## FINANCING FISCAL DEFICITS

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### Introduction
- The sharp and sustained decline in oil prices since mid-2014 led to large fiscal deficits and exacerbated an already weak fiscal position.
- Even prior to the collapse in oil prices, Algeria’s fiscal policy was on an unsustainable path given the exhaustibility of hydrocarbon resources at a relatively short horizon.
- Algeria recorded consecutive fiscal deficits from 2009 to 2013 as government spending surged following the global financial crisis and the Arab Spring; the fiscal deficit widened significantly in 2014 when oil prices began to drop.

### Fiscal shock and policy response
- Fiscal deficit rose to 15.6 percent of GDP in 2015 as oil prices fell to new lows.
- Government medium-term fiscal consolidation plan:
  - Reduced fiscal deficit from 15.8 percent of GDP in 2015 to 14.0 percent in 2016.
  - Aims to bring the deficit close to zero by 2019, mainly through further spending cuts combined with higher taxes and continued subsidy reform.
- Staff projection under the authorities’ envisaged spending cuts:
  - Nonhydrocarbon growth will slow to almost zero in 2018.
- Alternative (staff) view:
  - A more gradual fiscal consolidation, enabled by more diversified financing, combined with further exchange rate depreciation and ambitious structural reforms, would have less impact on growth while still placing fiscal policy on a sustainable path.

### Financing environment and reserves
- Savings in the oil stabilization fund (Fonds de Régulation des Recettes, FRR) have been nearly completely depleted.
- International reserves: US$113 billion, or nearly two years of imports, at end-2016.
- Liquidity in the banking sector declined dramatically after the oil price shock, limiting the capacity of the domestic banking system to absorb new government debt.
- Once-substantial bank deposits at the Banque d’Algérie evaporated as oil prices fell, tightening domestic liquidity and increasing yields across the Treasury yield curve.

### Historical financing of deficits (2009–16)
- Cumulative fiscal deficit 2009–16: 8,297 billion dinars (equivalent to US$75 billion).
- Financing sources for the cumulative deficit (percent of total):
  - Deposits of public entities: 46 percent.
  - FRR: 42 percent.
  - Net domestic debt issuance: 6 percent.
  - Net foreign borrowing: negligible.
- Note: Borrowing from public entities is tantamount to central government borrowing but not reflected in government debt statistics; government is obliged to replenish these deposits, with no set timeframe.

### Debt position and public assets (end-2016)
- Algeria’s asset-liability position remains strong despite near depletion of the FRR, due to a low level of debt.
- Central government debt, end-2016 (US$1 = DZD 110.9):
  - External debt: US$1.6 billion; DZD 174.8 billion; 1.0 percent of GDP.
  - Domestic debt: US$30.7 billion; DZD 3,407.3 billion; 19.9 percent of GDP.
    - Treasury securities: DZD 977.5 billion; 5.7 percent of GDP.
    - National Bond for Economic Growth: DZD 569.1 billion; 3.3 percent of GDP.
    - Debt from financial support operations: DZD 1,860.7 billion; 10.9 percent of GDP.
  - Total: US$32.3 billion; DZD 3,582.1 billion; 21.0 percent of GDP.
- Algeria among the least indebted countries in the world, with almost no external debt and domestic debt at 20 percent of GDP.

### Domestic debt market characteristics and capacity
- Domestic debt market is underdeveloped and illiquid:
  - Secondary market trading as a share of annual issuance has declined for bills, BTAs, and OATs.
  - OATs secondary trading fell from 91 percent of issuance in 2013 to 27 percent in 2015.
- Banking sector asset composition, 2016 (percent of total):
  - Credit to the government: 34 percent.
  - Credit to public enterprises: 47 percent.
  - Credit to private sector: 4 percent.
  - Cash and reserves at the BA: 12 percent.
  - Foreign assets: 1 percent.
  - Other assets: 2 percent.
- Staff baseline projection of government gross financing requirement: DZD 2,147 billion over 2017–19.
- End-2016: claims of domestic banks on the government amounted to DZD 2,761 billion, or a third of total bank assets.
- Banks could absorb additional government debt without changing asset composition:
  - DZD 455 billion over the next three years (assuming bank balance sheets grow in line with nominal nonhydrocarbon GDP).
  - If banks reduced claims on public enterprises by one third, they could absorb an additional DZD 1,492 billion.
- Two conclusions:
  - Financing future deficits by the banking sector will likely involve some reallocation of credit toward the government.
  - To avoid crowding out the private sector, the government will need financing beyond the domestic banking sector.

### Options to deepen domestic financing
- Consider issuing another national sovereign bond (building on the National Bond for Economic Growth that raised DZD 569 billion in 2016), but risks include fragmenting the debt market and yielding limited retail participation.
- Recommended reforms to develop the domestic debt market:
  - Sound issuance policy with regular, balanced supply across maturities to create a liquid yield curve.
  - Public debt management strategy aligned with risk preferences and market development.
  - Communications strategy to articulate macro objectives and the debt program.
  - Capacity building and resources for the debt management office.
  - Diversify investor base via development of the insurance and mutual fund industries.
  - Upgrade clearing and settlement infrastructure.
  - Encourage banks to mobilize informal savings by offering broader services (debit/credit cards, e-payment services, financial products consistent with religious preferences).

### Risks to avoid
- Borrowing reserves from the central bank to finance the budget deficit should be avoided:
  - Equivalent to creation of base money; risks driving up the overall price level and accelerating the fall in internal reserves.
  - Undermines central bank credibility and independence and reduces incentives for fiscal consolidation.

### External borrowing: advantages and context
- External borrowing (debt issued in foreign currency and purchased by non-residents) advantages:
  - Mitigates crowding out effects by tapping foreign savings.
  - Favorable financing conditions: interest rates on emerging market sovereign debt remain near historically low levels as investors search for yield.
- External debt, end-2016:
  - Government external debt: US$1.6 billion (1.0 percent of GDP).
  - Since 2006, external debt has remained less than US$3 billion.
  - 2016: African Development Bank provided Algeria a €900 million budget support loan—the AfDB’s first loan to Algeria in 12 years.
  - Remaining external debt is owed to official bilateral creditors on concessional terms.
- Staff debt sustainability projections:
  - Baseline (authorities’ medium-term fiscal consolidation plan): government debt projected to fall from 21.0 percent of GDP in 2016 to 14.6 percent in 2022.
  - No further fiscal adjustment scenario (primary balance constant at 2016 level): debt projected to increase to 39.4 percent in 2022, still below the 70 percent sustainability benchmark for emerging market countries.
  - Implication: Algeria has space to borrow more without threatening debt sustainability.

### Rationale for external borrowing (benefits)
- Strengthens international reserves: borrowing externally would shore up reserves with little risk to debt sustainability given Algeria’s low level of debt.
- Broadens the investor base: current government debt investors are almost entirely domestic banks and insurance companies; external borrowing would tap savings outside the country.
- Sets a benchmark for the private sector: regular sovereign debt issuance can establish a yield curve in foreign currency usable as a reference for private or public companies borrowing externally.
- Increases awareness about the Algerian economy: international issuance would raise investor awareness and could facilitate external borrowing by nongovernment entities and generate more foreign direct investment.
- Creates incentives to follow sound policies: increased investor scrutiny can create pressure on the government to follow sound macroeconomic policies and enhance transparency.

### Risks of external borrowing
- Rollover risk: international issuance exposes Algeria to sudden shifts in investor sentiment that would affect its ability to roll over maturing debt; a “sudden stop” could force Algeria to find alternative financing sources.
- Foreign currency risk: external borrowing exposes Algeria to foreign exchange rate risk. The dinar is significantly overvalued and Algeria lacks a forward market to hedge positions.
- Potential increase in financing costs from deterioration in international investor sentiment unrelated to Algeria.
- Supply-side pressure on yields: the supply of emerging market debt could increase as other oil exporters seek to finance large deficits, putting upward pressure on yields.

### Algeria’s external debt capacity and market options
- Current vulnerability indicators are very low (external debt/external-exports ratios and short-term external debt/reserves ratios).
- Algeria could issue around US$2 billion, or just over 1 percent of GDP, in Eurobonds per year given minimal external debt and still large reserves.
- Examples of large 2016 sovereign issuance in the region:
  - Qatar issued US$9.0 billion (5.7 percent of GDP).
  - Saudi Arabia issued US$17.5 billion (6.0 percent of GDP).
- Possible instruments and sources:
  - Eurobonds.
  - Sukuk (Islamic bonds): Global Sukuk issuance reached US$120 billion in 2013; demand has generally outstripped supply.
  - Syndicated lending: has financed infrastructure, energy projects, and extractive industry; can provide access where bond markets are closed but often include covenants and discontinuation risk.
  - Borrowing from official creditors: Algeria has outstanding debt to Canada, France, Saudi Arabia, the United Arab Emirates, Japan, and Belgium; recently borrowed €900 million from the AfDB.
- Market development and preparatory requirements:
  - Algeria has never issued an international sovereign bond and needs to develop capacity for international issuance:
    - Preparation includes hiring legal advisors, conducting roadshows, and acquiring a sovereign credit rating (Algeria does not have a credit rating).
    - Investor outreach will be especially important given limited financial integration.
  - Borrowing costs depend on external and fiscal positions, economic growth, government effectiveness, and potential inclusion in major bond indices.

### Privatization and sale of state-owned assets
- Privatization can yield substantial deficit financing but past attempts have largely failed.
  - At least 392 state-owned enterprises (SOEs) with 2015 revenues equal to 26 percent of GDP.
  - Sonatrach is the largest SOE.
  - Public banks account for 87 percent of total banking assets.
  - The Bourse d’Alger at end-2016 had five listed equities with total market capitalization of DZD 45.8 billion, equal to less than 1 percent of GDP.
- Constraints and required actions:
  - Need to communicate benefits of sales and establish compensation/retraining mechanisms for displaced workers.
  - Many SOEs depend on subsidized loans, episodic bailouts, and other state support; restructuring will be necessary to attract investor interest.
  - Stock market reforms suggested include relaxing the “49/51 rule” limiting foreign investors to a minority stake and eliminating the state/SOEs’ right to block share sales to/from foreign investors.
- Privatization can improve public finances, SOE governance, and efficiency but will likely take time.

