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Algeria: Selected Issues

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International Monetary Fund
Published Date:
March 2006
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1. The Association Agreement between Algeria and the European Union: Economic Implications and Challenges1

This chapter analyzes the potential economic impact of Algeria’s Association Agreement with the European Union (AAEU). Costs are likely to occur in the short run and benefits over the longer term. The policy actions needed to increase the benefits of the AAEU consist of maintaining sound macroeconomic policies, accelerating already initiated structural reforms, and liberalizing trade more generally.

A. Introduction

1. Algeria has recently ratified an Association Agreement with the European Union (AAEU).2 This agreement represents a major policy initiative and comes at a time when Algeria is facing a number of challenges, including diversifying the economy and achieving the transition to a market economy. The AAEU raises some strategic questions and policy issues, mainly: (a) what is the potential economic impact of the AAEU; and (b) how can Algeria maximize the benefits of the AAEU?

2. Algeria is the eight Mediterranean country to implement an AAEU.3 Being one of the last countries ratifying the agreement provides Algeria with a great opportunity to draw lessons from the experience of its predecessors, even though the structure of the Algerian economy is somewhat different than that of other Mediterranean countries.4 At the same time, coming late in the game creates some urgency for Algeria to catch up with its neighbors.

3. This paper aims at exploring the questions and policy issues raised above. It concludes that:

  • The economic impact of Algeria’s AAEU includes both costs and benefits, with costs likely to occur in the short run and benefits over the longer term. Costs would come at the earlier stages and may include some impact on fiscal revenue, trade diversion, transitional unemployment, and enterprise closures. Algeria’s strong financial position together with deep economic reforms could help mitigate the short-term costs of the agreement. The benefits would come mostly over the longer term and consist of welfare gains, increased foreign direct investment, transfers of technology and knowledge, and higher productivity and potential growth.
  • Realizing the potential benefits of the AAEU depends to a large extent on Algeria’s commitment to reforms. Indeed, the Barcelona Process positively affected mainly the countries that showed serious commitment to reform. Thus, Jordan, Tunisia and Morocco have benefited from higher foreign direct investment (FDI) and higher growth largely because they were committed to reforms with the objective of integrating their economies in world markets. Other Mediterranean countries did not fully exploit the opportunities created by the AAEU so far, and, consequently, benefited to a lesser extent from the agreement.
  • The AAEU could become a catalyst for Algeria to meet its main economic challenges as it commits the country to a course that can be completed successfully only through a decisive implementation of a wide range of economic reforms.

4. The paper proceeds as follows. Section B lays out the major elements of Algeria’s AAEU and makes a comparison with other AAEUs. Section C discusses the potential economic implications (costs and benefits) of the agreement. Section D discusses economic policy issues and challenges. Section E concludes.

B. Major Provisions of the Algeria-EU Association Agreement

5. The AAEU is part of the European Union’s stepped-up effort toward deepening and widening its relations with the South-Eastern Mediterranean countries. It is a partnership agreement that is comprehensive in its coverage with economic, financial, social, cultural, technological as well as political and security implications. The main economic provisions of Algeria’s AAEU are the following:

Free trade area

6. At the core of the agreement is the progressive liberalization of trade in goods and services, as well as increased liberalization of capital movements. The agreement calls for the establishment of a free trade area in most industrial goods over a 12-year period through a gradual elimination of tariffs, and provides for preferential access for some agricultural products. The EU is already Algeria’s major trade partner: more than 60 percent of Algeria’s imports originate in the EU and 55 percent of its exports, mainly hydrocarbon products, go to the EU (Figure 1). For European firms, the dismantling of tariff protection in Algeria will expand market access. For Algeria, which already enjoys zero tariffs on its exports of manufacturing goods to the EU pursuant to the Trade and Economic Cooperation Agreement signed in 1976, there is no direct effect of market expansion in this area.

Figure 1.Direction of Algeria’s trade

(In percent)

Source. Direction of Trade Statistics, International Monetary Fund.

7. However, as for most other Mediterranean countries, Algeria’s AAEU stipulates an increase in the effective rate of protection in the earlier stage.5 Excluding the list of agricultural products, the agreement comprises 3 lists of industrial products on which customs duties are to be eliminated at different speed, with tariffs on raw materials and intermediate goods to be abolished as the agreement becomes effective (Table 1).6 In contrast, Egypt and Tunisia have four lists in their agreements, while Lebanon has a single list. Not phasing out tariffs on all goods simultaneously would provide some time for local industries to modernize before facing international competition. However, abolishing tariffs on intermediary inputs immediately, as in the case of Algeria, raises effective rates of protection in the short run, which in turn may risk delaying the modernization of local industry, as the latter does not face early on the foreign competition that results from trade liberalization.7 Delayed modernization, in turn, makes competition harder later on. Having one list is, therefore, advantageous, as it does not increase effective protection during the first years of the implementation of the agreement and does not provide preferential treatment to any product or sector. Multiplying the lists also means providing different degrees of preferential treatments to different industries and could result in inefficient reallocation of resources.

