Report No. 12992-ET

EthiopiaPublic Expenditure Policy for Transition(In Three Volumes) Volume I Report Summary and Reform Measures

October 21, 1994

Country Operations DivisionEastern Africa DepartmentAfrica Region

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CURRENCY EQUIVALENT

CurrscUzdt rr(fr.)Offmi"l Zxc eRstr. USSIN.6 rr 5L59 (July 1994)Weig"t NWd Measurm Metri Syukm

ACRONYMS AND ABBRIVIATIONS

AIDS Acqurd Immumi Deficey Syndrom MOF Ministry oFmanceAAU Addis Ababa Unirity MOH inistry of HealthADB Affican Ddevelopma ntlank M0ONRDEP Misty afNatural Resourc Developmnt andADF AficanDevomt Fund Em P ctioaAISCO Agrutrl puts Supply CprMOPD f ngand DoeAUA Alea.UanvtyofArculu MSFC&TD Mini*y of Sot Fam and o Ministy ofADT Averaw eDai TIafc Coffoe and Tea DeveopmeBOP Balance of Pay tT o d CIDA Canadian Interational Delopment Agscy MC:H Mod&aChid Heald tCGs Centl GoVments NFR Natna Food ResewvCSA Centa Statisc Authriy NEP Wow EconomicPlicyCDE Chamin de ForDibouti-Ehopian NoGO Nooveizannt OwranizaCRDA Chrsias Relief Dewlopuient Asoatio Om Operation & MainanceCAA Civil Aviation Authority ORS Or R dration SaltEMBS Educon Manag Ihnnation System OPEC organizaion of Ptoeum Epotig CouniesEMPDA Education Matris Productio an Disbh o Agecy PTC P_epr TrnsportCorpoationERRP EmergeyRecovery and Reconsftucion Proect PSSA Pansin and Socal Scunty AdministrationESTAS Eian Shippig and Transit Amcy Senices PFP PolicyFramworkperEAL EhpianAiie PWP ProWaniurg PlanEC. EAiopian Calnda PHC PHuay Hea CarEFrC Ethiopian Frgh Transport Coroation PCs PrduceCooperavesETIMEX Eti Impot and Export PERD Pubic Entepis Rem and Dvetture PrgmEPRDF Edtopian Pwls Revlutionay Demoraic Frui PER Publi Experditu ReviewEPHARMAOOR Ethiopian Phamaicl Corp orn PERA Public Expediture Review AgiulureERA Ethiopian Road Authority PEP PambicIvestmnt ProgramESL Ethiopi Shipping Lnes Copoatn RGs Regional GovenmeEEC Euopen Economir Commissio RRC Reiad Rehabiitadi CommissionEPI Expanded Prram fft Iunization RTA Road Transport AuthorityFP Famly Pbnning SC. Savie CoopeaivsFAO Food and Agricture Orgmat of the Unid Nation Sfls Sely Tramitted DiseasesFAP Fortry Action Plan SSEs SmaRlScalbEnterprieGRI Genetic Resoure Iswtit SEPA Southern Ehiopian, Peoples AdministrationG1Z Gemn Aso" for Tecdal Cooperation SFP Sta FamGNFS Goods and Non FaPtor Sevives SI Swedb ions D A rG.C. Greian Clendar TYPPO Thee-Year Plan Prepari GuidesGDP Gro Domestic Prodact TS Trane and SubaidsGNP GrossNaio Ploduct TG Transitdn GovermetHV Human Iumunodeficency Vruw TGE Transitional Go _unet ofEopi,ICOR Ibnc al Capital Output Rao UNECEF Und NatioCildm' FundIPEs Industril Publc Enterp_s UNFPA United Natm Fund fiw Population ActiviesLAR h usttu ofAgriculture Research UNDP Uted Natio Devlopmet PrornICDR bstie ofCuriculum Devlop and Rearch UNESCO Unit Natons Educational, Socetific and CuuralIRR IntlRatedsofRm RetuIDA hi De A UNHCR UnidNaions Hi herCommisi frRegesJOE nbv n O of Ethiopia USAID Unied States Agescy fir nteaoal DevelopmentMTSC Manrm and Tns rvices Corpon WRDC WerRe pCommiMLUP ster Lnd Ue Pla WBR Wodd Bank ReportMOE MinisryofEducation WHO Wold Heh Ornization

Vo}ume I Page

I. Rort Sunmmay ........ .. 1-ix

H. Reform Measures ............ xx-xxi

PREFACE

This Report is based on the findings of a Bank mission which visited Ethiopia inSeptember/October 1993. The Mission was led by Fayez S. Omar (principal Reportauhor, Resident Economist, World Bank Resident Mission, Addis Ababa). The Missionwishes to thank the Transitional Government of Ethiopia, particularly Vice-MinisterGetachew Gebre, for invaluable cooperation. It also wisbes to thank USAID, UK-ODA,and the CEU for their funding of several consultants. The Mission consisted of EduardIrgens, Simon Thomas, Idermit Gill, Howard Barnm, Seung Choi, LorenzoMarchesini, Lili Liu (all World Bank); David Dunlop, Eyerusalem Fasika (both WorldBank Consultants), Maureen Woodhall, Teferra Mengesha, Victor Kumar (World Bankfmunded consultants); Satish Mishra (USAID); John Short (UK-ODA funded); and DavidBevan (CEU funded). The Mission also benefited from background notes prepared byLarry Forgy (USAID); Denis Ghalgher (UK-ODA funded); GiJa Dutt (USAIDfnded). Sanjay Pradhan (World Bank, lead advisor), Abhay Deshpande and Amar JitSodhi (both World Bank, Resident Mission, Addis Ababa) provided valuable advice; andGraeme Donovan (World Bank) was the peer reviewer. The Mission also benefited froman MP study on public expenditure issues which preceeded the PER. Gayle E. Smithedited the Report. Roboid Covington, Yeshi Gizaw, Lora Clarkson with assistance fromEleni Houghton (all World Bank), were responsible for the processing and the physicalproduction. CEU supported the production of this report with fimding.

