the worrisome medium-term prospects for the oil sector, Directors expressed concern that the pace and the scope of reforms may be falling short of the daunting challenges posed by the prospective depletion of oil reserves and the high demographic pressures on the labor market.

Against this background, Directors agreed that structural reforms aimed at furthering the transition to a market economy, strengthening the incentive system for domestic and foreign investors, and improving price signals need to be further accelerated and broadened to create new sources of growth and foreign exchange earnings to replace the dwindling oil resources. They welcomed the authorities' intention to implement institutional reforms to strengthen competition, governance, property rights, and the rule of law.

Directors considered that a strong and credible fiscal consolidation strategy within a transparent medium-term fiscal framework (MTFF) will be key to maintaining financial stability and instilling confidence in Syria's fiscal solvency. Given the high uncertainty surrounding oil prices, reserves, and extraction rates, Directors agreed that the MTFF should target a steady improvement in the non-oil budget balance, keeping the government's inter-temporal budget constraint in clear perspective, and moderating distributive demands fueled by higher oil prices.

Directors welcomed the authorities' commitment to fiscal consolidation as reflected in the tax and expenditure measures adopted in the 2005 budget, and their sustained effort to increase efficiency and broaden the tax base, while strengthening tax administration. Directors called on the authorities to build on this progress and develop a comprehensive fiscal reform package aimed at further simplifying tax provisions and removing tax exemptions. Efforts to revamp tax administration, including the creation of a large taxpayer unit, should be sustained to prepare for a successful launch of the VAT. A comprehensive review of public expenditure could help identify measures to raise fiscal savings and enhance the supply side of the economy. Overhauling the price subsidy system, while at the same time strengthening social safety nets, could be an important source of savings and efficiency gains. Civil service reform—in a manner that does not create social disruptions—is also needed to address overstaffing, low pay, and lack of skills. Directors urged the authorities to contain the accumulation of new debt, with a few suggesting that windfall revenues be used to pay down the debt.

Directors welcomed the recent laws to allow greater autonomy and flexibility to public enterprises and public banks in order to improve their financial position, stem their drain on public finances, and ensure a level playing field for private sector enterprises. Directors called on the authorities to elaborate and implement their plan to restructure those enterprises that can be salvaged, and to develop case-by-case solutions, including liquidation, to deal with the rest. Directors encouraged the authorities to envisage the privatization of selected enterprises.

On monetary policy, Directors agreed that the present level of interest rates is appropriate and that a continuation of the current pace of credit expansion carries limited inflationary risks, given the still low stock of bank loans. However, given state banks' weak risk management capacity and their limited lending experience, Directors recommended close monitoring of credit developments to contain credit risk and the adoption of a modern credit scoring system. They welcomed the authorities' intention to strengthen the role of the central bank in formulating and implementing monetary and exchange rate policies, and to re-orient the activities of the Commercial Bank of Syria toward traditional commercial banking. Directors urged the authorities to move swiftly on the much delayed agenda of launching a government securities market, which is critical for moving toward a more efficient monetary framework and market-determined interest rates, and for financial sector development. Directors welcomed the authorities' plan to establish a Securities Commission.

Directors stressed that liberalization and increased competition brought about by the entry of private banks need to be complemented by a more comprehensive state-bank restructuring strategy and sustained efforts to strengthen bank regulation and supervision. Directors noted the passage of the Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) law and encouraged the authorities to continue to strengthen the AML/CFT framework and develop its implementing rules and regulations.

Directors welcomed the steps taken in the past year toward exchange rate unification and current account convertibility, in particular the decision to allow the financing of private sector imports of raw material and intermediate goods through the official market. Given the significant narrowing of the spread between the official and free market rates, Directors saw that attendant risks to unification are limited and, hence, urged the authorities to move swiftly to unify the foreign exchange market and adopt current account convertibility. Directors welcomed the authorities' plan to move to a managed float system after completing the necessary preparatory work. With regard to the trade system, while acknowledging the positive steps in this area, Directors encouraged the authorities to introduce promptly the new tariff structure, eliminate non-tariff barriers, and tackle other trade-related barriers.

Directors urged the authorities to improve the coverage, timeliness, periodicity, and quality of economic and financial data to allow in-depth economic analysis and policy formulation. They urged the authorities to participate in the Fund's General Data Dissemination System.