### Simulating the financing strategy — Alternative scenario (2017–22)
- Scenario summary:
  - Staff developed an alternative scenario where the government creates fiscal space for a more gradual fiscal consolidation.
  - Cumulative gross financing requirement over 2017–21 is DZD 9,713 billion in the alternative scenario versus DZD 2,819 billion in the baseline scenario.
  - The government borrows from official bilateral and multilateral sources in the amount of US$1.7 billion on average per year during 2017–20.
  - Starting in 2018, the government is assumed to issue US$2 billion in Eurobonds per year at an interest rate of 5 percent and a maturity of 10 years.
  - Remaining financing needs are met by domestic debt issuance.
  - The alternative scenario assumes no financing from the sale of state-owned assets.
- Fiscal and debt projections (selected figures preserved exactly):
  - Gross financing requirement (annual, selected years):
    - 2017: 1,682
    - 2018: 1,556
    - 2019: 1,851
    - 2020: 1,917
    - 2021: 1,462
    - 2022: 1,246
  - FRR withdrawal:
    - 785 in 2017; 0 in 2018–2022.
  - Deposits of public entities (annual):
    - 164, 131, 105, 84, 67, 54 (2017–2022).
  - Domestic borrowing (annual):
    - 389, 941, 1,365, 1,487, 1,115, 898 (2017–2022).
  - External borrowing (annual):
    - 345, 483, 380, 346, 279, 293 (2017–2022).
    - Multilateral: 115, 121, 127, 80, 0, 0 (2017–2022).
    - Official bilateral: 230, 121, 0, 0, 0, 0 (2017–2022).
    - Eurobond: 0, 241, 253, 266, 279, 293 (2017–2022).
  - Public debt (percent of GDP): 21.2, 25.9, 29.3, 31.2, 31.7, 31.0 (2017–2022).
    - Domestic public debt: 18.5, 20.9, 22.8, 23.5, 23.2, 21.9 (2017–2022).
    - External public debt: 2.7, 4.9, 6.5, 7.7, 8.5, 9.2 (2017–2022).
- Outcomes:
  - Debt levels in the alternative scenario are higher than in the baseline but remain moderate and stabilize at the end of the projection period.
  - Total public debt peaks at 31.7 percent of GDP in 2021 before starting to decline (baseline peak: 19.6 percent of GDP).
  - Domestic public debt equals 21.9 percent of GDP in 2022 while external public debt stands at 9.2 percent of GDP in 2022.

### Conclusions and policy recommendations
- Algeria needs sustained fiscal consolidation to restore fiscal sustainability given heavy reliance on hydrocarbon revenues and the collapse of oil prices.
- Avoid unnecessarily abrupt fiscal consolidation:
  - The authorities’ medium-term consolidation is extremely ambitious and risks damaging growth and employment.
  - More gradual spending cuts combined with further exchange rate depreciation and wide-ranging structural reforms would have less impact on growth while still placing fiscal policy on a sustainable path.
- Algeria can afford a more gradual consolidation:
  - Government debt is low and external debt is nearly nonexistent; Algeria has fiscal space to borrow more without threatening debt sustainability.
- Consider a mix of domestic and external borrowing to finance deficits:
  - Domestic issuance helps develop local financial markets and create a yield curve benchmark.
  - Excessive domestic borrowing could crowd out private credit in a tighter liquidity environment; external borrowing would mitigate crowding out, strengthen international reserves, broaden the investor base, and raise awareness about Algeria’s economy.
- External borrowing options include Eurobonds, Sukuk issuance, syndicated lending, and official creditors.
- Privatization of selected SOEs could complement debt financing but will require transparent processes, restructuring of inefficient SOEs, and social compensation/retraining mechanisms.

*Prepared by Andrew Jewell; IMF staff analysis and projections as presented in the source PDF.*

### Introduction ___________________________________________________________________________ 3

### FINANCING FISCAL DEFICITS

### Introduction
- The sharp and sustained decline in oil prices since mid-2014 has led to large fiscal deficits and exacerbated an already weak fiscal position.
- Even prior to the collapse in oil prices, Algeria’s fiscal policy was on an unsustainable path, in particular given the exhaustibility of hydrocarbon resources at a relatively short horizon.
- Algeria recorded consecutive fiscal deficits from 2009 to 2013, as government spending surged following the global financial crisis and the Arab Spring.
- The fiscal deficit widened significantly in 2014, when oil prices began to drop.

### Background
- (Section present in source; detailed content not provided in this excerpt.)

### Domestic Borrowing
- (Section present in source; detailed content not provided in this excerpt.)

### External Borrowing
- (Section present in source; detailed content not provided in this excerpt.)

### Selling State-Owned Assets
- (Section present in source; detailed content not provided in this excerpt.)

### Simulating the Financing Strategy
- (Section present in source; detailed content not provided in this excerpt.)

### Conclusions
- (Section present in source; detailed content not provided in this excerpt.)

*cr17142 - Introduction (May 15, 2017) — IMF PDF chapter: FINANCING FISCAL DEFICITS*

### 15.6 percent of GDP in 2015 as oil prices fell to new lows.

### cr17142 - 15.6 percent of GDP in 2015 as oil prices fell to new lows.

### Fiscal shock and policy response
- Fiscal deficit rose to 15.6 percent of GDP in 2015 as oil prices fell to new lows.
- Government medium-term fiscal consolidation plan:
  - Reduced fiscal deficit from 15.8 percent of GDP in 2015 to 14.0 percent in 2016.
  - Aims to bring the deficit close to zero by 2019, mainly through further spending cuts combined with higher taxes and continued subsidy reform.
- Staff projection under the authorities’ envisaged spending cuts:
  - Nonhydrocarbon growth will slow to almost zero in 2018.
- Alternative scenario (staff view):
  - A more gradual fiscal consolidation, enabled by more diversified financing, combined with further exchange rate depreciation and ambitious structural reforms, would have less impact on growth while still placing fiscal policy on a sustainable path.

### Financing environment and reserves
- Savings in the oil stabilization fund (Fonds de Régulation des Recettes, FRR) have been nearly completely depleted.
- International reserves remain at US$113 billion, or nearly two years of imports, at end-2016.
- Liquidity in the banking sector declined dramatically after the oil price shock, limiting the capacity of the domestic banking system to absorb new government debt.
- Once-substantial bank deposits at the Banque d’Algérie evaporated as oil prices fell, tightening domestic liquidity and increasing yields across the Treasury yield curve.

### Historical financing of deficits (2009–16)
- Cumulative fiscal deficit 2009–16: 8,297 billion dinars (equivalent to US$75 billion).
- Financing sources for the cumulative deficit (percent of total):
  - Deposits of public entities: 46 percent.
  - FRR: 42 percent.
  - Net domestic debt issuance: 6 percent.
  - Net foreign borrowing: negligible.
- Note: Borrowing from public entities is tantamount to central government borrowing but not reflected in government debt statistics; government is obliged to replenish these deposits, with no set timeframe.

### Debt position and public assets (end-2016)
- Algeria’s asset-liability position remains strong despite near depletion of the FRR, due to a low level of debt.
- Central government debt, end-2016 (US$1 = DZD 110.9):
  - External debt: US$1.6 billion; DZD 174.8 billion; 1.0 percent of GDP.
  - Domestic debt: US$30.7 billion; DZD 3,407.3 billion; 19.9 percent of GDP.
    - Treasury securities: DZD 977.5 billion; 5.7 percent of GDP.
    - National Bond for Economic Growth: DZD 569.1 billion; 3.3 percent of GDP.
    - Debt from financial support operations: DZD 1,860.7 billion; 10.9 percent of GDP.
  - Total: US$32.3 billion; DZD 3,582.1 billion; 21.0 percent of GDP.
- Algeria among the least indebted countries in the world, with almost no external debt and domestic debt at 20 percent of GDP.

### Domestic debt market characteristics and capacity
- Domestic debt market is underdeveloped and illiquid:
  - Secondary market trading as a share of annual issuance has declined for bills, BTAs, and OATs.
  - OATs secondary trading fell from 91 percent of issuance in 2013 to 27 percent in 2015.
- Banking sector asset composition, 2016 (percent of total):
  - Credit to the government: 34 percent.
  - Credit to public enterprises: 47 percent.
  - Credit to private sector: 4 percent.
  - Cash and reserves at the BA: 12 percent.
  - Foreign assets: 1 percent.
  - Other assets: 2 percent.
- Staff baseline projection of government gross financing requirement: DZD 2,147 billion over 2017–19.
- End-2016: claims of domestic banks on the government amounted to DZD 2,761 billion, or a third of total bank assets.
- Banks could absorb additional government debt without changing asset composition:
  - DZD 455 billion over the next three years (assuming bank balance sheets grow in line with nominal nonhydrocarbon GDP).
  - If banks reduced claims on public enterprises by one third, they could absorb an additional DZD 1,492 billion.
- Two conclusions:
  - Financing future deficits by the banking sector will likely involve some reallocation of credit toward the government.
  - To avoid crowding out the private sector, the government will need financing beyond the domestic banking sector.

### Options to deepen domestic financing
- Consider issuing another national sovereign bond (building on the National Bond for Economic Growth that raised DZD 569 billion in 2016), but risks include fragmenting the debt market and yielding limited retail participation.
- Recommended reforms to develop the domestic debt market:
  - Sound issuance policy with regular, balanced supply across maturities to create a liquid yield curve.
  - Public debt management strategy aligned with risk preferences and market development.
  - Communications strategy to articulate macro objectives and the debt program.
  - Capacity building and resources for the debt management office.
  - Diversify investor base via development of the insurance and mutual fund industries.
  - Upgrade clearing and settlement infrastructure.
  - Encourage banks to mobilize informal savings by offering broader services (debit/credit cards, e-payment services, financial products consistent with religious preferences).

### Risks to avoid
- Borrowing reserves from the central bank to finance the budget deficit should be avoided:
  - Equivalent to creation of base money; risks driving up the overall price level and accelerating the fall in internal reserves.
  - Undermines central bank credibility and independence and reduces incentives for fiscal consolidation.

### External borrowing: advantages and context
- External borrowing (debt issued in foreign currency and purchased by non-residents) advantages:
  - Mitigates crowding out effects by tapping foreign savings.
  - Favorable financing conditions: interest rates on emerging market sovereign debt remain near historically low levels as investors search for yield in a low global interest rate environment.
- External debt, end-2016:
  - Government external debt: US$1.6 billion (1.0 percent of GDP).
  - Since 2006, external debt has remained less than US$3 billion.
  - 2016: African Development Bank provided Algeria a €900 million budget support loan—the AfDB’s first loan to Algeria in 12 years.
  - Remaining external debt is owed to official bilateral creditors on concessional terms.
- Staff debt sustainability projections:
  - Baseline (authorities’ medium-term fiscal consolidation plan): government debt projected to fall from 21.0 percent of GDP in 2016 to 14.6 percent in 2022.
  - No further fiscal adjustment scenario (primary balance constant at 2016 level): debt projected to increase to 39.4 percent in 2022, still below the 70 percent sustainability benchmark for emerging market countries.
  - Implication: Algeria has space to borrow more without threatening debt sustainability.