Table 1.Differences in the Economic Provisions of Various Association Agreements
Effective onFree Trade Area (industrial goods)Free trade area (agricultural and fishery products)Liberalization of services and rights of establishmentCumulation of rules of origin
AlgeriaSep-05List 1: immediate abolishment of tariffsProtocol 1 for imports of agricultural products into the CommunityNo right of establishmentYes, with Morocco and Tunisia
List 2: dismantling starting the 3rd year, over 6 yearsProtocol 2 for imports of agricultural products to AlgeriaNo less favorable treatment than that accorded to any third country
Other: dismantling starting the 3rd year, over 11 yearsProtocol 3 for imports of fishery products to the Community
Protocol 4 for imports of fishery products to Algeria
Protocol 5 for imports of processed agricultural products
EgyptJun-04List 1: immediate dismantling over 4 yearsProtocol 1 for imports of agricultural products into the CommunityRight of establishmentNo
List2: dismantling starting the 4th year, over 7 yearsProtocol 2 for imports of agricultural products to EgyptLiberalization of services
List 3: dismantling starting the 6th year, over 8 yearsProtocol 3 for processed agricultural products
List 4: dismantling starting the 7th year, over 10 years
JordanMay-02List 1: dismantling starting the 5th year, over 5 yearsProtocol 1 for imports of agricultural products into the CommunityNo right of establishmentNo
List 2: immediate dismantling over 5 yearsProtocol 2 for imports of agricultural products to JordanNo less favorable treatment than that accorded to any third country
Others: immediate abolishment of tariffs
LebanonMar-03All products: dismantling starting the 6th year, over 8 yearsProtocol 1 for imports of agricultural products into the CommunityTreatment granted to either party with respect to the right of establishmentNo
Protocol 2 for imports of agricultural products to Lebanonand supply of services based on GATS
MoroccoMar-00List 1: immediate dismantling over 4 yearsProtocol 1 for imports of agricultural products into the CommunityRight of establishmentYes, with Algeria and Tunisia
List 2 dismantling starting the 4th year, over 10 yearsProtocol 2 for imports of fishery products to the CommunityLiberalization of services
Others: immediate abolishment of tariffsProtocol 3 for imports of agricultural products to Morocco
TunisiaMar-98List 1: immediate dismantling over 6 yearsProtocol 1 for imports of agricultural products into the CommunityRight of establishmentYes, with Algeria and Morocco
List 2: immediate dismantling over 11 yearsProtocol 2 for imports of fishery products to the CommunityLiberalization of services
List 3: dismantling starting the 5th year over 9 yearsProtocol 3 for imports of agricultural products to Tunisia
Others: immediate abolishment of tariffs
Source: European Union
Source: European Union

8. Comprehensive trade liberalization is not envisaged for agriculture, but the Agreement provides that the EU and Algeria will review the trade regime for agriculture in the year 2010.

Harmonization of the regulatory framework

9. The second essential element is that, like in all other agreements, Algeria’s AAEU aims to harmonize its trade regulations, with a view to phasing out any practices that distort trade between the partners, such as monopolies, government subsidies, or privileges granted to public enterprises. The AAEU calls for the harmonization of norms and standards (in transport, telecommunications, etc.), and of regulations and rules concerning accounting and financial services, statistics, and customs. Financial and technical support for Algeria’s adjustment efforts to adopt EU and international technical standards will be provided under the MEDA programs of the EU. This can be critical for restructuring Algeria’s industry and diversifying the economy by improving access to the EU and world markets for Algerian manufactured and industrial products.

Cooperation

10. The third element of the AAEU aims to increase economic, financial, social, and cultural cooperation. Cooperation is strategic because it can sustain the main economic policies that need to accompany the implementation of the agreement.

11. In addition to other types of economic cooperation in others countries’ AAEUs, Algeria’s AAEU includes support to privatization.8 In light of Algeria’s need to reduce the role of the state and diversify the economy, EU’s support to Algeria’s privatization process would address in a timely manner the constraints posed by public enterprises.

12. The EU’s financial cooperation with Mediterranean countries is implemented through two instruments: MEDA programs and loans from the European Investment Bank. The envisaged financial cooperation with Algeria entails facilitating reforms and modernizing the economy; upgrading economic infrastructure; promoting private investment and job creating activities; offsetting the effects on the Algerian economy of progressive introduction of a free trade area, in particular through industrial restructuring and modernization; and accompanying measures for policies implemented in the social sectors. Between 1999 and 2003, the EU’s commitments to Algeria under the MEDA program were € 345 millions (6.3 percent of total commitments), with an appropriation amounting to only € 59 millions (17 percent of commitment). The national indicative programs for 2002–04 and 2005–06 provide together for a commitment of € 256 million. Furthermore, the loans granted by EIB to Algeria amounted to € 1.1 billion for the period 1999–2003. The technical assistance component of MEDA programs and EIB loans is an important element for capacity building and transfer of knowledge.