ETIDQP1APUBUC EXPENDITURE POLICY FOR TRANSMTION

1. REPORT SUMMARY

BACIKGROUND

1. The events of 1991 plunged Ethiopia into a period of tumultuous and far-reaching cune.With the defeat of the mUitary regime of Mengistu Haile Mariam by the Ethiopian PeoplesRevolutionary Dmocratic Front (EPRDF) and the subsequet fomation of the TransitionalGovenunent of Ethiopia (TGE), the country's geographic boundaries, social and political relationsand economic structure were dramatically re-defined.

2. Guided by a National Charter drafted in July 1991 as a preursor to the forthcomingconstitudon, the policies adopted by the TGE during its first three years in power reflected aradical departure from a past characterized by a high degree of centralization and militarization.The new Government endorsed the findings of an intenationally-supersed refeendum iErea, thus ending 30 years of conflict and recognizing the independence of an area which hadbeen considered the fourteenth provice of Ethiopia by previous governments. The NaionalCharter redefined Ethiopia's internal boundaries by prescrbing the creation of 14 self-dministering regions. The new regionalization policy laid the groundwork for a potentlysignificant devolution of power from the center to the periphery and, importantly, for increasedpolitical participation by Ethiopians having a wide range of economic, social, religious, ethnicand experientl backgrounds. Although not without difficulties, regional elections were corvenedin 1992 with national elections scheduled in 1994 follow the ratification of a new nationalconstitution.

3. Regionalization is perhaps the most promient feature of government in Ethiopia'simmediate and long-term; a policy which will have direct bearing upon both expendtr policyand implementation. The Government's regionalization policy emerged in response to thecenralization which surfaced as the dominant characteristic of govermnent in Ethiopia during theimperia era and was reinforced during the tenure of the last regime. As a consequence ofcenalization, political institutions outside of the center were nrmntary, and litteadministrative experience or capacity was developed at the regional and district levels. In the eyesof at least some Ethiopians, the intensity of centralization in the past is perceived as beingintimately comwcted with the country's history of unsatisfactory and authoritarian rle. There isnow a strong political commitment to foster a substantial degree of d lizionby devolvingpower and responsibility to the regions; statements to this effect were among the first to be madeby the Transitional Government.

4. The changes promoted in the economic sphere have been no less significant. In the NewEconomic Policy stament issued in 1991, the TGE made clear its intention to transform thestagnant command economy inherited from its predecessor into a fumctioning market-basedeconomy. The Government has since adopted a series of reform measres designed to establishzmarket-oriented foundations after several decades of pervasive state intervention in all aspects ofthe economy. The goals of the reform program, as described in the agreed Policy FrameworkPapers of October 1992 and July 1993, are the atainment of ecmnomic stabilization and the

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provision of an adequate structural and regulatory framework for growth and development.Within this framework, the Government has announced that it will gradually reduce its role inthe productive sectors, in favor of increased participation of the private sector, and expand itsrole in the social and infrastructure sectors.

5. While economnic transformation remains a central priority, the Governnent faces multipleand competing demands. Decades of insecurity, violence and economic decline have left Ethiopiawith a daunting legacy. During the last 20 years, millions of Ethiopians were internally displacedor forced across international borders as refugees, and many are now in need of resettlementassistance. Localized production shordalls means that relief aid is still required in many parts ofthe country. Much of the country's infrastructure was destroyed; what remains is in a state ofgross disrepair. Social services remain inadequate and are, in many parts of the country,altogether unavailable. While Ethiopia has attained a new level of peace and security, theperpetuaon of conflict in neighboring Sudan and Somalia means that Ethiopia must continue toplay host to hundreds of thousands of refugees and bear the consequences of regional instabilityin the Horn of Africa. Intenally, the Government's pledge to foster the growth of democracy hasexpanded the parameters of political activity to include elections, the creation of a newconsitution and the overhaul of the judiciary, while decentralization to the regions hasnecessiated the restructuring of every component of governme -. The Govermment is proceedingwith its plans to demobilize a large segment of the existng army and is completely restructuringmilitary, police and security forces. Each of these factors is affected by and will affect thechoices determining expenditure policy.

6. Expenditure policy in Ethiopia nmst, therefore, play a vital role in facilitating thesition from war to peace, from a command to a market based economy. In fulfilling its role,

public expenditure policy faces some serious challenges. In terms of social services, resourceallocations for and delivery of health and education have been extremely poor, resulting in a veryworrsome social indicators. Estinates of the number of children dying within one year of birthre about 30 per 1000, and life expectancy at birth is less than 48 years. It is estimated that only

25 percent of the population is covered by providers of health care. Over 80 percent of womenare illerate, and less than one-third of their children have received any immunization. The grossenrollment ratio at the primary education level had fallen to possibly below 30 percent; one ofthe lowest in the world.

7. Damage of physical infrastructure has been no less severe. There are an estimated 1,160schools which had been partially or completely damaged during the war. Edtiopia's road networktoday has one of the lowest road densities in Africa. Of the total 22,500 km. of sparselydistributed network, 90 percent is classified in fair or poor condition; ie. requiring resurfacingor extensive rehabilitation. The war has also resulted in considerable damage to the domesticnetwork of airports, several of which are currenty operating at sub-standard safety levels. Theextrmely high expenditure levels on the military diverted resources away from neededinvestnents in agricultural research, extension, and infrastructure such as irrigation and ruralroads. The resources allocated to the agricultural sector under the command economy, weretypically spent on subsidizing productive activities, leaving the sector, which represents thebackbone of the economy, completely vulnerable to enviromental degadation and droughts.

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8. At present, Ethiopia is one of the poorest countries in the world, with a GDP per capitaof $110, and at least a third of the population living below the absolute poverty line.

ExN nITURE POLICY IN TRANSIION.