*Prepared by Andrew Jewell; IMF staff analysis and projections as presented in the source PDF.*

### 5.7 percent, having fallen 103 basis point on

### cr17142 - 5.7 percent, having fallen 103 basis point on

### Overview
- Yields on sovereign debt issued by GCC oil exporters fell in absolute terms despite worsening economic conditions and increased risks.
- Algeria’s official reserves peaked at US$194 billion in 2013 and are projected to drop to US$93 billion in 2017.
- Algeria’s total external debt is 2.5 percent of GDP; government external debt is 1.0 percent of GDP.
- Algeria’s nominal GDP was US$156 billion in 2016.

### Rationale for external borrowing (benefits)
- Strengthens international reserves.
  - Borrowing externally would shore up reserves with little risk to debt sustainability given Algeria’s low level of debt.
- Broadens the investor base.
  - Current government debt investors are almost entirely domestic banks and insurance companies; external borrowing would tap savings outside the country.
- Sets a benchmark for the private sector.
  - Regular sovereign debt issuance can establish a yield curve in foreign currency usable as a reference for private or public companies borrowing externally.
- Increases awareness about the Algerian economy.
  - International issuance would raise investor awareness and could facilitate external borrowing by nongovernment entities and generate more foreign direct investment.
- Creates incentives to follow sound policies.
  - Increased investor scrutiny can create pressure on the government to follow sound macroeconomic policies and enhance transparency.

### Risks of external borrowing
- Rollover risk.
  - International issuance exposes Algeria to sudden shifts in investor sentiment that would affect its ability to roll over maturing debt; a “sudden stop” could force Algeria to find alternative financing sources.
- Foreign currency risk.
  - External borrowing exposes Algeria to foreign exchange rate risk. The dinar is significantly overvalued and Algeria lacks a forward market to hedge positions.
- Potential increase in financing costs from deterioration in international investor sentiment unrelated to Algeria.
- Supply-side pressure on yields.
  - The supply of emerging market debt could increase as other oil exporters seek to finance large deficits, putting upward pressure on yields.

### Algeria’s external debt capacity and market options
- Current vulnerability indicators are very low (external debt/external-exports ratios and short-term external debt/reserves ratios).
- Algeria could issue around US$2 billion, or just over 1 percent of GDP, in Eurobonds per year given minimal external debt and still large reserves.
- Examples of large 2016 sovereign issuance in the region:
  - Qatar issued US$9.0 billion (5.7 percent of GDP).
  - Saudi Arabia issued US$17.5 billion (6.0 percent of GDP).
- Possible instruments and sources:
  - Eurobonds.
  - Sukuk (Islamic bonds): Global Sukuk issuance reached US$120 billion in 2013; demand has generally outstripped supply.
  - Syndicated lending: has financed infrastructure, energy projects, and extractive industry; can provide access where bond markets are closed but often include covenants and discontinuation risk.
  - Borrowing from official creditors: Algeria has outstanding debt to Canada, France, Saudi Arabia, the United Arab Emirates, Japan, and Belgium; recently borrowed €900 million from the AfDB.

### Market development and preparatory requirements
- Algeria has never issued an international sovereign bond and needs to develop capacity for international issuance.
  - Preparation includes hiring legal advisors, conducting roadshows, and acquiring a sovereign credit rating (Algeria does not have a credit rating).
  - Investor outreach will be especially important given limited financial integration.
- Borrowing costs depend on external and fiscal positions, economic growth, government effectiveness, and potential inclusion in major bond indices.

### Privatization and sale of state-owned assets
- Privatization can yield substantial deficit financing but past attempts have largely failed.
  - At least 392 state-owned enterprises (SOEs) with 2015 revenues equal to 26 percent of GDP.
  - Sonatrach is the largest SOE.
  - Public banks account for 87 percent of total banking assets.
  - The Bourse d’Alger at end-2016 had five listed equities with total market capitalization of DZD 45.8 billion, equal to less than 1 percent of GDP (compared to 46 percent for Morocco and 21 percent for Tunisia).
- Constraints and required actions:
  - Need to communicate benefits of sales and establish compensation/retraining mechanisms for displaced workers.
  - Many SOEs depend on subsidized loans, episodic bailouts, and other state support; restructuring will be necessary to attract investor interest.
  - Stock market reforms suggested include relaxing the “49/51 rule” limiting foreign investors to a minority stake and eliminating the state/SOEs’ right to block share sales to/from foreign investors.
- Privatization can improve public finances, SOE governance, and efficiency but will likely take time.

### Simulating the financing strategy — Alternative scenario (2017–22)
- Scenario summary:
  - Staff developed an alternative scenario where the government creates fiscal space for a more gradual fiscal consolidation.
  - Cumulative gross financing requirement over 2017–21 is DZD 9,713 billion in the alternative scenario versus DZD 2,819 billion in the baseline scenario.
  - The government borrows from official bilateral and multilateral sources in the amount of US$1.7 billion on average per year during 2017–20.
  - Starting in 2018, the government is assumed to issue US$2 billion in Eurobonds per year at an interest rate of 5 percent and a maturity of 10 years.
  - Remaining financing needs are met by domestic debt issuance.
  - The alternative scenario assumes no financing from the sale of state-owned assets.
- Fiscal and debt projections (selected figures preserved exactly):

  - Gross financing requirement (annual, selected years):  
    - 2017: 1,682  
    - 2018: 1,556  
    - 2019: 1,851  
    - 2020: 1,917  
    - 2021: 1,462  
    - 2022: 1,246

  - FRR withdrawal: 785 in 2017; 0 in 2018–2022.
  - Deposits of public entities (annual): 164, 131, 105, 84, 67, 54 (2017–2022).
  - Domestic borrowing (annual): 389, 941, 1,365, 1,487, 1,115, 898 (2017–2022).
  - External borrowing (annual): 345, 483, 380, 346, 279, 293 (2017–2022).
    - Multilateral: 115, 121, 127, 80, 0, 0 (2017–2022).
    - Official bilateral: 230, 121, 0, 0, 0, 0 (2017–2022).
    - Eurobond: 0, 241, 253, 266, 279, 293 (2017–2022).

  - Public debt (percent of GDP): 21.2, 25.9, 29.3, 31.2, 31.7, 31.0 (2017–2022).
    - Domestic public debt: 18.5, 20.9, 22.8, 23.5, 23.2, 21.9 (2017–2022).
    - External public debt: 2.7, 4.9, 6.5, 7.7, 8.5, 9.2 (2017–2022).

- Outcomes:
  - Debt levels in the alternative scenario are higher than in the baseline but remain moderate and stabilize at the end of the projection period.
  - Total public debt peaks at 31.7 percent of GDP in 2021 before starting to decline (baseline peak: 19.6 percent of GDP).
  - Domestic public debt equals 21.9 percent of GDP in 2022 while external public debt stands at 9.2 percent of GDP in 2022.

### Conclusions and policy recommendations
- Algeria needs sustained fiscal consolidation to restore fiscal sustainability given heavy reliance on hydrocarbon revenues and the collapse of oil prices.
- Avoid unnecessarily abrupt fiscal consolidation.
  - The authorities’ medium-term consolidation is extremely ambitious and risks damaging growth and employment.
  - More gradual spending cuts combined with further exchange rate depreciation and wide-ranging structural reforms would have less impact on growth while still placing fiscal policy on a sustainable path.
- Algeria can afford a more gradual consolidation.
  - Government debt is low and external debt is nearly nonexistent; Algeria has fiscal space to borrow more without threatening debt sustainability.
- Consider a mix of domestic and external borrowing to finance deficits.
  - Domestic issuance helps develop local financial markets and create a yield curve benchmark.
  - Excessive domestic borrowing could crowd out private credit in a tighter liquidity environment; external borrowing would mitigate crowding out, strengthen international reserves, broaden the investor base, and raise awareness about Algeria’s economy.
- External borrowing options include Eurobonds, Sukuk issuance, syndicated lending, and official creditors.
- Privatization of selected SOEs could complement debt financing but will require transparent processes, restructuring of inefficient SOEs, and social compensation/retraining mechanisms.

*Source: IMF staff calculations; ALGERIA INTERNATIONAL MONETARY FUND.*

### Introduction: Why Worry About Fiscal Risks?

### Introduction: Why Worry About Fiscal Risks?

### Overview and motivation
- Algeria faces many fiscal risks that may significantly affect the central government’s fiscal balance and the path of public debt.  
- Authorities reduced an important source of fiscal risks by closing several special treasury accounts that led to spending overruns in the past, but other sources of fiscal risks create uncertainties on fiscal outcomes and could challenge fiscal consolidation if they materialize.  
- Understanding what factors may have a substantial impact on available fiscal space is critical for setting the appropriate pace of fiscal consolidation and for assessing debt sustainability under various scenarios.

### Fiscal shocks: frequency, scale, and duration
- Cross-country evidence: macroeconomic shocks and financial sector bailouts are the most frequent and tend to have the highest impact.  
- An IMF study of 230 episodes of contingent liability realizations in 83 countries shows financial sector bailouts accounted for the largest fraction of those episodes.  
- Distribution of associated costs is highly skewed: the average cost was about 3 percent of GDP, but in (rare) instances the impact on public debt exceeded 15 percent of GDP per annum.  
- The average duration of fiscal shocks episodes is 3.2 years.  
- The longest episode in the study’s sample occurred in Algeria and lasted 21 years (1991-2012), cumulatively costing the equivalent of 14.8 percent of 2012 GDP. This took the form of debt assumptions by the central government (equal to around 82 percent of the total impact) and recapitalization of state-owned banks.

### Public sector structure and exposure
- The Algerian public sector is very large:
  - The public sector, including the central government, accounted for 46 percent of the country’s value-added in 2015.  
  - Activities carried out by the public sector excluding the central government accounted for 27 percent of total value-added.  
- The public sector includes a myriad of entities:
  - Close to 400 SOEs.  
  - A large social protection sector comprising several social funds.  
  - A large number of nonfinancial institutions that are autonomous commercial entities (EPICs).  
  - Six public banks that dominate the banking sector.  
  - Other public financial institutions, including ten public insurance companies and the National Postal Agency.  
  - Local governments.  
- These entities are linked by a web of financial interactions, each opening potential transmission channels for fiscal risks.

### Analytical framework
- A tentative mapping differentiates fiscal risks by nature: macroeconomic, specific, and institutional fiscal risks.  
- Specific fiscal risks can be endogenous to the public sector (e.g., guaranteed debt) or exogenous (e.g., environmental risk), and explicit or implicit.  
- Fiscal risks can affect or originate in any of the fiscal institutions described above.

### Main sources of fiscal risks

Macroeconomic uncertainty
- Oil price volatility is a key source of macroeconomic and fiscal volatility: about 60 percent of fiscal revenue stems from the hydrocarbon sector.  
- Following the fall in oil prices in 2014, hydrocarbon revenues declined by about a third in 2015.  
- Baseline debt projection: gross public debt, excluding guarantees, is expected to remain relatively small (from 8.8 percent of GDP in 2015 to 14.6 percent of GDP in 2022).  
- Under plausible alternative scenarios and stress tests, debt could increase significantly, although staff judged it would remain within sustainable margins.