13. Social and cultural cooperation includes guaranteeing national treatment for Algerian and EU nationals that have found legitimate employment in the partner country. As far as labor movement is concerned, parties are committed to a dialogue aimed at achieving progress. Priority is to be given to projects and programs that (a) improve living conditions in Algeria; (b) help create businesses in Algeria by Algerian workers legally settled in the European Community; (c) promote the role of women; (d) improve social protection and health systems; and (e) contribute to the development of the housing sector. This part of the agreement is also present in the AAEUs of Morocco and Tunisia. These sections intend to address the EU’s special relationship with the Maghreb countries and reduce the flow of economic migrants into the EU arising from the disparity in income and living conditions between the two regions. Although the agreements cannot change the present economic incentives to migrate, they give an incentive to the EU to assist the region in achieving higher economic growth on a sustained basis, with the view of slowing the flow of migration.

Liberalization of the energy sector

14. An important element of Algeria’s AAEU is cooperation in the energy and mining sectors. The objective is to gradually liberalize these sectors and the agreement includes developing partnerships between European and Algerian companies in the exploration, production, processing, distribution and provision of other services in the energy and mining sectors. This element is particular to Algeria’s agreement and does not appear in other countries’ agreements (Table 1). Given the structural importance of the hydrocarbon sector in Algeria (38 percent of GDP, 98 percent of exports of goods, and 71 percent of fiscal revenues in 2004), this part of the agreement is critical to increase FDI in Algeria. Algeria has already passed a law that liberalizes the hydrocarbon sector more generally.

Regional integration and rules of origin

15. A fifth objective of the Algerian agreement is to promote integration among the Maghreb countries. This element appears only in the AAEUs of Algeria, Morocco, and Tunisia. Currently, trade among the Maghreb countries is limited and counts for less than 2 percent of their total external trade. In addition to fostering trade between Algeria, Morocco, and Tunisia, regional integration could help reduce the so-called hub-and-spoke effect, which creates incentives for firms to locate in the “hub”, i.e. the EU, as it gives them free access to all the “spokes”, in this case Algeria, Morocco, or Tunisia.

16. Algeria’s AAEU also allows for a cumulation of rules of origin for goods produced in Morocco, Tunisia, the EU, and Algeria. This is a very important element to increase regional integration in the Maghreb. It also exists in Morocco and Tunisia’s agreements, and does not appear in other Mediterranean countries’ AAEUs. However, in order for the Maghreb countries to benefit from cumulation of origin under the AAEU, the rules of origin applied in the bilateral trade between these countries should be the same as those applied in the AAEUs. Currently, the rules of origin are identical in the bilateral agreements between the three Maghreb countries, but they differ from those in the AAEU.9 This means that the countries need to revise the rules of origin in their bilateral free trade agreements to be able to benefit from diagonal or full cumulation of origin in their trade with the EU.

Liberalization of services and right of establishment

17. The main weaknesses in the Algerian AAEU are the absence of the right of establishment and the limited commitment to liberalizing services. All other Mediterranean countries have included the right of establishment and liberalization of services in their respective agreements. The exclusion of the right of establishment could be an obstacle for potential foreign investors. The experience of the Central and Eastern European countries shows that the liberalization of services has been a major element in attracting FDI (Hoekman et al. 1996). Therefore, the liberalization of services would have been a great innovation for Algeria and helped diversify the economy. One way for Algeria to make up for this weakness is to reduce government intervention in the services sector as was done in the hydrocarbon sector. Furthermore, Algeria has still the possibility of committing to the liberalization of services when acceding to the World Trade Organization.

C. Potential Macroeconomic Impact

18. Typically, most adjustment costs come in the short term, whereas most benefits arise in the medium and longer term. The benefits of trade liberalization tend to be dynamic and depend to a large extent on accompanying reforms.

19. When dealing with issues relating to economic liberalization, it is easier to measure the costs than the benefits. Economic sectors and private or public interests benefiting from protection have incentives to publicly denounce the proposed changes and declare their losses. By contrast, the general public that stands to gain from trade liberalization has a much more diffuse economic interest and is not as well organized. The following section assesses the impact of the agreement on the economy as a whole.

Benefits

Welfare

20. The creation of a free trade area between Algeria and the EU both creates and distorts trade. Trade expands because it faces lower tariff and nontariff barriers than previously. Algerian consumers and producers using imported inputs are better off, whereas producers of import-competing goods are worse off and customs revenues decline because of lower tariffs.