9. In responding to these challenges, the Government aims to reduce Ethiopia's high levelof poverty by reallocating state resources to the rehabilitation of assets, provision of improvedsocial and economic services and creation and promotion of conditions that wiUl allow the privatesector to assume a central role in production, employment generation and broad-based economicgrowth. The current year's budget allocations reflect new trends in expenditure policy: sinceFY89, defense spending has declined from 25 to 8 percent of total budgeted Governmentexpenditure, while spending on infrastructure has climbed from 7 to 17 percent and that on socialservices increased from 13 to 23 percent. Allocations to the productive sectors have shown aparallel decrease.

10. Although it represents only a one year expenditure profile, the shift in aggregate sectoralallocations illustrates the new direction of expenditure policy in Ethiopia. Apart from mintaininglaw and order, the Government has stated its intention to focus, in futtire, upon the transport,health and education sectors, and within these: (i) road rehabilitation and rural roads; (ii) civilaviation infrastructure; (iii) rehabilitation of schools; and (iv) rehabilitation of health facilities.Should resources allow, expenditure will be allocated to the construction of newv schools andhealth facilities required to redress the uneven distribution of social services throughout thecountry. It is anticipated that public investment will also target medium- and large-scale irrigationschemes, and other rural infrat ructure in the agricultural sector.

11. Sustaining the new expenditure policy will require building upon recent initiatives torestrucxre and reshape the role of the state. In this regard, the Govermnent has stated itsintention to continue on its course of transforming its role from that of producer to that offacilitator of private production and growth. This will require intersectoral and intrasectoralreallocations of public expenditure that augment the gains of the past two years, specificallyfurther reduction in the expenditures on direct production in agriculture and industry, and parallelincreases in expenditure in transport, irrigation infrastructure, health and education. Thegovernment must also contiue to focus on intrasectoral reallocations which aim to redress theinbalance between wage and non-wage expenditures and between maiunen and newinvestment; and which aim at focussing expenditures within these key sectors on programs whichbenefit large numbers of poor Ethiopians.

12. Drawing the appropriate balance between redressing the country's significant socio-economic imbalances and addressing the pressing need for reconstruction and rehabilitation thatis the most obvious legacy of war is a particularly difficult issue for the TGE. In key sectors-atpresent including health, education and transportation but in future likely to include energy andother infrastructural sectors-the Govermment must choose between expanding services to includepopulations that have been traditionally underserved and maintaining the service facilities thatalready exist. In each case, the Government is faced with hard choices and will be challenged todefine priorities in such a manner as to ensure both economic and social sustainaility.

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A NEW RoLE FOR TE PRIVAIE SECrOR.

13. Sustaining growth rates at levels high enough to generate rapidly increased per capitaincome and consumption in the long term will require an investment to GDP ratio of at least 25percent. With governnent investment at about 13 percent of GDP, there is a need to vastlyincrease the levels of private investment. There is, therefore, an urgency to support private sectordevelopment. Although the fiscal deficit (before grants) remains a central long tern developmc.itissue, the government has, to its credit, controlled inflationary recourse to central bank financing.In addition, the 1994 budget provides for substantial reallocation o. public expenditure away frondefence and support to pubic enterprises towards the provision of public goods such as educationand health and economic infrastructure. This should help enlarge the role the private sector cantheoretically play in the supply of consumer and intermediate goods. But, given a small and weakdomestic private sector in Ethiopia, there is a need for active promotion of the private sector,both in its domestic and foreign forms.

14. In the absence of a unified national strategy for private sector development, Governmentprivate sector strategy is often interpreted on the basis of the decisions taken by line ministriesregarding the granting of operating licenses and the allocation of public land for specific tpesof economic activity. As the private sector itself is not at the forefront of the economic reformdesign effort, there is neither the data base to understand the mechanics of its operation nor theconstraints on its future growth. The degree of business confidence in the reform program, onthe one hand, and the ability to assess the level of risk in estinating future income stream fromany proposed investment, on the other, will be central determinants of private sector investmentin Ethiopia. While a stable macroeconomy is critical to the latter, Government needs to play amore proactive role in fostering this business confidence. To this end, some of the measureswhich need to be considered include: (i) the abolition of unnecessary licensing requirements infavor of registration for all private businesses with assets below a certain threshold; (ii) reviewingand amending the current Investment Code, as necessary, on the basis of implementationexperience gained to date; (iii) abolition of commodity-based trading licenses to registered privatebusinesses in favor of a general trading license; and (iv) reconstituting the management boardsof public enterprises with a view to increased private sector participation.

1S. The proactive role of govenmnent in the development of the private sector in Ethiopia willneed to be carried out in the context of a National Private Sector Strategy. This would be mosteffective if done in consultation with private sector investors, both domestic and foreign,opeating in Ethiopia, and in the context of extremely low levels of foreign direct investment. Inmapping such a strategy, some of the key issues which need to be dealt with include: (i) theestablishment of a national data base on private sector; (ii)assessment of the pace of theprivatization process; (iii) an examination of the current tax burden and incentive structure ondifferent categories of private business; and (iv) an analysis of private sector credit requirementsand of the feasibility of cash-flow, instead of collateral-based lending. As part of the privatesector development strategy, attention needs to be given to foreign private investment. Thisassumes an added importance in the Ethiopian context, given the anemic state of the country'sdomestic private sector, the relatively low levels of skill and "know how", and the need tostimulate medium and long term foreign direct investments to sustain the balance of paymentswhile reducing dependence on external assistance.

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IMPROVING EXPENDITURE EFFICIENCY

16. Withdrawal of government from productive sectors in favor of increased private sectorparticipation, and directing government resources to support social services and infrastructure,are positive steps for broad-based growth and poverty reduction. The effectiveness of publicspending can be further improved, however, by increasing the efficiency of expenditures. In otherwords, essential broad-based social services and infrastructure programs which were underfundedin the past will now benefit from increased allocations. However, future budgets must ensure thatessential activities within these sectors are funded appropriately, and the capacity to implementthem is adequate. For example, the overall ratio of the non-wage recurrent budget to capitalexpenditures has fallen in recent years from 120 percent in FY89 to 40 percent in the FY94budget; specifically, allocations for materials have been declining steadily. This has; contributedto the continued deterioration in the quality of government services. Some critical elements inimproving the efficiency of public expenditure policy are discussed below.