Implicit obligations to state-owned enterprises (SOEs)
- SOEs are often a significant source of implicit contingent government liabilities, especially where political interference or excessive borrowing exists.  
- There are currently 392 SOEs in Algeria, varying in size from large firms to small companies.  
- Revenues of the two biggest SOEs (the state-owned oil company and the state-owned gas and electricity company) were equivalent to 26.1 percent of GDP in 2015. Revenues from all other SOEs amounted to less than 4 percent of GDP.  
- Sectoral concentration of SOEs (2015):
  - Oil industry: one group with 154 subsidiaries, accounting for 88 percent of the oil industry’s value-added.  
  - Construction: 64 SOEs contributing 21 percent of the sector’s value-added.  
  - Transportation: 55 SOEs accounting for 16 percent of the sector’s value-added.  
- Financial support to SOEs:
  - Direct budget transfers to SOEs are relatively low (less than 1 percent of GDP), but the cost of other types of financial support rose from 0.7 percent of GDP in 2005 to slightly more that 3 percent of GDP in 2016.  
  - These operations have mostly taken the form of SOEs debt assumptions (debt buy-backs) and coverage of loan subsidies.  
  - Dividends received by the state are very low, reflecting SOEs’ weak financial performance; in 2014, a third of the SOEs were loss making.  
- Illustrative instances and staff estimates:
  - In 2016, one SOE received government T-bill issuance amounting to DZD 904.2 billion (5.3 percent of GDP) as compensation for operating losses incurred from 2011 to 2013.  
  - Staff estimates that, under current market conditions, the liabilities of this particular SOE could increase government debt by DZD 230 billion per year (1.3 percent of 2016 GDP).  
- SOE returns and outlook:
  - The overall return on equity of the central government on its portfolio of SOEs is most likely very low or negative.  
  - SOE conditions appear to have deteriorated further following the fall in oil prices, and SOE debt is expected to grow for structurally unprofitable SOEs. Part of that debt is likely to be transferred to the central government balance sheet through debt assumptions and other support.

Box: Types of government financial support to SOEs
- Loans at a subsidized rate: difference between market and subsidized rate is borne by the central government and paid to the lending institution.  
- Debt buy-backs (debt assumptions): central government assumes indebtedness of an SOE, often when a non-performing loan jeopardizes a public bank’s prudential ratios.  
- Trésor debt write-offs: Treasury provides cash advances/loans to SOEs that may be written off when not repaid.  
- Overdraft freezing: Trésor signs agreement with a bank to freeze cumulative overdraft of an SOE; interest on outstanding overdraft is paid by the central government.  
- On-lending: central government borrows on behalf of a public institution and then lends to it (e.g., Fonds national d’investissement).

Explicit guarantees to SOEs
- Explicit guarantees have grown significantly: from 0.3 percent of GDP in 2005 to 18.5 percent of GDP in 2016.  
- In 2016, the level of guarantees was equivalent to 88 percent of central government debt.  
- Guarantees have been frequently called in the past at significant cost to the government.  
- Guarantees over 2005-16 mainly covered financing of projects by one large, structurally loss-making SOE:
  - In 2016, guarantees to that SOE represented 80 percent of the total stock of guarantees and 3 percent of GDP.  
  - Debt buy-backs for that SOE in 2016 amounted to 407.8 billion dinars, or 2.4 percent of GDP, constituting the entirety of debt assumed that year.  
- Governance/oversight gaps:
  - How guarantees are granted is not governed by a legal or regulatory framework.  
  - In practice, guarantees are granted for project financing that exceeds 25 percent of bank capital, but there is no legislation or regulation requiring guarantee ceilings be approved with the annual budget.  
  - There appears to be little risk assessment of the loans or of the SOE’s debt structure when the guarantee is issued.

### Transmission channels, uncertainty, and policy implications (summary points from the introduction)
- Fiscal shocks can be large, adverse, and nonlinear; cross-country analysis points to macroeconomic shocks and financial sector bailouts as the most impactful.  
- Given Algeria’s large public sector footprint, widespread SOE presence, significant reliance on hydrocarbon revenues (~60 percent of fiscal revenue), and sizable explicit guarantees, fiscal risks could materially affect fiscal consolidation and debt trajectories.  
- Identifying and quantifying plausible fiscal risks and incorporating them into debt sustainability analysis and policy decisions is critical to safeguarding fiscal space.

*Prepared by Racheeda Boukezia.*

### 18.      Government guarantees have conflicting objectives. The state, as the main shareholder

### 18.      Government guarantees have conflicting objectives. The state, as the main shareholder

### Government guarantees and conflicting objectives
- The state, as the main shareholder of SOEs, seeks to ensure financing for its own investments and thus develops incentives and policies to encourage financing from public banks.
- The state, as the sole owner of the public banks, seeks to ensure that the prudential ratios of its banks are respected, creating an additional incentive to grant loan guarantees.
- Granting guarantees is risky: the state tends to assume SOEs debt or recapitalize public banks when rising public sector NPLs worsen prudential ratios.
- The practice promotes a form of regulatory forbearance instead of minimizing fiscal risks and ensuring a level-playing field in the banking sector.

### Risks from other nonfinancial public institutions (EPICs)
- There are 66 commercially-oriented autonomous public institutions (“Établissements Publics à Caractère Industriel et Commercial,” EPIC) which are not legally incorporated as enterprises.
- EPICs operate in many economic sectors (communication, press, tourism, culture, utilities, etc.) and many implement the government’s social policies.
- Financial support to EPICs takes the form of direct transfers, on-lending, and direct loans or cash advances from the central government.
- Fiscal risks associated with EPICs can be sizeable because many operate in sectors where prices are regulated, typically at levels that are too low to cover costs (water distribution and cereal distribution cited as examples).
- An unexpected increase in demand for the good, or an increase in the cost to produce the good (e.g., related to a surge in commodity prices), would increase fiscal costs.
- In 2016, transfers to EPICs from the central government to cover the cost of food subsidies (cereal and milk) accounted for about 1.3 percent of GDP.
- Financial interactions with EPICs, 2016 (In percent of GDP): direct transfers; on-lending to FNI*; direct lending from Trésor; cash advances. (Chart source: Algerian authorities; *FNI: Fonds National d’Investissement)

### Risks related to public banks
- Public banks accounted for 87 percent of total banking assets in 2015.
- Public banks heavily support state-directed economic activity by financing structural and strategic projects via state-guaranteed loans, often at a subsidized interest rate and with an interest-free grace period (up to five years).
- While still adequately capitalized, the banking sector faces rising credit, liquidity, and interest rate risks because of the impact of durably low oil prices on the economy.
- Since 1991, the government has repeatedly supported public banks via recapitalization or financial consolidation to ensure full respect of solvency ratios.
- Financial consolidation has entailed the systematic assumption of non-performing SOE debt, often secured by a state guarantee.
- Other forms of financial support include freezing SOE overdrafts, assuming interest rate differentials on loans, or covering exchange rate losses on external public debt.
- From 1991 to 2012, the government’s total support, other than bank recapitalizations, amounted to DZD 2,157.1 billion, equivalent to 13.3 percent of 2012 GDP.
- Bank recapitalization during 1991-2012 amounted to DZD 238.8 billion (1.5 percent of 2012 GDP).
- A bank recapitalization also occurred in 2016 and another is planned for 2017.
- Financial Impact of Government Support to Public Banks (DZD billions and percent of 2012 GDP, 1991–2012):
  - Assumptions of debt (including non-performing loans):  
    - 1991-2000: 612.2; 3.8  
    - 2001: 349.4; 2.2  
    - 2002: 117.0; 0.7  
    - 2005-2007: 277.2; 1.7  
    - 2009: 720.4; 4.0  
    - 2010: 297.2; 1.8  
    - 2011-2012: 235.7; 1.5  
  - Losses associated with exchange rates and interest-rate differentials assumed by the central government (1991-2012): 195.7; 1.2
  - Recapitalizations (1991-2012): 238.8; 1.5
  - Total financial support over the period: 2,395.9; 14.9
- Source: Algerian authorities.

### Social protection system
- The national insurance protection system comprises: a) benefits covering illness, maternity, and disability, as well as life insurance; b) pension; c) insurance against work-related accidents and diseases; d) family benefits; and e) unemployment insurance.
- Independent workers are not entitled to c, d, and e, whereas the national pension system benefits employees and independent workers, with variable contribution rates and ceilings.
- The pension fund (CNR) has been facing financial difficulties as paid contributions have not covered liabilities, and unpaid contributions have been increasing due to financial difficulties of some enterprises and the Ministry of Labor, Employment, and Social Security granting a smoother contribution payment schedule to these enterprises.
- The CNR’s financial gap was estimated at 3.2 percent of GDP in 2016.
- The pension system has benefited from solidarity from other social funds (CNAS and CNAC) to cover CNR’s losses.
- The authorities expect this type of financing to be renewed for the CNR at least until 2020 in the amount of around DZD 540 billion per year.
- Studies are underway to introduce new forms of financing for the CNR, including earmarking some existing or new taxes or parafiscal taxes; new incentives (e.g., reduced contribution rates) are being considered to foster integration of non-registered workers in the informal sector.
- No actuarial analysis is available for the system as a whole to permit assessment of long-term sustainability and the capacity of CNAS and CNAC to sustain the CNR until at least 2020, as planned by the authorities.
- In the absence of other financing sources and given the large informal sector, it seems likely that the CNR financial gap will deepen over the years.
- Possible impacts on the central government budget include limited but likely fiscal consequences, potential financial support in the form of subsidies or direct transfers (past instance cited: 1993), and increasing withdrawal of CNR funds from the National Postal Agency, which would put additional pressure on the government’s liquidity.
- According to the CNAS, there are around 6 million contributors to the protection system and a little more than 3 million retirees entitled to a pension.
- Per the 2011 employment survey, 46 percent of wage earners were not registered.

### Overview of social protection institutional structure (Box 2)
- Three funds under the Ministry of Labor, Employment and Social Security:
  1. CNAS: social benefits in kind and cash, family benefits, and insurance against work-related accidents and disease.
  2. CNR: the pension system (including for surviving spouses and other beneficiaries).
  3. CNAC: unemployment benefits, aid schemes for distressed companies, and economic reintegration programs.
- Contributions are paid by employees and employers based on a defined contribution rate defined by law.
- Independent workers contribute to CASNOS.
- Contribution bases and pension system features described, including legal retirement ages and contribution/benefit indexing.
- Contribution rate summary (as of January 1, 2017) includes sections and combined employer/employee shares with total social benefits appearing as 34.50% (table formatting in source).