21. Trade diversion, working in the opposite direction, may reduce welfare. Trade diversion occurs when, due to the lower tariffs facing EU products, imports are diverted away from other foreign producers and towards the EU. If, however, the EU is not as efficient (i.e. is a higher cost source of supply) as other foreign suppliers, trade diversion may lead to a net welfare loss. This risk is higher in Algeria than in Morocco and Tunisia, because the EU accounts at present for only 60 percent of Algeria’s imports, whereas more than three-fourths of Morocco’s and Tunisia’s imports already come from the EU.

22. From a static analysis perspective, Algeria is expected to enjoy a net welfare gain. Whether Algeria stands to gain or lose, whether the benefits of trade creation will outweigh the losses from trade diversion is an empirical matter. According to the import demand model developed by Geraci and Prewo (1982) and applied by Testas (1997), a measure of trade creation, TC, is derived by multiplying the amount of imports from the EU, MEU, by the product of the price elasticity of import demand, η, and the percentage change in the import price induced by the tariff, t, changes resulting from the trade liberalization:

TC = ηMEUΔt/(1+t)

A measure of trade diversion, TD, is obtained by multiplying the amount of imports from the rest of the world (non-EU), MNEU, by the elasticity of substitution between imports from EU and non-EU suppliers, σ, and the price change induced by the tariff changes due to integration:

TD = σ MNEUΔt/(1+t)

Rough estimates based on 2004 imports, an average tariff rate and a change in tariff rate of 19 percent, an import price elasticity of -0.80, and an import substitution elasticity of -0.79 suggest that Algeria’s expected net welfare gain would be about 1 percent of 2004 GDP.10

23. Furthermore, trade creation and trade diversion should be viewed in a dynamic context. Algeria can lessen the costs of trade diversion and the resulting loss in welfare by adopting a more liberal commercial policy towards the rest of the world, i.e. multilateral trade liberalization and reduction of all tariff and nontariff barriers in the context of joining the WTO. Another action in this direction would be to improve the cost structure of doing business and thereby enhance prospects for inward FDI.

Foreign direct investment (FDI)

24. The second benefit that could result from the AAEU is an increase in FDI. Free trade agreements in general, including the AAEU, act as a signal to foreign investors of increased international openness. This important economic benefit of the AAEU would enhance existing investment incentives, such as Algeria’s relatively low labor costs and its proximity to European markets.11 Algeria’s recent decision to liberalize the energy sector will also be an important factor to attract higher FDI. In contrast, a FDI-limiting aspect of Algeria’s AAEU is the absence of liberalization of services and right of establishment.

Productivity gains

25. Efficiency improvements and productivity gains would also be important benefits of the AAEU. Increased competition would force producers to reduce production costs and pay closer attention to consumers’ preferences. Furthermore, technology and innovation would spread more rapidly in a market that is open to international competition, and reduce monopolistic and other rent-seeking behavior under the pretext of protecting domestic industries. Consequently, the economy could gradually become more efficient and able to adapt to change more quickly. Business efforts to stay competitive, adapt to technical change, and keep up with changing markets would allow resources to be used more efficiently. This, in turn, would help create a more attractive environment for investment, which brings growth and more jobs. Europe’s example shows that this is a main source of benefits from opening up to external trade (Hoekman 1995). However, given that the state plays an important role in Algeria’s productive sector, and since competitiveness is not generally a primary goal in public enterprises, this process would require decisive actions on behalf of the government.

Costs

Fiscal Impact

26. The customs revenue loss for Algeria as a result of the AAEU is estimated to rise steadily from about 0.1 percent of GDP in 2005 (since the agreement became effective only in September 2005) to some 0.4 percent of GDP in 2006 and further to 2 percent of GDP by 2017, when the agreement will be fully implemented (Table 2).12 To put these losses in perspective, revenue from customs duties was only 2.1 percent of GDP in 2004 while collection of value added tax (VAT) and excise taxes combined amounted to 4.6 percent of GDP. The estimated revenue loss, once the agreement is fully implemented, corresponds to about one fourth of domestic indirect taxes. The revenue loss would be higher if account is taken of the impact of trade diversion and of the adverse effect of the agreement on the import substitution sector. Working in the other direction, however, potential higher economic growth resulting from the agreement will generate additional fiscal revenues, which would partly offset these losses.

Table 2.Fiscal impact of the AAEU
Nonhydrocarbon ImportsCustoms RevenuesEffective TariffCustom revenue losses
(In billions of US

Dollars)
In billions of US

Dollars)
(in percent)In percent of

total customs

revenue
In percent of

GDP
20017,6621,34317.5
20029,7801,61116.5
200310,9511,85817.0
200415,1751,92712.7
2005 Proj.19,1212,09611.05.30.1
2006 Proj.22,1702,0419.215.90.4
2007 Proj.25,1632,2589.018.00.4
2008 Proj.28,4162,3708.323.80.7
2009 Proj.32,0182,5057.828.61.0
2010 Proj.36,1922,7057.531.81.3
Source: Algerian authorities, and Fund staff estimates and projections.
Source: Algerian authorities, and Fund staff estimates and projections.