17. Civil Service Reform. The decline in the quality of government services in the past hasbeen exacerbated by the declining productivity of civil service. The policy of automatic hiringcombined with efforts to limit expansion in the wage bill resulted in a large and underpaid civilservice. The political and economic changes over the last three years, and the opening up ofprivate sector employment opportunities, has also led to the loss of capable and experienced civilservice employees. To reverse this decline in quality, the government has already made progressin wage reforms, the most importamt of which is an upward adjustment in the wage structure. Inthe medium term, however, given the overall revenue constraint and expenditure requirements,retrenchment of redundant employees, and, to a lesser extent, some rationalization of expenditurewill probably provide the only source for wage decompression and upward wage adjustment. ThePER Mission was unable to access comprehensive data on civil service employment and wagestucture, but a government review of civil service is currently underway to determine thepossibility and scope of further reforms in civil service. Therefore, a ful discussion of neededreforms in this area must await the government's study, as well as the outcome of thereassignment of some civil service employees from the center to the regions, which is also inprogress in the context of regionalization.

18. Budget Planning. To improve the efficiency of public expenditures, a number ofmeasures need to be considered. These include: (i) ensuring an appropriate balance betweendifferent categories of expenditure -wages and salaries, materials, and capital expenditures; (ii)improving the predictability of resource availability, and its natching with expenditures; (iii)improving the selection of investment projects. The main instrument for achieving theseobjectives could be a three-year rolling plan, under which a three-year budget framework isestablished, setting out the main budget parameters, including overall allocations for wages andsalaries, materials, and capital expenditure, as well as revenue estimates. Projects to be includedin the capital budget should be consistent with the respective sector strategy, and all projects,ongoing and new, would be subjected to econonuc appraisal as a condition for inclusion in thecapital budget. The estimated future operational and maintenance expenditures associated with acapital project should be part of project sulbmissions and should be entered into the recurrentbudget projections if the project is accepted. Such measures are essential for improved budgetaryplanning and can form the basis for further improvement in the budget process (eg. budgetingby program) with a view to a more efficient allocation of fiscal resources and higher budgetimplementation rates.

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19. Budget Transfers. The past policies of generalized subsidies have largely failed intargeting the vast majority of the poor. Further liberalizing agricultural policies, promoting smalland medium size private enterprises, encouraging labor-intensive technologies, and generallyproviding an enabling policy environment for private sector development are some of the keyalternative measures which will foster output growth, income generation and poverty reduction.In addition, an improved and expanded social services system with increased budgetary allocationand expenditure on primary health, education, and infrastructure will help improve hunu capital,reduce aspects of non-income poverty, and increase earning potential in the longrun.

20. Although it is recognized that social safety net progtams, which require substantial budgetsupport, are second best options to growth and improved social services, there are specialcircumstances in Ethiopia which require some direct targeting programs. The safety netallocations in the FY 1994 budget are, therefore, appropriate, particularly in view of the failureof past policies of generalized subsidies. More, however, can be done. In particular, the pensionsystem, which can be viewed as another means ot transfer, needs to be improved. Some of thespecific problems which need to be quickly addressed pertain to the long term viability of thesystem as well as to its administration, efficiency of management, and the rules andimplementadion of pension entitlements.

21. Other Measures. hnproving expenditure efficiency will also require that the Governmentundertake measures with regard to the use and provision of information, to coordination, and toimproving transfers. In the information field, data critical to prioritizing public expenditure islacking. With donor assistance, as necessary, the Government needs to identify data constraintsat the sectoral and program levels, to collect, monitor and analyze these data, and to establish,initially on a modest scale, a national computer network with ultimately all ministries linked toit. With regard to coordination, it is important that the Govermment improve coordination amongvarious government agencies at the national level, which are responsible for planning, budgeting,and management. At the sectoral level it is necessary to improve coordination as regards theharmony between the center and the Regions in matters of sectoral policies and programming.The Government must also re-orient donor coordination to ensure support for its new policies andinvestment priorities.

REGIONALIZATION

22. The 1993/94 budget was the first to be prepared in accordance with the newregionalization policy. Under the new arrangements, each region is required to submit a capitalbudget proposal through the Ministry of Planiing and Economic Development, and a recurrentbudget proposal through the Ministry of Finance. After appropriate iterations, these Ministriesare required to prepare a consolidated general Government budget for consideration by theCouncil of Ministers. These arrangements were incompletely operative during this, the first yearof official budgetary regionalization; as a consequence, the impact of regionalization on functionalcomposition of actual expenditure could be masked this year. In terns of the shares ofexpenditure falling within the central and regional budgets, approximately two-thirds of bothrecurrent and capital spending will remain the responsibility of Central Government, at least inthe short :erm; it is intended that recurrent spending, at least, should move closer to equality indue course.

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23. Despite the detailed articulation jf revenue instruments which have been allocated to theRegions, it remains unclear what levels of revenue they will generate. This has implications forthe type of transfer formulas (from the center to the regions) that are feasible and desirable; inparticular, such formulae will have to be capable of considerable short-run flexibility.

24. Another unresolved issue regarding the fiscal impact of regionalization is whethrEthiWopia will adopt a genuinely federal fiscal structure, constitutionally enshrined and with apartitioning of sovereignty between Central and Regional Governments. The stated intentions ofGovernment suggest that this is the desired outcome of the regionalization process, but prior tothe unveiling of the new constitution this intention rmains unfulfilled. Such a shift wouldcertainly represent a major break with Ethiopiaes historical traditions, and even with currentarrangements which, de facto, teserve overwhelming powers to the Center. Depending on howthis issue is resolved, two differtnt cpaestions become paramount.