### Treasury correspondents and deposit financing
- Financing the deficit using private deposits and deposits of public entities entails fiscal risks for the government.
- Algeria has been using deposits at the National Postal Agency and at the Trésor, including deposits of public institutions, local governments, social protection funds, and private depositors, to finance its deficits.
- The balances on these deposit accounts are sizeable and constitute an immediately available funding source for the government.
- The financing of the government’s deficit through these deposits is currently not included in the public debt, although the government in essence incurs a liability.
- Fungibility of private deposits and social protection funds with government accounts may create liquidity pressures in case of substantial and unexpected withdrawals from depositors.
- These deposits represented 6.7 percent of GDP at end-2016.

### Local governments
- Financial support to local governments comes from a financial equalization system administered by the “Caisse de solidarité et de garantie des collectivités locales” (CSGCL).
- The CSGCL provides financial assistance to loss-making local governments or localities hit by natural or other disasters and temporary support for inter-community investment projects.
- Local governments are not currently a significant source of fiscal risks.
- CSGCL’s revenues derive solely from local taxes.
- Local governments have increased the property tax base and improved tax collection to offset the reduction in revenues from the business turnover tax (taxe sur l’activité professionnelle, TAP).
- Share of property taxes in local government revenues: from 5 percent in 2014 to 11 percent in 2016 and a projected 20 percent in 2017.
- Fiscal risks associated with local governments may increase if the central government allows local governments to borrow directly from public banks with the CSGCL’s guarantee; this would create another source of fiscal risks and should be introduced with appropriate safeguards to assess, limit, and report guaranteed debt.

### Public-Private Partnerships (PPPs)
- PPP development is at an incipient stage; a PPP framework law is being drafted but some PPPs have been developed under ad-hoc provisions in sector laws (desalination, electricity production, transport, water distribution).
- Existing PPPs include highly capital-intensive industries and management-delegation contracts in transport and water distribution.
- Oversight: CNED-PPP, a dedicated unit in the Ministry of Finance, has been tasked with developing alternative financing models, finalizing the PPP framework law, drafting guidance and procedures, and providing oversight (technical support for launch, tender, execution, and financial evaluation).
- Risks associated with PPPs are currently considered low but could increase as use expands; net present value of existing PPP contracts is unknown, but authorities believe it is low.
- For foreign companies, special purpose entities supporting contracts will depart from the 51/49 rule, allowing foreign private partners to control investment, financing, and execution and to bear associated risks (exception for subsidized activities where risks from price differentials remain with the central government).
- Typical PPP fiscal risks (implicit guarantees, increased contingent liabilities) could materialize as PPP usage grows.
- Recommended PPP framework enhancements:
  - Ensure PPP projects are integrated within the overall investment strategy, the medium-term budget framework, and the budget cycle; specify criteria to guide decisions on when a PPP should be considered as a procurement option.
  - Require transparent budgeting, reporting, and accounting, including of future cash flows associated with the contracts and the contingent liabilities over the life of the contracts.
  - Prescribe limits on the public sector’s exposure to PPP risks (e.g., ceilings on total stock of PPPs’ direct and contingent liabilities, flow of PPP-related payments and contingent commitments permitted in a given year, or both).

### Environmental risks
- Algeria is in a highly seismic region; several earthquakes have occurred in the north in recent history.
- The 2003 earthquake killed 2000 people and left 10,000 injured.
- The government has provided substantial assistance in response to natural disasters.
- EM-DAT reports total cost to the budget of DZD 363.1 billion (8.8 percent of GDP in 2003).
- Other environmental disasters (floods) impacted the budget from 2004 to 2012 to a lesser extent: DZD 93 billion, equivalent to less than 1 percent of 2012 GDP.

*Source: Algeria — IMF country report chapter content provided in the file.*

### 36.      Some of the fiscal risks identified above have a relatively high likelihood of

### cr17142 - 36.      Some of the fiscal risks identified above have a relatively high likelihood of

### Major fiscal risks and their likelihood
- The risk that the government assumes debt guarantees granted to some SOEs is the most significant and the most likely to materialize.
- The total stock of guaranteed debt amounted to 18.5 percent of GDP in 2016.
- Financial compensation for the operating losses of one SOE is likely to recur and could be sizeable; compensation for losses incurred in 2014-16 amounted to about DZD 230 billion per year (1.3 percent of 2016 GDP).
- The financial sustainability of the social protection system, without further reforms or new financing mechanisms, appears to be in jeopardy; staff could not estimate the likelihood or potential impact in the absence of actuarial data.
- The size and complexity of the public sector amplify fiscal risks: financial difficulties in any public entity have a high probability of being quickly transmitted to the central government’s budget.
- The planned fiscal consolidation, while necessary, is likely to put more stress on economic growth and could trigger the materialization of some fiscal risks, particularly those stemming from guarantees granted to SOEs with declining financial performance.

### Transmission channels of fiscal risks (summary of Box 3)
- Subsidies and transfers to SOEs and EPICs:
  - Direct transfers and subsidies to SOEs and other nonfinancial public institutions are significant, not linked to financial performance indicators, and subject to macroeconomic risks linked to world prices and domestic demand.
- Payment arrears:
  - SOE financial difficulties may generate payment arrears to other public institutions: the social protection sector (social contributions), public banks (debt service), other SOEs (utility payments), and the central government (taxes).
  - Arrears in social contributions have reportedly already impacted the liquidity of the CNR and could, in the long term, impact the sustainability of the social protection system.
  - Arrears to the private sector (e.g., payments to contractors) or from the private sector to public entities also transmit fiscal risks.
- Banking system liquidity:
  - SOEs and other public institutions experiencing cash-flow difficulties could draw down deposits with their banks (mostly public), worsening banking system liquidity.
  - Increased long-term bank financing by SOEs from public banks would increase liquidity pressures on the asset side of banks’ balance sheets.
- Banking sector credit risk:
  - Borrowing from SOEs in financial difficulty could translate into non-performing loans and weaker prudential ratios, potentially requiring public support such as recapitalization or financial consolidation.
- Debt guarantees:
  - Structurally weak SOEs demand government guarantees from public banks; deterioration in SOE financial performance could trigger government assumption of guaranteed debt or recapitalization of a public bank.
- Social protection sector:
  - Without new financing mechanisms or further reform, financial difficulties of the social protection system could increase and spill over to government debt.
  - The Trésor has been using deposits from its correspondents (local governments, public institutions, the social protection system, and private depositors) held at the National Postal Agency as a source of financing deficits; while massive withdrawal is unlikely, this practice is a potential source of liquidity pressure.

### Estimated impact of fiscal risks that have materialized
- Cumulative impact of identified fiscal risks that materialized between 1991 and 2016 is estimated at 33.9 percent of 2016 GDP (actual cost likely higher).
- Fiscal risks that materialized between 1991 and 2016 (amounts in DZD billions; percent of 2016 GDP):
  - State-owned enterprises:
    - Debt write-off: 169.6 (1.0 percent of 2016 GDP)
    - Overdraft freezing: 133.6 (0.8 percent of 2016 GDP)
    - Others (including the assumption of arrears): 29.4 (0.2 percent of 2016 GDP)
  - Contingent liabilities:
    - Assumptions of debt (2005-2015): 1,083.6 (6.3 percent of 2016 GDP)
  - Exposure to financial sector:
    - Financial consolidation of public banks: 2,396.4 (14.0 percent of 2016 GDP)
  - Environmental risks:
    - Earthquake and floods: 456.1 (2.7 percent of 2016 GDP)
  - Total (1991–2016): 4,268.7 (25.0 percent of 2016 GDP)
- Fiscal risks that materialized in 2016:
  - State-owned enterprises:
    - Debt write-off: 4.5 (0.0 percent of 2016 GDP)
    - Overdraft freezing: 0.0 (0.0 percent of 2016 GDP)
    - Others (including the assumption of arrears): 2.2 (0.0 percent of 2016 GDP)
  - Contingent liabilities:
    - Assumptions of debt: 605.8 (3.5 percent of 2016 GDP)
    - Implicit guarantees (financial compensation for accumulated loss): 904.2 (5.3 percent of 2016 GDP)
  - Exposure to financial sector:
    - Public bank recapitalization: amount not provided; not estimated
  - Total (2016): 1,516.7 (8.9 percent of 2016 GDP)

### Conclusion and policy implications
- Fiscal risks in Algeria are manifold; key sources include:
  - Government guarantees of loans to state-owned enterprises.
  - Potential need to recapitalize public banks.
  - Implicit commitments to state-owned enterprises.
  - Reported financial difficulties of the state-run pension system.
- Many of these risks have materialized in the past at sizeable cost to the government.
- Planned fiscal consolidation, while necessary, increases the likelihood of some risks materializing and could amplify their impact.
- Summary mapping of source of fiscal risk, likelihood, potential impact, and impact of fiscal consolidation on likelihood (as presented):
  - Macroeconomic uncertainty: High; High; →
  - Implicit obligations to SOEs: High; High; ↗
  - Explicit debt guarantees: High; High; ↗
  - Other nonfinancial public entities (EPIC): High; Medium; →
  - Public banks: High; Medium; ↗
  - Social protection sector: Reportedly, high; ?; ↗
  - Local governments: Low; Low; →
  - PPP: Low; Low; →
  - Environmental risks: Medium; High; →
- Gaps and safeguards:
  - The complex web of financial interactions generates significant fiscal risks that need close monitoring and safeguarding.
  - There are few safeguards to prevent transmission of risks across public entities to the central government’s budget.
  - Little is known at the central government level about the probability of occurrence of the various risks; consolidated statistics on the financial operations and debt of the public sector as a whole do not exist.
  - Recommendation: Put in place a process to identify, quantify, report, and manage fiscal risks, particularly given that fiscal consolidation is expected to increase the likelihood that some risks materialize.
- Structural reform context:
  - Algeria needs wide-ranging structural reforms to improve the investment climate, support diversification, and facilitate a dynamic private sector.
  - Strengthened institutional and legal frameworks would accelerate product market, labor market, and financial sector reforms.
  - Public sector restructuring, including restructuring and gradual privatization of non-strategic SOEs, could enable private sector growth.
  - Macroeconomic policies should support reforms, notably using some 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.

*IMF staff analysis as presented in the source content.*

### Introduction

### Introduction

### Main diagnosis
- The collapse in oil prices has exposed the shortcomings of Algeria’s growth model centered on heavy government redistribution of hydrocarbon revenues.
- Algeria’s proven hydrocarbon reserves are projected to be exhausted in 21 years (oil) and 54 years (gas).
- With prolonged lower oil prices, the government no longer has sufficient resources to sustain high levels of spending and public-sector job creation for a young and fast-growing population.
- Algeria adopted a new constitution in 2016 that establishes as an explicit objective the promotion of a diversified and more market-based economy.
- The authorities are working on a strategy, with World Bank support, to reduce dependence on hydrocarbons and foster high value-added tradable sectors, recognizing that a dynamic private sector must become the main engine of growth and job creation.