Balance of payments

27. The agreement is also likely to result in lower savings and higher investment, and thus in a reduction in the external current account surplus. Tariff dismantling may stimulate private consumption by making available a wider range of consumer goods, while investment could increase as a result of higher private capital inflows and of efforts to expand or upgrade production capacity. Furthermore, sizable investments in infrastructure will be needed over the medium term to improve the business environment and help attract larger flows of foreign direct investment. Given Algeria’s strong financial position and in light of the favorable prospects for hydrocarbon exports, some deterioration in the external current account balance could be supported.

Industrial restructuring

28. As tariffs and other forms of protection are phased out, local industry will incur transitional costs of adjustment. Industries and factors of production that are adversely affected because of a reduction in their effective rate of protection may experience a reduction in output and incomes, respectively. Gradually, investment and factors of production will move to sectors that have gained a comparative advantage. Because of the reduction of trade barriers over a 12-year period, the required structural adjustment is gradual. The EU can play an important role in providing financial and technical assistance in this transformation and the development of Algeria’s private industry. However, the restructuring would be delayed if the government decides to support the losses of the public enterprise sector facing foreign competition. Thus, soft budget constraints—imprudent or politically motivated bank lending, and write-offs of bad debt by the government—could retard enterprise restructuring, because loss-making public enterprises would continue to absorb resources that would otherwise have flowed to more efficient and productive enterprises.

Transitional unemployment

29. Enterprise closure could result in transitional unemployment. There are no estimates for these costs in Algeria. Rutherford et al. (1995) have estimated these adjustment costs for Tunisia at about 4 percent of GDP. While this is perceived to be a one-time adjustment cost, in the case of Algeria such costs would be spread over several years from the third year of the AAEU (when the tariff dismantling on strategic sectors starts) until the capital stock is reallocated, which would be beyond the twelfth year. This cost would be mitigated to the extent that the AAEU spurs additional investment and generates dynamic benefits. The cost would also be moderated by higher flexibility in the labor market, an increased role of market forces and reduced government intervention in resource allocation, and privatization.

D. Economic Policy Issues and Challenges

30. The Algerian authorities now face the challenge of making full use of the opportunities provided by the AAEU. The opening of the economy reinforces the need to accelerate the implementation of the reforms already initiated by the authorities. While Algeria can learn from the experience of other Mediterranean countries, it should also catch up as other countries, particularly its closest neighbors, have been implementing their agreements for more than five years now.

31. The experience of other Mediterranean countries shows that only countries committed to reform benefited fully and without delay from higher growth and foreign direct investment. Although it is difficult to quantify to what extent the AAEU had an impact on these countries macroeconomic results, the favorable economic developments in Jordan and Tunisia were likely related to the wide-ranging reforms that accompanied trade liberalization in these countries. Jordan, Tunisia, and Morocco, witnessed an improvement in their economic growth and FDI (Figure 2). In other Mediterranean countries, growth did not pick up following the implementation of their AAEUs and their share of the world export market remained constant at less than 1 percent over the last decade. Positive outcomes in all countries included lower inflation and lower unemployment, higher openness to trade (except in Lebanon), and an improvement in the external current account balance (except in Egypt).

Figure 2.Selected Indicators

Source. International Monetary Fund.

32. Against this background, important lessons can be drawn: First, the challenges raised by the AAEU represent an opportunity for Algeria to achieve high growth.13 Second, while the 12-year transition permits adjustment to be spread over time, it also delays the benefits while the transitional costs are felt early. Building upon and expeditiously exploiting the principle of liberalization that is inherent in the AAEU will advance the benefits.

33. To benefit substantially from the AAEU, the policy actions can be divided into three categories: (a) maintaining sound macroeconomic policies; (b) undertaking structural reforms aimed at diversifying the economy and achieving a transition to a market economy; and (c) liberalizing trade more generally.

Macroeconomic policies

34. Continuing to maintain macroeconomic stability is a prerequisite. By lowering import prices, the initial effect of the AAEU is to stimulate overall demand in the economy. Given Algeria’s strong external position and assuming that the recent oil price hike includes a permanent element, the authorities should aim at using part of the fiscal space to preserve domestic balances on a sustainable basis—a key condition for higher foreign and domestic investment. This could be achieved through using part of the fiscal space to compensate for potential revenue losses resulting from tariff dismantling. Furthermore, the authorities should also aim at mitigating the burden of the transitional costs of the AAEU (public enterprise and bank restructuring).