25. First, within a federal structure, the crucial question is whether the Regions areadequately resourced. They must either have direct control over revemne instumencommensurate with their sovereign sphere of action, or have enshrined rights to equivalentlysubstanial shares of centrally-collected revenues. The mechanics of such an arageent arerendered more difficult in the Etiopian case by the extreme imbalance between the Regions, interms of their economic characteristcs, and the consequenti need for large interregionaltransfers. Additional problems may arise due to the potential difficulties of fiscal control by thecenter and the uncertainty of revenue mobilizaion by the regions. Second, within a unitary butdevolved state, on the other hand, the center retains a more direct responsibility for ensuring thata reasonably uniform provision of public services is maintained across the country. The crucialconsideration is the capacity of the center to deliver these services at arms length. In either case,however, and depending on the constitutional outcome, substantial additional work to ensme theefficient fumntioning of the devolved fiscal structure will be needed. This may be a key focus forthe next public expenditure review.

26. There are two other very important, but less appreciated issues. First, the idea that theRegional Governments can supplement their resources by establishing profitable enterprises is tobe discouraged. Such an approach would undermine the government's strategy to move towardsa market-based economy and its effort to promote development of the private sector.

27. Second, present thnking on transfers appears to reflect a separation between the capitaland recurent budgets. This is likely to make the functioning of the system more, rather thaless, difficult. Organizing efficient reltions between Center and Regions would be difficudtenough even if the vehicle were a fully-integrated budget at each level; the present nmehanism,where interaction involves separate budget components, and integration occurs only at the generalgovernment level, will make this goal harder to attain.

28. The critical characteristic of the CentraVRegional expenditure split, from the regionalperspective, is the extent to which the delivery of social services has become a regionalresponsibility. Attention should be given to the adequacy of the inter-regional allocation, and the(probably highly differential) capacity of the regions to implement programs. To the extent thatexisting implementation agencies remain in place at the point of delivery, these difficultes mayan the short-run be less acute at that level than at the higher, newly appointed managers' level.

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At best, this provides ? grace period during which the problem can be addressed. The wholeregionalization exercise is proceeding with major changes in policy regime preceding the creationof the institutional capacity to handle them. This is driven by a political imperative and reflectsthe present reality. Whether or not regionalization is successful, however, will depend to a greatextent upon whether timely action is taken to build the necessary implementation capacity.

SECJOR STRATEwiES AND EXPENDITRE PouICY

29. The context for the new sectoral policies and strategies is an overall development strategyof "agriculture-development-led-hndustrialization". The strategy is based on broadening theagricultural production base through improved productivity, over the short and medium term, andincreased land utilization, particularly in the lowlands, over the medium and long term. Policyfor the agricultural sector will be one of promoting private activities, while Govermnent's rolein the sector will focus mainly on afforestation, the provision of extension and research, andinfrsucture, particularly rural roads and imgation schemes.

30. Increased agricultural production, employment, and income will provide the impetus fornew manufacturing industrial production, primarily directed at fulfilling, to the extent possible,local demand for agricultural inpus and machinery. Such industries, however, will be allowedto emerge on the basis of comparatve advantage, utilizing labor-intensive technology, and,wherever possible, local raw materials. The import-substtudon approach is not an objective ofthis strategy, particularly in light of the failure of such policies in Ethiopia in the past. On theother hand, the promotion of exports will be an integral and essential component of the generalstrtegy. Here again, diversification of agricultural production, increased agricultural output, andexpanded mineral production will be the main elements for increased export-earnings in the shorttenm

31. The overall strat will require supportive policy shifts that will allow for thedevelopment of a healthy and educated work-force, which will require considerable investmentbefore results can be achieved. Specifically, priority emphasis must be placed on primaryeducation and primary health care, literacy and umneracy training for the non-school workingpopulation, vocational and technical training and, as resources increase, higher-level education.Government strategies in the social sectors appear to support the need for this type of investmentin human resources.

32. A key to the success of this, or any other development strategy in Ethiopia, however, isa reduction in the population growth rate. The " National Population Policy in Ethiopia" issuedby the TGE in April 1993 ahms at increasing the prevalence of contraceptive use from the curreat4 percent to 44 percent by the year 2015 and for reducing the fertility rate of 7.7 children perwoman to 4. The challenge is to implement this strategy effectively and to achieve its targetswithout delay.

AGRlcuLrm

33. Bacgond. Over the past ree deades, the agricultural sector has been in deep crisis.Agdcultral gowh averaged 2.2 percent per year during the 1960s, but dropped to 0.7 percentin the 1970s and stagnated at 0.5 percent in the 1980s. Performance in the early 1990s has beeneven less saisfactoy, with producion decling by 0.5 perent in PY 1992. lhe prnmay factorsinluencing dismal performance in the sector include: i) suppression of private sector initiatives

in the past; ii) outdated production techology in the dominant peasant subsector; iii) iadequateinfrastructure in nual areas; lv) poor linkage of research and etension services to productionactivities; and v) indequate support services, such as extenion and credit. Sectoral performancewas firther costained by recuremt droughts and, until recenty, armed conflict. PY 1993mared a strong recovery as sectoral grwth returned to a positive 4.5 percent. FY 1994 outputis likely to be seriouly affcted by drought and infestation.

34. The total area under cultivation has increased only margially from about 5.7 millionhectar in the early 1980s to an estmated 6 milion in the early 1990s, and less than 3 percentof cultivated lan is currently equipped for irrigpion. Further expansion of cultivable ltand wasuntil recenly contdad by Goverment policies which prohibited the development of additonalar and by the sector's depndence on rainfall. Crop yields have also stagnated at about I tonper hectare, a reflection of low fertilizer use, the highy-swed distution of other necessaryinpus and undedeveloped agre-tomic praices.

35. The availability of land for both crop and livestock production would not appear to bea constrain to increased agriculural production, although agriculural extensification wouldrequire massive investments, particularly in infrastructure, resoes for which are unlikely tobe available in the short and medim tem. Ethiopia's national territory covers about 113 millionhecaes of wbich 14 miHlln are classified as land udlized for crop production and 45 millionhectes as pasture and rangelands. The Master Lan Use Plan prepared in the mid-1980s showsa potental arable land area (defined as land with a dependable growing period in excess of 90days and with favorable soil ci) in the order of maiude of 55 million hecares.Loss of fertile land through soil oeosion, however, continues unabated and this poses a seriousthreat to land productivity and agricultural producin The highlands contnue to be pardcularlyvunerable and require udiae policies and meams for arrestng connued land degradation.Anoer equaly serious containt to agulurl development is recurrent drought, the effectsof which upon crop production could be redced by developing utapped irngation poteni.Improving yields, and intensificaton.