### Purpose of the paper
- Outline considerations for a successful structural reform strategy based on diagnostics, literature review, and cross-country examples.
- Estimate likely impact of structural reforms on potential growth.
- Structure: diagnostic of key structural issues (Section B); considerations for reform design (Section C); estimates of reform impact on potential growth (Section D); conclusions (Section E).

### Major structural impediments identified
- Restrictive business environment and complex regulations.
- Difficult access to finance and a small/shallow financial system.
- Weak governance, limited transparency, and inadequate competition.
- High barriers to entry, dominance of state-owned enterprises (SOEs).
- Rigid labor markets, jobs-skills mismatches, and excessive growth in wages relative to productivity.

---

### Snapshot of the economy

- Algeria ranks low in survey-based measures of competitiveness; in the World Economic Forum’s Global Competitiveness Report 2016–17, Algeria ranked 87 out of 138 economies.
- In 2015, Algeria’s productivity (output per capita) ranked in the bottom third of 104 countries and was the lowest among MENA oil exporters.
- The economy remains dominated by the state and heavily reliant on hydrocarbons; over the past decade a large share of new job creation has been in the public sector or construction driven by public investment.
- In 2016, the broader public sector (civil service and public enterprises) was the largest employer, providing jobs for nearly 40 percent of the working population (ONS, 2016a).
- SOEs accounted for about third of overall value-added in the economy in 2015 (ONS, 2016b).
- 87 percent of banking assets are held by public banks.
- Nonhydrocarbon exports are minimal and concentrated: more than 60 percent of bilateral nonhydrocarbon exports are within five product categories; export quality has declined since the early 1990s.

---

### Constraints to private sector development

### Sectoral and firm structure
- Private sector value-added: construction and services represent more than two-third of private sector total value-added; manufacturing represents only 5 percent (2015).
- Formal private sector firms are mostly small: 98 percent employed less than 9 employees in 2011 (ONS economic census of 2011).
- The private sector employs about 50 percent of the labor force (including informal sector); jobs in the informal sector accounted for about 38 percent of total employment in 2016.
- Over the past 20 years manufacturing fell from 15 percent of GDP in the 1980s to 5 percent in 2015.

### Business climate and institutional weaknesses
- In 2017, Algeria ranked 156 out of 190 on the World Bank’s Ease of Doing Business Index.
- Survey respondents report pervasive bureaucracy, cumbersome administrative procedures, and corruption as significant obstacles.
- Legal and institutional frameworks are weaker than many peers: weaknesses in the rule of law, property and contractual rights, quick settlement of contract disputes, and bankruptcy proceedings.
- Market for goods and services inefficient: in the World Economic Forum’s Global Competitiveness Report 2016, Algeria ranked 138th out of 140 for local competition and 130th for tariff and non-tariff barriers to market entry.
- Indicators signal insufficient transparency and competition and limited capacity of anti-monopoly policy (ranked 109th and 110th in relevant sub-pillars).

### Financial sector constraints
- Credit to the private sector is 23 percent of GDP.
- Algerian capital markets are nascent; market capitalization amounts to less than 1 percent of GDP.
- The banking system is dominated by state-owned banks; public banks have engaged in directed lending and government-supported programs.
- Substantial collateral requirements, lengthy bankruptcy proceedings, and subsidized bank lending reduce private credit supply to SMEs and tradable-sector firms.

### Labor market dysfunctions
- Unemployment rate: 10.5 percent in 2016.
- Labor force participation rate: 41.8 percent in 2016.
- Since 2013 private sector created only 141,000 new formal jobs—less than 2 percent of the working population in 2016.
- Female and youth participation were especially low in 2016: female participation 16.6 percent; youth participation 26.7 percent.
- Labor market rigidities include costly hiring and firing regulations, centralized collective bargaining, mandated dismissal costs, and high payroll taxes; these factors contribute to mismatches and limited hiring in private sector.
- Real wages have grown faster than productivity since 2005 (index, 2005=100: real wages vs. productivity, 2005–2015).

---

### Key structural impediments (survey and indicator highlights)

- World Economic Forum and other survey-based indicators place Algeria behind regional peers and other resource-rich countries across multiple structural pillars: labor, corruption, bureaucracy, infrastructure, trade, education, legal framework, finance, and regulations.
- New business density (2008–14) is low relative to MENAOI and EMDC comparators.
- Financial Development Index places Algeria below many peers.
- World Governance Indicators (2015) show weaknesses across Voice and Accountability, Political Stability, Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption.

---

### Important considerations for a successful reform strategy

### Priority reform areas
- Revamp the business environment to reduce bureaucracy and administrative complexity; accelerate digital economy transition.
- Strengthen institutional and legal frameworks to secure property and contractual rights, ensure transparency, prevent corruption and rent-seeking, and quicken contract dispute and bankruptcy resolution.
- Promote greater competition in product markets by reducing barriers to entry and exit, restructuring SOEs, privatizing nonstrategic SOEs, reducing price restrictions via subsidy reform, and strengthening competition authority enforcement.
- Increase openness to trade and foreign investment: pursue regional integration (Maghreb, Europe), pursue WTO accession, and relax the “51-49 rule” for foreign ownership, especially in tradable sectors.
- Financial sector reforms: revisit strategic roles of public banks, channel public banks towards non-commercial development activities or full competition with private banks, strengthen creditors’ rights, modernize bankruptcy framework, promote payment technologies, strengthen prudential frameworks, restructure public support programs for entrepreneurs, and reduce interest rate subsidies.
- Capital markets development: lift restrictions on foreign investors accessing domestic bond markets; attract domestic investors via partial divestment of public enterprise loans.
- Labor market reforms: relax hiring procedures and stringent layoff rules, allow more flexible working hours, ensure enforceable labor regulations to reduce discretionary enforcement, reform unemployment benefit eligibility to reduce informal-sector incentives, and target active labor market policies to vulnerable groups (unskilled women and youth).
- Education and skills: review education and vocational systems to improve quality; revise curricula with private sector input to address skills mismatches and attract investors.

### Ongoing and recent policy steps
- Government adopted a broad strategy to reshape the growth model and is fleshing it out with World Bank support.
- Improved Doing Business ranking from 163rd in 2016 to 156th 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, providing an opportunity to relax it for nonstrategic sectors.
- New laws to foster SME development were adopted; regulations for using foreign currency were eased for export companies.
- Dialogue underway among trade unions, employers, and government to review the labor code with an aim to increase labor market flexibility while protecting workers.

---

*Prepared by Moez Souissi and Greg Auclair. (Content unit: Introduction, IMF country report material.)*

### Box 1: What Reforms? A Selected Literature Review

### Box 1: What Reforms? A Selected Literature Review

### Transmission channels and types of reforms
- Institutional and legal reforms
  - Property rights and the ability to enforce contracts are critical elements of a country’s institutional and legal frameworks.
  - Insecure property and contract rights raise private discount rates and deter long-horizon, up-front fixed-cost investments.
  - Strong institutions that secure property and contract rights promote private investment and entrepreneurship and have a first-order effect on long-term economic growth.
- Product market reforms
  - Regulatory and institutional barriers to firm renewal handicap technology adoption and long-run income.
  - Low product market competition impairs productivity growth, inhibits new firm creation and business investment, and reduces the speed of diffusion of new technologies and production techniques.
  - Product market reforms improve competition and boost aggregate productivity by reallocating capital and labor to fast-growing sectors.
- Financial sector reforms
  - Developed financial markets improve productivity by lowering the cost of capital.
  - Productivity payoffs from banking system reforms (including privatization and strengthening supervision) are higher in more bank-based systems.
  - Reducing financial repression and credit restrictions facilitates reallocation of resources; policies encouraging securities markets improve allocation of capital and spur innovation.
- Labor market reforms
  - Rigid hiring/firing practices and weak income protection encourage informality and hinder labor movement to more productive sectors.
  - Less stringent labor market regulations facilitate labor movement to more productive firms and foster firm entry and exit.
  - Strengthening unemployment benefit systems appears to boost employment relatively quickly, improve job search and hiring, and is associated with stronger investment and output growth.

### How to sequence and package reforms: approaches and assessment
- Approaches defined
  - Big-bang: implement many reforms across areas in a very short period.
  - Piecemeal: implement reforms within one area before moving to another, disregarding interdependence among areas.
  - Gradualist: implement reforms in different areas simultaneously over an extended period, accounting for preconditions and complementarities.
- Assessment for Algeria
  - Big-bang approach is unlikely to succeed in Algeria because:
    - Algeria’s institutional and legal frameworks are relatively weak; sweeping reforms could increase uncertainty for firms.
    - Algeria’s technical capacity may be insufficient to introduce many reforms simultaneously; insufficient capacity can prevent addressing distributional effects, triggering public resistance and reform fatigue.
  - Piecemeal approach may fail because:
    - Multiple binding constraints are interrelated; focusing on one area at a time can leave other constraints intact and ignore complementarities (example: Brazil in the early 1990s where trade liberalization without labor reform led to informalization).
  - A gradual but sustained approach is recommended:
    - Implement reforms progressively across several areas at the same time.
    - Where preconditions exist, some reforms should precede others (e.g., strengthen legal and governance framework before privatization of SOEs).
    - Where complementarities exist, implement reforms together (e.g., product market reforms and opening to FDI).
- Advantages of gradualism for Algeria
  - Spreads out adjustment costs, reducing public resistance.
  - Gives government time to strengthen institutional and legal frameworks and avoid the “institutional trap”.
  - Can create incentives for an acceleration of reforms as initial successes generate momentum.
  - Adapts to existing technical capacity by allowing trial and error and mid-course adjustments.
- Timing caveats
  - Implementation should occur in a reasonably short time frame; too long a time lag between reforms is undesirable.
  - Example: New Zealand took about five years between product market liberalization and labor market reforms in the 1980s, which mitigated potential overall gains.
  - Cross-country evidence: countries that used gradualism took from four to fourteen years to implement their reform packages, with the average length being just over eight years.

### Sequencing considerations (key criteria)
- Compatibility with macroeconomic stability: include reforms that support short-term growth (legal reforms to improve investment climate; trade and FDI liberalization; financial deepening).
- Complementarity: time actions to exploit complementarities (e.g., product market reforms can lower resistance to labor market reforms).
- Lead time: phase in reforms considering preparatory work and gestation periods (e.g., capital market reforms require time to build institutional structure and staff).
- Distributional effects: include compensatory measures (conditional targeted cash transfers, unemployment benefits) and a regional perspective to ensure inclusive growth; well-targeted safety nets can help mitigate distributional effects.