35. Flexible management of the exchange rate together with a monetary policy stance aimed at consolidating the low inflation currently prevailing in Algeria are also important.14 Removing import barriers, other things being equal, would lead to a depreciation of the equilibrium real exchange rate.15 However, if trade liberalization is accompanied by reform-driven productivity gains, this could offset the depreciation of the equilibrium real exchange rate. In fact, the ultimate objective of trade liberalization is to raise standards of living through productivity gains, not to lower them through real depreciation. Furthermore, the increase in real oil prices suggests a tendency for the equilibrium rate to appreciate, which, again, offsets the real depreciation resulting from trade liberalization. Close monitoring of Algeria’s productivity relative to its trading partners together with the changes in real oil prices would help to determine the likely path of the equilibrium real exchange rate.16

Structural and institutional reforms

36. Priority reforms should aim at reducing the role of the state in the economy, attracting FDI, and improving competitiveness. They should include modernizing the financial sector, boosting domestic competition through stepped up privatization and a redefined role for the government, improving the business environment, and increasing labor market flexibility.

Financial sector reform

37. Banking reform would improve the mobilization of domestic saving and the efficient allocation of the financial resources available for intermediation. Modernizing the banking system requires in particular privatizing several public banks to reputable investors; improving the governance of the remaining public banks; strengthening banking supervision; and developing the regulatory structure.17

Industrial restructuring

38. The modernization of the Algerian industry calls for actions on two fronts: (a) restructuring and privatizing the public enterprise sector; and (b) upgrading the domestic industry to improve competitiveness.

  • Restructuring/privatizing nonfinancial public enterprises is an essential reform to attract FDI and improve competitiveness. In order to facilitate the efficient use of resources, it is crucial to free-up the resources that are currently retained by underperforming public enterprises. Accelerating the restructuring/privatization of the state-owned enterprises through an open and transparent bidding process, while making sure that the existing social safety-net is adequate to alleviate the consequences of these reforms on employment, are essential. A major privatization program would also provide immediate opportunities to foreign investment. It would help confirm with investors the government’s seriousness about reducing its role in the economy, which is a prerequisite for greater competition. Algeria should benefit from EU assistance in this area, as mentioned in the provisions of the agreement.
  • Upgrading the domestic industry will help mitigate the costs of the AAEU on Algerian enterprises, while preparing them for foreign competition. This could be achieved through a joint Euro-Mediterranean “mise à niveau” program. Such programs have been implemented in Tunisia, Morocco, Lebanon, and Egypt to restructure local industries with the view of improving their competitiveness in international markets. However, the results have been mixed. In Morocco, for instance, few enterprises have benefited from these programs, and small and medium enterprises were not concerned.18 In Tunisia, however, this initiative has been successful and, so far, 50 percent of industrial enterprises benefited from this program. The reason behind the failure of these programs in some countries was mainly their complexity. Thus, Algeria should aim for a simple “mise à niveau” program that includes measures that stimulate the adoption of new technology, provide training to labor, and favor increased mobility of resources across sectors.

Improving the business environment

39. Improving the quality of institutions would further facilitate foreign investment and enhance long-term growth prospects. Institutional/governance indicators show that institutions in Algeria remain relatively weak (Table 3). Institutional reforms would create an investment climate more hospitable to innovation and competition. These reforms should include adopting a modern legal and regulatory framework for property rights, bankruptcy mechanisms, foreign direct investment, and financial transactions; and establishing a competent and independent judiciary. In addition, institutions for social insurance should assist agents affected by liberalization in order to avoid the unfair allocation of the social cost of integration. Although the AAEU does not address these concerns directly, it provides for the adoption of basic EU competition rules with respect to collusive behavior, abuse of dominant position, and competition-distorting state aid to the extent these affect trade with the EU. Given the prevalence of state-owned enterprises in Algeria, this reform could have important benefits.

Table 3.Country Ranking of Selected Indicators of Attractiveness for Foreign Direct Investment(Percent share of countries with lower score)
WBWBWBWBIEFICRGGCRGCRWB
Regulatory

Quality 3/
Government

Effectiveness 3/
Rule of

Law 3/
Corruption 3/Economic

Freedom 4/
Country

Risk 5/
Business

Competitiveness 6/
Growth

Competitiveness 6/
Business

Environment 7/
Jordan576260696464586679
Egypt2949545236383640
Lebanon344244425310
West Bank and Gaza1813203670
Syria132742291435
Mashreq (average)3039444642374753
Tunisia4669586548566960
Morocco455652584761554669
Algeria2036284329691432
Maghreb 1/ (average)3754465541624646
Central Europe 2/ (average)817169687764585671
Malaysia668165665774787091
Korea7280686372767772
Singapore9999959999969093
Sample size20920920920916114010310467
Incl. industrial countries?YesYesYesYesYesYesYesYesYes
Sources: Various country reports; for details see footnotes.

Includes Morocco, Tunisia and Algeria.

Includes Czech Republic, Hungary, Poland, and Slovak Republic.