36. Setor Strategy. Goverment segy in the agricultural sector is to withdraw from mostproductive activities in favor of increased private sector participaon and to provide a policyenviromnent conducive to such parcipation, notably through lberalized tansport and marketingof inputs and outputs, and through addreing broader constaints to pfma sector activides. TheGovernment will focus its own activites on the provision of research and support services tosustin increased private sector productivity, including the promodon of techniques to reduceerosion through reforestation and the intoduction of improved practices through the extensionservice. In the short term, however, Government intends to condnue to be involved in the importand supply of goods and services such as ferdlizer and seeds, but only to the extent that theprivate sector respone is week.

37. In the immediate term, Govermment activities in the sector will focus on: (i) improvementin food security by developing peasant agriculture; (ii) completing ongoing projects and programsrdated to the rehabilitation and new construction of rural roads and irrigation infrastructure; (iii)strengthenin the environment for the competitive narketing of inputs; and (iv) privatization ofstate fars. Over the medium to long term, Government strategy for the sector will focus on thedevelopment of effective technology packages to be disseminated through the extension system;improvement of irrigation agronomy; development of medium- and large-scale irrigation schemes;and the promotion of improved rangeland livestock technology.

38. Expendtue Polcy. Public expenditure policy is expected to reflect those sectoralpriorities. The FY 1994 budget allocations for agriculture indicate progress towards consistencywith the Govermment strategy for the sector. As a percent of total goverment expenditures,allocations for the agricultural sector dropped from 21 percent in FY 1993 to 12 percent in FY1994; significantly, allocatiow reflect the fact that Government has shifted its role in the sectorfom one of engaging directly in production to one of supporting the activities of privateproducers. The allocations of expenditures within the agricultural sector have also witnessedimportant changes between FY 1993 and FY 1994. Expenditure on research, for instance,icreased from 6 percent of the agricultural expeniue budget to 15 percent; peasant agriculturedevelopment's share rose fr-m 50 to 75 percent, while state farm development dropped from 38percent to 7 percent. The agricultural budget for FY 1994 appears to be, therefore, supportiveof the new general policy and strategy for the agricultural sector, although a refinement of theproject content to further reouce government involvement in productive activities should beinoduced in future budgets, starting with the FY 1995 budget.

INDUSTRY

39. Background. Like the rest of the economy, Ethiopia's industrial sector stgnated overthe past two decades. This was primarily due to the inappropriate macroeconomic policies andstate-led industrialization strategies pursued by the previous government. Private sectorinvestment and activities in m were systematically discouraged with the result thatprvate enterprise were denied an opportunity to grow and develop throughout the 1970s and1980s. The manuacuring sector is, therefore, dominated bv a Mnmber of industrial publicepriss which together contribute about 75 percent of total value added in mamnfacturing and

account for 58 percent of total industrial wage employment. Up until 1992, when the TGEintduced a new Public Enterprises Act, all industrial public enterprises were managed ditecdyby several large sub-sector corporations under the sWervision of the Ministry of Industry. Thesub-sector corporations have been dissolved and individual factories have become separate legalentities with their own Boards of Directors and management.

40. In the short- to medium-term, the industria sector has the potental to grow at a ratemuch higher than that of the agricultural sector. It can sustain a growth rate of 8 to 9 percent peryear, which is in line with the average growth rate the sector achieved in the 1960s. Immediategrowth will likely be achieved through the improved utilization of existing capacity by allindustr enterprises, and especially by the privately-owned small-scale entprises' employmentgeneration, which now operate at about 50 percent. Over the medium term, the sector's growthcould be boosted by the realization of a large number of private investments in (prducing mainly finished consumer goods for the domestic market) which have been grantedinvestment certificates recenly.

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41. Sector Strategy. The Government's strategy for industry is to stongly encourage privatesector activity. A key policy goal for the Government will be to foster the creion of acompetitive envirornent for industrial activity, by encouraging establim of new privateenterprises, and ensuring tdat public enterprises compete with them on an equal footing. Nominalprotection, which has been sharply reduced in the past year will be reviewed firther over thecoming years, based on a study of effective protection. A number of unnecessary regulatoryconstainus on the private sector have been removed. The TGE inends to keep regulations underclose review to determine where further simplification can take place. The Government's strategystates that over the long term ownership of industry will be limited to a selected munber of keyestablishments, such as large-scale engieari and metallurgical plants, and large-scale fertilizerplants, which will operate under full managerial and financial autonomy. All other publiceneprises will be divested.

42. Consistent with this strategy, it is envisaged that the development of the industria sectorwill be largely the responsibility of the private sector. Although some state-owned enterprises willconinue to be major actors on the industrial production scene, they will be subjected to a hardbudget constraint, their operations will be commercial and autonomous, and their investment willbe largely fimded from their own resources or on a commercial basis. The policy of extendingprefereial treatn for state enterprises has been largely dbcontinued, and Government policiesas regard credit, land, and the supply of inputs are expected to be even-handed as regards privatevs. public ownership.

43. The Government will facilitate private sector participation, particularly in the developmentof labor-intensive industries, closely linked with agriculture, and which can compete in exportmarkets. Govermment investment in the industial sector will be phased out as on-going projectsare completed, and expenditure support for the sector will focus mainly on the provhion ofessential infiastmcture.

44. Exp_dIte Polc. In comparison with budget allocations during the pre-TGE period,the industrial sector's share of Capital Budget has been decreasing markedly since the TGEinduced the New Economic Policy in November 1991. Whereas the industy sector's share ofthe Capital Budget was 18.5 percent in FY 1989, it declined sharply to 9.8 percent in FY93 andhas been further reduced to 8.5 percent in the current fiscal year.