### State-owned enterprises (SOEs): role and reform guidance
- Problem statement
  - SOEs enjoy privileges that create implicit barriers to product market competition (preferential access to credit, low bankruptcy risk), reducing incentives to increase productivity and innovate.
  - SOE reform is needed to create economic space for private sector emergence.
- Risks
  - Reforming SOEs can provoke strong resistance, particularly from employees who enjoy greater protections than private sector counterparts (example: strikes during 1990s restructuring attempts).
  - Prior engagement with unions is important to build trust and offset distributional effects.
- Recommended approach
  - Privatization should be gradual, particularly where legal and institutional frameworks are weak.
  - International examples:
    - Hungary: open sales to strategic investors including foreign investors, establish a transparent privatization agency, and introduce complementary laws (banking, insurance, state asset management, accounting, bankruptcy).
    - Russia: rapid privatization using vouchers led to oligarchic concentration and reversal due to weak institutions and lagging banking reforms.
  - For SOEs that remain state-owned, classify into public-welfare firms versus commercial firms; for commercial SOEs, prioritize boosting market competitiveness, improving profitability, and reforming incentive systems for employees and managers.

### Overcoming resistance to reforms: institutional and design factors
- Sustaining reform momentum
  - Identify and exploit drivers of reforms; strong reform momentum often coincides with periods of stress and turbulence.
  - Build results-based monitoring and evaluation systems and publicize results to track progress and create feedback loops.
  - Engage opponents of reform through inclusive consultations to build trust and make opponents more willing to rely on mitigation commitments.
  - Communicate effectively to build consensus on merits, objectives, expected benefits, and implementation process.

### How macroeconomic policies can support reforms
- Implement fiscal reforms to promote equity in sharing adjustment costs:
  - Gradually replace costly and regressive energy subsidies with targeted monetary transfers.
  - Eliminate tax exemptions and strengthen tax administration to increase nonhydrocarbon revenues and allow compensatory spending.
- Conduct gradual fiscal adjustment:
  - Use available space to conduct fiscal consolidation gradually to offset short-term costs of structural reforms.
  - Strengthen efficiency of public investment to reduce growth impact of capital spending cuts.
- Strengthen monetary policy transmission mechanisms:
  - Continue to strengthen channels to anchor inflation expectations around the inflation target, as some reforms may create short-run inflationary pressures.
- Allow further exchange rate depreciation and unify the exchange rate system:
  - Further depreciation would help eliminate real exchange rate overvaluation, mitigate Dutch disease, inflate oil revenue in local currency, and reduce budget pressures.
  - Unify foreign exchange market to eliminate arbitrage and improve allocation of resources.

### Quantifying possible payoffs of structural reforms in Algeria
- Methodologies used
  - Distance-to-frontier analysis: estimates long-run cross-country association between growth and structural indicators; impact simulated as g_i = β_i (I_A - I_B) where β_i is estimated from cross-country panel and I_A and I_B are indicator values for Algeria and a chosen benchmark.
  - Synthetic control (counterfactual without reform): used to estimate impact of reforms in specific country cases.
- Data sources for robustness
  - IMF (2008): annual indicators of enacted reforms in international trade, FDI, and the financial and agricultural sectors; data coverage 1973-2005.
  - Mitra (2016): draws on structural indicators from multiple sources (Fraser Institute, IFS, ILO, PRS, World Bank Doing Business, World Bank Education Statistics, WEF Global Competitiveness, WEO, World Governance Indicators).
- Distance-to-frontier (IMF 2008) illustrative payoffs
  - If Algeria progresses halfway between its current levels and the highest attainment observed for an emerging market, potential GDP growth could increase by:
    - 0.5 percentage points from product market reforms;
    - 0.3 percentage points from current account reforms;
    - 0.3 percentage points from labor reforms (following Bouis and Duval, 2012);
    - 0.2 percentage points from financial sector reforms;
    - 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.
- Mitra (2016) results
  - Applying Mitra (2016) — which decomposes growth into capital, labor, and productivity and regresses average growth of each factor against indicators — also points to potentially larger gains from reforms, mostly from improvements to productivity, assuming Algeria converges halfway to EMDC levels across indicators.

_Italic: IMF — Box 1: What Reforms? A Selected Literature Review (excerpts)._

### 2.7 percentage points. The main channel would be the impact on productivity, which could alone

### cr17142 - 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.

### Productivity impacts and decomposition
- Total additional growth from reforms: 2.7 percentage points.
- Productivity channel alone: 2.1 percentage points of additional growth.
- Impact on capital: 0.4 percentage points.
- Impact on labor: 0.15 percentage points.
- Contributions to 2007–14 potential productivity growth are reported as percent shares of total productivity growth (figures shown in source charts).
- Mitra (2016) findings on factors associated with potential productivity growth:
  - Worker talent: an improvement in the quality of education by 1 unit (Global Competitiveness Report scale, where 1 is poorest and 7 is highest) would raise productivity growth by 0.7 percentage points.
  - Diaspora support (making better use of diaspora): increases productivity growth by 0.6 percentage points.
  - A competitive business environment (improvement comparable to moving 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 (technology transfer through FDI as a proxy) contribute to productivity via technologies and management techniques that improve use of energy, capital, and worker talent and encourage innovation.

### Synthetic Control Method (SCM) estimates of comprehensive structural reforms
- Definition of comprehensive structural reform used: improvement in percentile rank of a country by 15 or more points on at least four indicators in a five-year timespan.
- Number of cases identified as comprehensive structural reforms in the database: 12 cases.
- Matching period for SCM to estimate synthetic GDP: 15 years (during which neither the treated country nor its comparators initiated reforms).
- Post-treatment observation window in SCM: divergence observed over the following 10 years.
- SCM results summary:
  - Largest observed impacts: Albania, Hungary, Portugal, and El Salvador.
  - Two large-impact cases involved EU accession, which combined reforms with new trade, financial, and monetary arrangements and supporting structural and investment funds.
  - Average result: GDP per capita is 20 percentage points higher after 10 years (attributable to reforms).
  - Median SCM impact: 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).
  - 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.
  - A country-specific illustrative counterfactual: Had Algeria implemented comprehensive reforms in 2006, it may have achieved a GDP per capita of around US$1,140 above its current level in PPP terms.
  - Over the 10-year post-treatment timespan, only one country performed worse than its synthetic control (Chile during the 1980s), where radical reforms combined with an overvalued currency and a banking crisis resulted in a severe GDP contraction.

### Methodological notes and limitations
- Distance-to-frontier methodology limitations:
  - Implicitly assumes reform impacts are homogeneous across countries.
  - Assumes it is possible to isolate effects of specific reforms and abstracts from complementarity and sequencing of reforms.
  - Results may be biased because impacts are not necessarily additive.
- SCM rationale and mechanics (brief):
  - SCM approximates a counterfactual without reforms by combining a set of donor countries into a synthetic unit that matches pre-treatment characteristics and evolution (see Box 2 description).
  - The impact of an intervention is estimated as the difference between actual outcomes and the synthetic control after treatment.
- SCM donor pool exclusions:
  - “No-reform” pool excludes countries that improved their percentile rank by 15 or more points on two or more indicators during pre- and post-treatment periods.
  - Countries were matched based on similarity of evolution of PPP GDP per capita.

### Policy conclusions and recommendations
- Core conclusion: Algeria needs to reshape its growth model away from heavy dependence on hydrocarbon revenues and related fiscal spending toward a private sector-led growth model.
- Structural impediments identified:
  - Restrictive business environment and weak institutional frameworks.
  - Inadequate access to finance and high barriers to entry.
  - Highly rigid labor markets and significant jobs-skills mismatches.
  - Excessive growth in wages relative to productivity.
- Recommended reform package:
  - Product market reforms.
  - Labor market reforms.
  - Financial sector reforms.
  - Legal reforms to improve the business climate and encourage private investment.
- Implementation guidance:
  - Actions should be implemented gradually and carefully sequenced to increase effectiveness, accounting for strength of institutions, reform pre-conditions, and short-term costs.
  - A sequenced approach (not “Big-bang”) is advised, but implementation should occur in a reasonably short time frame because structural reforms take time to bear fruit.
  - Macroeconomic policies can support reforms by alleviating short-term costs; fiscal space should be used where available to offset short-term costs and to help manage potential reform resistance.
- Expected payoff:
  - 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.

*ALGERIA, INTERNATIONAL MONETARY FUND*

### Introduction

### Introduction

### Recent Inflation Developments and Stylized Facts
- Inflation continued to accelerate in 2016 and stood at 6.4 percent on average in 2016.
- Timeline and drivers:
  - Starting in early 2012, headline inflation picked up following the ramp-up in public spending in the wake of the Arab Spring.
  - In 2013, inflationary pressures subsided, reflecting in part the impact of fiscal consolidation.
  - Since mid-2014 inflation accelerated again, largely driven by higher food prices and a sustained rise in manufactured goods prices.
- Composition and volatility:
  - Manufactured goods prices contributed more than 55 percent on average to overall inflation.
  - Core inflation (overall inflation excluding fresh agricultural products and products with regulated prices) rose from 0.4 percent in January 2014 to 4.7 percent in December 2016.
  - Headline inflation reached 6.9 percent year on year in December 2016.
  - In 2016, inflation peaked at 8.1 percent in July before subsiding momentarily, then accelerated again toward end-2016.
  - Contribution of food prices to overall inflation: peaked at 41 percent in July 2016, declined to 7.5 percent in October 2016, and rose to 34 percent in December 2016.
- Short-run pass-through:
  - Simple scatter plots for 2010–16 indicate short-term pass-through of import prices and the exchange rate to core inflation is not large.
  - Short-term variations in real money have little impact on core inflation over the 2010–16 monthly horizon.

### Relevant Literature (summary of theoretical underpinnings and empirical studies)
- Theoretical frameworks considered:
  - The monetary theory (Friedman and Schwartz (1963)): inflation as a monetary phenomenon.
  - The purchasing power parity (PPP) theory: domestic goods prices equal foreign goods prices in domestic currency over long term.
  - The markup theory (Duesenberry (1950)): equilibrium price level set as a markup on input prices.
- Empirical studies for oil-producing countries—selected findings:
  - Ben Naceur (2012) for Algeria (2002–2011, VECM): non-oil GDP gap explains inflation in short run; money supply and real GDP growth most important in long run.
  - Sultan (2011) for Saudi Arabia (1980–2008, ECM): world inflation, money supply, and nominal exchange rate explain inflation in short and long run.
  - Klein and Kyei (2009) for Angola (VECM): domestic prices mainly affected by nominal exchange rate.
  - Alavirad and Athwale (2005) for Iran (univariate ECM): budget deficit positively associated with prices in long run.
  - Basher and Elsamadisy (2012) for GCC (1980–2008, nonstationary panel): money, foreign prices, and NEER key short-run determinants; only money affects inflation in long run.
  - Kandil and Morsy (2009) for GCC (1970–2007, VECM): prices in major trading partners important foreign factor; public capital spending eases inflationary pressures in long run; excess demand important in short run for some countries.