Aggregate indicators of governance (2004) developed in Kaufmann, D. et al., Governance Matters, Policy Research Paper No. 2196, World Bank, 1999; and database available at http://www.worldbank.org\wbi\governance\gov_data.htm, and http://www.worldbank.org/wbi/governance/datasets.htm.

Index of Economic Freedom published by the Heritage Foundation and The Wall Street Journal, 2005. http://www.heritage.org/index/

Composite risk ratings by International Country Risk Guide, October 2005.

Growth Competitiveness index published in Competitiveness Report by World Economic Forum, 2004. http://www.weforum.org

Based on results of survey used for the World Bank’s World Development Report 1997 as presented by Brunetti, a. et al., in Institutional Obstacles for Doing Business, Policy Research Paper No. 1759, World Bank, 1997; and database available at http://www.worldbank.org\wbi\governance\wdr97data.htm

Sources: Various country reports; for details see footnotes.

Includes Morocco, Tunisia and Algeria.

Includes Czech Republic, Hungary, Poland, and Slovak Republic.

Aggregate indicators of governance (2004) developed in Kaufmann, D. et al., Governance Matters, Policy Research Paper No. 2196, World Bank, 1999; and database available at http://www.worldbank.org\wbi\governance\gov_data.htm, and http://www.worldbank.org/wbi/governance/datasets.htm.

Index of Economic Freedom published by the Heritage Foundation and The Wall Street Journal, 2005. http://www.heritage.org/index/

Composite risk ratings by International Country Risk Guide, October 2005.

Growth Competitiveness index published in Competitiveness Report by World Economic Forum, 2004. http://www.weforum.org

Based on results of survey used for the World Bank’s World Development Report 1997 as presented by Brunetti, a. et al., in Institutional Obstacles for Doing Business, Policy Research Paper No. 1759, World Bank, 1997; and database available at http://www.worldbank.org\wbi\governance\wdr97data.htm

Increasing labor market flexibility

40. Increased labor market flexibility together with stepped-up social safety net provisions are also needed to help reduce the transitional costs. The reallocation of resources from previously protected sectors to export-oriented and import-substituting activities is likely to take time, thus resulting in temporary employment losses. Increased labor market flexibility would facilitate industrial restructuring prompted by the AAEU and thus support the efficient reallocation of resources. In order to minimize the transitional costs, a social safety net targeting benefits to the most vulnerable and providing support and training for displaced workers is also critical.

Further trade liberalization

41. Further trade liberalization should aim at increasing regional integration, and at liberalizing multilateral trade and trade in services, and deregulating the market.

Regional integration

42. Regional integration represents a key element for the success of the AAEU, notably because of its consequences in terms of creating economies of scale that will compensate for the small size of domestic markets of individual countries and will promote investment flows into the region. If Algeria wants to contain the adverse effects that could be generated from the AAEU(such as the “hub and spoke” effect that would favor localization of new investments in the EU), it will need to phase out barriers to trade with its neighbors, as well as with the rest of the world. The increase in market size resulting from regional trade facilitation between Algeria, Morocco, and Tunisia is estimated to lead to an increase in FDI in Algeria, Morocco, and Tunisia (Jaumotte, 2004).

43. Such integration would require that Maghreb countries accelerate the implementation of free trade in goods and services among themselves in the period ahead.19 Such integration should also not be based on specific products and quantities, as is the case in current bilateral trade arrangements in the Middle East (Lawrence 1997). The literature suggests that the limited impact of the Arab Maghreb Union can be partly attributed to attempts to reduce protection on a product by product basis rather than across the board, with minimal exception lists (Hubfauer et al. 1997).

44. While enhancing the need for regional integration, the AAEUs concluded by Algeria, Morocco, and Tunisia also facilitate such integration. In addition to clauses that mention specifically the promotion of regional integration within the Maghreb countries, the AAEUs could help integration by: (a) reducing protection in these countries over a 12-year period; (b) harmonizing regulatory aspects and procedures bilaterally with the EU, thereby providing these countries de facto with common standards; (c) EU assistance for infrastructure linkages among the various countries; and (d) allowing cumulation or rules of origin for trade between these three countries. The latter point may foster backward and forward linkages between Algeria, Morocco, and Tunisia and enhance the potential for intra-industry trade.

Multilateral trade liberalization

45. Greater openness would contribute to achieving higher growth performance while reducing potential trade diversion. Multilateral liberalization encompasses accession to the WTO and harmonization of trade procedures with other countries in the world. It should include further reducing tariffs, aligning MFN tariffs with those scheduled in AAEU, and gradually eliminating nontariff barriers with the objective of harmonizing them on the broadest possible basis. It also requires harmonization of norms and standards and of the regulatory framework, with a view to eliminating practices that distort trade, including monopolies and government subsidies.