45. The above shift rflects Government's inht to reduce the size of public investnt inindustial activities and to encourage private industral investment. It is important to note that,in line with this policy, no new investment which was not in the FY93 budget was inchlded inthe FY94 budget. A number of investment projects, for which budgetary support had beenrequested, have either been postponed or shifed to public enterprises' own financing methods(usig their internal cash generation and/or commercial borrowing). It should also be noted,however, that progress on divestiture of industial enterprises has been slow and needs to beaccelerated. Furthermore, the contiued restrctions on private participation in some industrimpresents obstacles for private sector development.

EDUCATION

46. Bacground. After achieving rapid growth in enrollments at the primary, secondary, anduniversity levels between 1973 and 1983, the development of education in Ethiopia slowed downdrastically between 1984 and 1989. Since 1989, the cumulative effects of war and economic crisishave resulted in declining enrollments and deteriorating quality at all levels, with the mostdramatic deterioration at the primary level. In 1991-92, Ministry of Education estimates that thegross enrollment ratio in primary schools may have fallen below the 1987-88 level of 35 percent.If so, this means that Ethiopia now has one of the lowest levels of participation in Africa. Drop-out and repetition are also serious problems. It is estimated that only about 53 percent of grade1 enrollees move to grade 2, only 32 percent complete grade 6, about 27 percent fnish juniorsecondary, and a meager 11 percent finish grade 12. Despite the initial growth in schoolenrollments after 1974, the share of the total government budget allocated to education declined.After reaching a high of 17.2 percent of total expenditures in 1974-75, education expendituresfell to 7.2 percent of the total in FY1989.

47. The sector suffers from poor infrastructure conditons. It is estimated that some 1,160primary schools (about 15 percent of the total) were fully or partially damaged during the waryears. About 638 primary schools, mainly in Tigray and Amhara regions, have been targeted forrehabilitation in current and proposed projects in the Emergency Recovery and ReconstructionProject (ERRP). Other schools, especially those in the southern regions, are in a very poor stateof repair because of inadequate or non-existent maintenance for many years. The Ministry ofEducation estimates that more than 1600 schools nationwide urgently require rehabilitation. Otherproblems include shortages of materials, textbooks, and furniture as a result of declining reallevels of expenditure. In addition, virtually the entire primary school budget is allocated toteacher salaries, leaving very little for non-salary items.

48. Sector Strate. The new strategy for the sector includes the following elements: (i)regionalization and decentalizaion of decision-making, management and organization, includingresponsibility for financial allocations for primary and secondary education and the training ofprimary school teachers; (ii) reform of the curriculum to meet local needs, and a fu alchange in language policy. Instead of all schools being obliged to teach in Amharic, each regionwill now choose the language(s) to be used as the medium of instruction in primary schools,thereby giving children the opportAity to receive basic education in their mother tongue;Amharic and English will be introduced as subjects from grade S and English used as the mediumof instruction at secondary and higher levels; (iii) expanding access to basic education byincreasing the provision of primary schooling (to be divided into 4 years of basic and 4 years ofgeneral primary schooling) and giving renewed emphasis to adult education; (iv) correctigregional and gender imbalances by giving special assistance to previously deprived areas andincreasing the participation of females both in education and the teaching profession; and (v)Introducing cost-sharing at upper levels (upper secondary and higher), with priority forgovernment support given to prmary education and financial assistance (through scholarships,loans or work) for needy and deserving students.

49. Iixpenditure Policy. Implementing this strategy requires large increases in the share ofthe budget going to education. Allocations to all categories of education need to increase quickly,with the greatest increase going to primary education. In the FY1994 budget allocations to thesector increased substantially as the share of education rose from about 7 percent of the PY 1989

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budget to over 13 percent. Accompanying the dramatic increase in total government spending oneducation are some changes in the allocation of these resoures across subsectors. The share ofprimary education increased from 45 to 47 percent between 1992/93 and 1993/94, and that ofseonday education from 24 to 28 percent of the total education budget. The share of highereducation fell from 13 to 11 percent.

50. Although increases in the public expenditure allocation to the sector have been substantial,more may be needed. The changes as a result of the new policy of regionalization, inc!uding thedecentralization of educational management, and the use of local languages as the medium ofinstuction in primary schools will impose high, and perhaps, unsustainable costs. The emphasison cost-sharing, therefore, represents an important change in financing policy. Devising effectiveways to implement cost sharing will be done in parallel to other reforms in the financing ofeducaion, particularly at the upper levels. The introduction of cost recovery for studentaccommodation and food, for example, is an important first step, which could be followed laterby the grdual introduction of tuition fees. It is also important to note that while the Govermenthas significantly increased the share of primay and secondavy education in the capital budget,there has not been a commensurate change in the recurrent budget. While much of the capitalspening is for the rehabilitation of existing facilities rather than the building of new facilities,the future implications of capital investments in the sector must be ddermined now. At the sametime, the allocation of recurrent expenditure to salaries dominates the primary and secondaryschool budgets while the share allocated for textbooks and materials remains quite small,particularly in light of the fact that needs in this area will increase until such time as theregionalization policy (which in this case includes, for example, the provision of textbooks inlocal languages) is fully operational. Even if increases in allocations to the sector do mateialize,this may not be sufficient to address the most important issues of declining enrollments.Indications seem to suggest that demand-side considerations for declining enrollments may be assignificant as supply-side constraints. In this regard, the Ministry of Education study on regionalvariations in enrolments will provide inortant iput in future expenditure policy decisions toreverse the decline in enrollment ratos.

HEALTH

51. Background. Health status indicators in Ethiopia display a worrisome picture. High ratesof mer respiratory infections along with malnutrition, diarrhea and childhood vaccinepreventable diseases interact to produce childhood morbidity and mortality rates that are amongthe highest in the world. Estimates of the number of children dying within one year of birth varyfrom 110 to 150 per 1,000. Life expecancy at binh is less than 48 years. Over 80 percent ofwomen are illiterate, and among these less than 33 percent of their children have received anyhnmunizaton, less than 25 percent of births were attended, and the contraceptive prevalence rateis less than 4 percent.