### Empirical Methodology
- Data and period:
  - Quarterly data covering 2003–2016.
- Model foundations:
  - Inflation model based on monetary and PPP theories: general price level as weighted average of tradable and non-tradable goods’ prices.
  - Non-tradable prices depend on imbalance between supply and demand of money; money demand depends on real GDP and interest rates.
  - Tradable goods prices depend on import prices and the exchange rate.
- Variables (log-transformed and seasonally adjusted):
  - ݌: core price level (consumer price index excluding fresh agricultural and regulated products)
  - 2݉: money supply (broad money excluding national oil and gas company’s deposits)
  - ݁: nominal effective exchange rate (dinar’s weighted average exchange rate against main currencies for imports: US dollar and euro)
  - ݐݎ݋݌݉݅݌: import prices (weighted average of export prices in foreign currency of Algeria’s main trading partners)
  - ܾݑ݌݌݁݀: total real public spending
- Short-term specification (VECM short-run equation components):
  - Error correction term ܥܧ captures speed of convergence to long-term level.
  - Short-term determinants include changes in exchange rate, money supply, import price levels, public spending levels, and the output gap (nonhydrocarbon output gap approximated by HP-filtered deviation).
- Time-series requirements:
  - Variables must be I(1) and cointegrated to estimate long-term relationships using VECM.
  - Stationarity tests used include augmented Dickey-Fuller; cointegration tested via Johansen and Juselius (1990).

### Results — Stationarity and Cointegration
- Unit root (augmented Dickey-Fuller) test results (Table 1): all variables are I(1) (non-stationary in levels, stationary in first differences). Reported test statistics:
  - ݌ (Logarithm of core price index): I(1) = -1.59; I(2) = -4.72 ***
  - 2݉ (Logarithm of broad money excluding Sonatrach’s deposits): I(1) = -0.56; I(2) = -4.01 ***
  - ݁ (Logarithm of the nominal effective exchange rate): I(1) = -1.28; I(2) = -5.88 ***
  - ݐݎ݋݌݉݅݌ (Logarithm of imports price index): I(1) = -2.48; I(2) = -5.69 ***
  - ܾݑ݌݌݁݀ (Logarithm of real total public spending): I(1) = -2.72; I(2) = -9.58 ***
  - *. ** and *** denote rejection of the presence of a unit root test at the 10, 5 and 1 percent significance level, respectively.
- Cointegration (Johansen and Juselius (1990) tests — Table 2):
  - Trace test indicates 1 cointegrating equation at the 0.05 level.
  - Max-eigenvalue test indicates 1 cointegrating equation at the 0.05 level.
  - Reported eigenvalues and statistics (selected):
    - None: Eigenvalue 0.629980; Trace Statistic 90.00975; Trace 0.05 Critical Value 69.81889; Prob. 0.0006
    - At most 1: Eigenvalue 0.352496; Trace Statistic 41.29405; Trace 0.05 Critical Value 47.85613; Prob. 0.1795
    - Max-Eigen (None): Eigenvalue 0.629980; Statistic 48.71571; 0.05 Critical Value 33.87687; Prob. 0.0004

### Results — Long-run Relationship
- Estimated long-run cointegrating relationship (as reported):
  ܾݑ݌݌݁݀െ0.49∗ݐݎ݋݌݉݅݌	൅0.63∗݁	2൅1.19∗݉ൌ0.35∗݌
  - Associated t-statistics in brackets: [2.98] [3.08] [2.33] [-4.53]
- Interpretation of coefficients and statistical tests:
  - Equation (1) passed all the specification tests.
  - All coefficients are statistically significant and have the expected signs.
  - External factors are the most important long-run drivers:
    - Exchange rate shifts would be fully reflected in domestic prices.
    - A 1 percent increase in import prices translates into a 0.6 percent increase in domestic prices in the long run.
  - Money supply impact:
    - A 1 percent increase in money supply results in about a 0.4 percent increase in the price level in the long run.
    - The coefficient on money is substantially less than unity, reflecting the extent of price controls.
  - Public spending:
    - Public spending is negatively and significantly associated with domestic prices in the long run.
    - A 1 percent increase in public spending is associated with a 0.5 percent decline in long-term prices, suggesting potential productivity gains from public spending that support price stability.

### Results — Short-run Dynamics
- Short-term inflation equation (as reported):
  ݌∆
  ௧
  ൌെ0.00െ0.03∗ܥܧ
  ௧ తଵ
  ൅0.36∗∆݌
  ௧ తଵ
  ൅0.15∗∆݌
  ௧ తଶ
  ൅0.08∗∆݁
  ௧ తଵ
  ൅0.04∗∆݁
  ௧ తଶ
  ൅0.17∗∆2݉
  ௧ తଵ
  ൅0.11∗∆2݉
  ௧ తଶ
  ௅0.02∗∆
  ௧ తଵ
  ൌ0.11∗ݐݎ݋݌݉݅݌∆
  ௧ తଶ
  ܾݑ݌݌݁݀൅0.03∗∆
  ௧ె1ݐ
  (2)
  ܾݑ݌݌݁݀൅0.01∗∆
  ௧ తଶ
  ݌ܽ݃ݐݑ݌ݐݑ݋൅0.24∗∆
  ௧ తస
  ߳	൅
  ௧
- Key short-run findings:
  - There is a negative and statistically significant error correction term (ܥܧ
  ௧ తଵ), confirming cointegration between domestic prices and determinants.
  - Persistence: inflation is highly persistent in the short run.
  - Reported short-run coefficients and t-statistics (selected):
    - ∆݌ (lag 1): 0.36∗ [2.36]
    - ∆݌ (lag 2): 0.15∗ [1.04]
    - ∆݁ (lag 1): 0.08∗ [1.62]
    - ∆2݉ (lag 1): 0.17∗ [2.85]
    - ∆2݉ (lag 2): 0.11∗ [1.86]
    - ∆ݐݎ݋݌݉݅݌ (lag 1): 0.02∗ [0.64]
    - ∆ݐݎ݋݌݉݅݌ (lag 2): 0.11∗ [-2.87] [note: sign and t-statistic reported as shown]
    - ∆ܾݑ݌݌݁݀ (lag 1): 0.03∗ [2.39]
    - ∆ܾݑ݌݌݁݀ (lag 2): 0.01∗ [0.51]
    - ∆݌ܽ݃ݐݑ݌ݐݑ݋ (lag 3): 0.24∗ [2.25]
- Partial interpretation:
  - When inflation is 1 percent below its equilibrium level in a given quarter, it would increase by about (text ends in source).

*Prepared by Moez Souissi.*

### 0.03 percent in the following quarter, suggesting that the speed of adjustment is fairly low. This is

### 0.03 percent in the following quarter, suggesting that the speed of adjustment is fairly low. This is

### Key empirical findings on inflation dynamics
- Inflation is highly persistent in the short run and moves slowly toward its long-run value following a shock.
- The speed of adjustment is low: when inflation is 1 percent below its PPP equilibrium level, it would increase by only 0.05 percent in the following quarter.
- Macroeconomic policy variables appear to play a limited role in short-run inflation dynamics, with money supply being the most important among them.

### Estimated short-run elasticities and impacts (as reported)
- A 1 percent increase in the money supply results in a price increase of about 0.2 percent (VECM evidence).
- A 1 percent increase in broad money increases the price level by 0.3 percent in the long run (money demand regression).
- A similar shock to public spending increases inflation marginally by 0.03 percent in the short run.
- Public spending has a negative long-run relationship with domestic prices in the money demand model; the long-run impact on domestic prices of higher fiscal spending is estimated at 0.1 (coefficient magnitude).
- Exchange rate fluctuations have a very limited impact on price levels over the short run (less than 0.1 percent).
- Changes in import prices have a marginal short-run impact on domestic prices (less than 0.1 percent).
- A positive nonhydrocarbon output gap of 1 percent is associated with a short-run increase in the level of prices of 0.2 percent (VECM) and 0.1 percent (ECM reported later).

### Variance decomposition results
- The direct effect of the domestic price variable on itself is high initially and declines slowly, reaching 47 percent after eight quarters.
- Innovations in M2 and the nominal exchange rate increasingly explain the variance of domestic prices over time, reaching about 40 percent after eight quarters.
- The price of imported goods explains a marginal proportion of the variance of domestic prices, remaining lower than 1 percent after eight quarters.

### Error-Correction Model (ECM) results and robustness
- An ECM was estimated to check robustness given the relatively small number of observations; it uses two cointegration relationships:
  - A monetary-theory-based relationship linking prices and money supply.
  - A PPP-based relationship expressing price levels as a linear combination of the exchange rate and import prices.
- ECM coefficient examples and interpretation:
  - When inflation is 1 percent below PPP equilibrium, it rises by 0.05 percent next quarter (speed of adjustment).
  - A 1 percent increase in money supply or fiscal spending results in a price increase of less than 0.1 percent in the short run (ECM).
  - A 1 percent depreciation of the exchange rate or a 1 percent increase in import prices is associated with an increase of less than 0.04 percent in short-run inflation (ECM).
  - A positive nonhydrocarbon output gap of 1 percent is associated with an increase of 0.1 percent in the level of prices (ECM).
- The broad money regression (Equation (3)) reports: ܾݑ݌݌݁݀ = 0.11*݁2 + 0.53*݉ = 0.30*݌ (coefficients and t-statistics shown in source).
- The PPP cointegration (Equation (4)) reports: ݁ = 1.41*ݐݎ݋݌݉݅݌ = 0.46*݌ (coefficients and t-statistics shown in source).

### Policy implications (as articulated)
- Fluctuations in the exchange rate do not appear to have a significant impact on inflation in the short term; anchoring the dinar to trading-partner currencies may not help guide short-term expectations.
- Monetary policy should provide a solid anchor for medium- and long-term inflation expectations:
  - Money is a determining factor of long-term inflation.
  - The central bank needs to reestablish control over domestic liquidity conditions and interest rates to strengthen transmission channels and anchor expectations around the inflation target.
- Fiscal consolidation must be strategic to contribute to stable medium- and long-run inflation:
  - In the short term, a drop in fiscal spending reduces inflationary pressures.
  - In the long term, fiscal spending can contribute to price stability via productivity gains in capital and labor.
  - Fiscal consolidation should improve the effectiveness of public investment and preserve funding for education, health, and research and development.
- Structural reforms should be stepped up to reduce nominal (wage) rigidities and strengthen competition:
  - Structural supply-side factors are important determinants of inflation (market imperfections and real wage rigidities keep wages above market-clearing levels).
  - Reforms to support labor market flexibility and improve functioning of goods and services markets are important.

### Model diagnostics and estimation notes
- The errors in the VECM/ECM are reported as uncorrelated and homoscedastic.
- The ECM specification underwent tests for absence of autocorrelation and heteroscedasticity, regression misspecification, omitted variables, and coefficient stability.
- Data cover a period of excess liquidity when interest rates were relatively low and flat; the nominal effective exchange rate was used as a proxy for opportunity cost of holding money, and real public spending was used as a scale variable.

*IMF staff analysis as presented in the Algeria country chapter.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17142.pdf_