Liberalization of services

46. The liberalization of the services sector could contribute substantially to Algeria’s prospects. First, as services are major inputs into the production of goods and services—such as finance, transport, etc.—reducing their cost can reduce substantially the total cost of production and thus improve the competitiveness of firms. Second, reforming services, such as education and health services, can also improve the quality and productivity of workers. Third, service sector reform and development can help overcome resistance to trade liberalization from influential segments of society by assisting industry and agriculture in confronting competition from imports through reduction in input costs and higher productivity, and by creating employment opportunities in service activities. Opening the services sector in the period ahead should include the transportation, telecommunication, and financial sectors. It requires dismantling barriers to entry and promotion of competition, while improving the legal environment and strengthening independent regulatory agencies. Given the limited tradability of services, the liberalization of this sector could generate substantial employment opportunities for the local labor force and lead to transfer of technologies.

E. Conclusion

47. The AAEU provides a major impetus toward an open trade regime over the next twelve years and constitutes a powerful catalyst for overall economic reform. Algeria has committed to a course that can be completed successfully only by adopting far-reaching interrelated reforms that aim at attracting FDI and improving the supply response. Thus, the benefits of the agreement could be substantial, but they will come relatively late and will be forthcoming only if major supplementary reforms are implemented consistently and early on. Ultimately, the success of the agreement hinges on Algeria’s ability to diversify the economy by generating a critical mass of foreign and domestic investment in labor-intensive export-oriented sectors.

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1Prepared by Taline Koranchelian
2Association Agreements with the European Union are part of the Barcelona Process that set a framework of cooperation and integration between Europe and the Mediterranean region. The objectives were to establish a common Euro-Mediterranean area of peace and stability; create an area of shared prosperity through the progressive establishment of a free-trade area between the EU and its Mediterranean Partners; and help to improve mutual understanding and tolerance among peoples of differing cultures and traditions. Algeria’s AAEU entered into force on September 1, 2005.
3So far, progress toward establishing free trade area has been achieved with most of the Mediterranean countries. The only Mediterranean country that has not yet signed an AAEU is Syria.
4Algeria is the only major oil-exporting country among the countries that have signed an AAEU.
5The effective rate of protection is equal to (Vd − Vw)/Vw, where Vd is the domestic value added per unit of a good at domestic prices (including tariffs), and Vw is the value added per unit of a good at world prices under zero tariffs.
6The first list includes raw materials and intermediate goods (e.g. mineral and chemical products, wood) on which tariffs should be abolished as soon as the agreement becomes effective; the second list is that of less strategic industrial products on which tariffs will be dismantled over six years (e.g. plastics, rubbers, machinery and electrical goods), starting two years after the agreement becomes effective; and the third list consists of the goods that are the most strategic for Algeria (e.g. textiles and footwear), the dismantling will take place over eleven years, starting two years after the agreement becomes effective.
7Reducing tariffs on intermediary inputs raises the effective rate of protection since lower prices on intermediary goods implies higher domestic value added per unit of a good.
8The other means for economic cooperation, which are common in all agreements, are: (a) regular economic dialogue covering all areas of macroeconomic policy; (b) communication and exchanges of information; (c) transfer of advice, expertise, and training; (d) implementation of joint actions; and (e) technical, administrative, and regulatory assistance.
9The bilateral free-trade agreements between the three Maghreb countries contain similar rules of origin based on the criterion of 40 percent of local value added, except for the tariff agreement between Tunisia and Algeria, which sets the threshold at 50 percent. However, the AAEUs of Algeria, Morocco, and Tunisia determine origin on the basis of sufficient processing of non-originating commodities, other than commodities wholly obtained in a single country. Depending on the good, origin is obtained in the following circumstances: (a) when the processed good is classified under a different harmonized system heading than that of all of the non-originating materials used to produce the good, provided that the processing involves more than a specified set of simple operations; (b) when the good undergoes specific processing, which may include one or more steps; and (c) when the value of materials imported from a third country is less than a given percentage of the ex-factory price. In some cases, the criteria are combined and, for several products, the inclusion of a single imported input means that the product no longer obtains origin.
10Algeria’s import price elasticity and substitution elasticity are estimated in Testas (1999) using data for the period 1971–91.
11Information on unit labor costs and average wages is not available. The minimum salary in Algeria is currently about US$1,700 per year.
12Estimates take into account price and substitution elasticities.
14Algeria’s exchange rate regime is a managed float with no pre-announced path for the exchange rate.
15Trade liberalization would have an impact on the equilibrium real exchange rate through both substitution and income effects: (a) a reduction in tariffs would increase demand for tradables relative to nontradables. This substitution effect would, in turn, tend to reduce the price of home goods, and hence result in a real depreciation; and (b) trade liberalization would also raise real income in the economy, which in turn would affect aggregate demand for all goods, including nontradables and hence tend to appreciate the equilibrium real exchange rate. The income effect is expected to be smaller than the substitution effect.

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