52. The main problem in the health sector has been its emphasis on urban curative careinstead of rural primary care, focusing on preventive and public health measures. Other keyconstraints are; (i) low coverage; (ii) supply shortages; (iii) low allocations for facilitymance; and (iv) distributional inequities. According to aggregate service statstics,governmen lities recorded about 0.25 visits per person per year in the late 1980s and early1990s. This coverage has tended to decline even firther in recent years. It is estimated tbat,currntly, only 25 percent of the population is covered by providers of health care. Another

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problem in the sector stems from supply shortages. Throughout the 1980s the supply of drugs andother medical supplies continued to diminish. The shortage was exacebated by real per capitadeclines in government health expenditures from about 2.5 birr during the early to mid-1980s toabout 2 birr in FY 1991 and 1992, and a secular reduction in the share of these expendituresallocated to non-wage items from 40-45 percent in the early 1980s to about one-third since 1991.The supply of most skilled health personnel also declined during this same period. Most notablein this regard has been the shortage in the number of physicians, pharmacists, X-ray technicians,lab technicians, and the principal cadre of rural health station staff and health assistants employedby the MoH.

53. Little facility maintenance was undertaken during the 1980s and many facilities requiredeither full replacement or rehabilitation. During FY 1988-91, recurrent health expenditurescomprised less than 3.8 percent of the total government budget, the lowest share over the lastfifteen years. Further, govemment health expenditures have been less than 1.5 percent of GDPthroughout the period and in recent years averaged about one percent of GDP. These sharescompare unfavorably with Tanzania at 3.2 percent, Kenya at 2.7 percent and Zimbabwe at 3.2percent of GDP (all in 1990).

54. In addition to the noted rural-urban and facility-specific expenditure differential forpharmceutical and related medical supplies, there is considerable distributional inequity acrossthe new regions. Current data suggest that the range of per capita recurrent expenditure on healthvaries from ten to twenty fold, depending on the regional population estmate used. Whie someof the vaiance may be due to adjustments made to rectify prior inequties in expenditure andservice provision, and some may also be due to the lack of scale economies in providing servicesto low density and widely scattered populations, the size of the expenditure differences issubstantal.

55. Sector Stra. The overall strategy for the health sector emphasizes delivery of prmaryhealth services at the local level and includes rehabilitation of damaged service delivery capacity,improvement of quality through training, consolidation of capacity in existing functioning units,expansion of health services in areas that are presently unserved, expansion of maternal and childhealth and family planning services, and control of communicable diseases (especily malaria,uberculosis, STDs and childhood diseases). Moreover, the straegy recogns the importantcomplementarily between the health and education sectors. The extraordinarily low rate of femaleliteracy and, even more importandy, low female completion of primary school, is the singlegreatest impediment to better health and lower fertility in Ethiopia. This linkage underlies theexpanded maternal and child health and family planing program co-financed by the TGE andthe donors.

56. Government health policy will be implemented primarily through Regional Governments.In war-damaged and underserved regions, it is envisioned that rehabilitation of damaged ordeteriorated facilities and construction of the facilities required to achieve greater primary healthcare coverage will be undertaken rapidly. In other war-damaged areas, where coverage wasinitially higher, rehabilitation, and not extension, will be the priority. In the remainder of thecountry, the stategy would focus on improving the services in existng facilities. This policythrust is reflected in health facility rehabilitation and construction implementation plans for FY1993194. During FY 1994, about 13, 14 and 38 percent of all health stations, health centers, andhospitals, respectively, will be rehabilitated, and an additional 3 and 6 percent of new health

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stations and health centers, respecively, are expected to be constructed. The feasibility ofexpanding the number of Govermnent hospitals by an additional 17 percent, through altenaivesources of funding, will be assessed during the year as well. This will be coupled with revisingpricing, poverty certificate care, and other cost-sharing measures in all public institutions torationalize subsidies and enhance the financial sustainability of rural facilities.

57. Expenditure Pelicy. Prioritization of the strategy elements and the financial costassociated with each are yet to be developed. However, the FY94 budget allocates 6 percent oftotal Government (central and regional) recurrent spending to the health sector budget, asubstantial improvement over past allocations of about 3 percent. The effectiveness of tisimproved allocation is further enhanced by the reduced share of the recurrent budget to be spenton hospitals (41 rather than more than 53 percent spent on such facilities during the 1987-90period) in favor of rural health facilities. Within the recurrent health budget, expenditures onregional clinics and health centers increased from about 17 percent in FY 1989 to 31 percent inPY 1994. In terms of the capital budget, allocations in PY 1994 have increased to 5.2 percentof total capital expenditures from last year's level of 3 percent. In 1Y 1989, capital budgetallocations to the health sector were 2 percent of total capital expenditures.

58. While the increase in allocations to the health sector is indicative of the effort to improvequality of services, and of new Government conmitment to this sector, the health sector remainsunderfianced. Uerfinancing is further exacerbated by the fact that, according to MoHestimates, over 300 rehabilitated and 100 newly-constructed acilities will come on line duringthe next two to three yeas; it is thus estimated that the recurrent budget will need to increase byat least 30 percent over the FY 94 recurrent allocations just to maintin the present degree ofunderfinancin. Second, if the public health related PHC services now financed primarily bydonors are transferred to Government to fund, financing would need to increase by approximately12 percent over the present FY1994 level. In sum, the recurrent budget is seriously underfindedin the order of about two fold.

59. Goverment enditure policy for the sector appears consistent with its broad strategyelements. However, there is no disaggregated data available on the funding of specific activities(e.g. primary health care or particular programs of intervention such as immunizationcampaigns). Govermment has indicated that in future budgets, it will develop priorities within theoverall strategy for the health sector and allocate specific projected capital and recurrent financialamounts to each program element. Such priorities and a projected financial plan woud improvethe implementtion of a consistent allocation of scarce financial resources towards policypriorities.

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TRTANSFORT

Backon

60. Roads. Road density in Ethiopia is among the lowest in Africa with only 15 km per 1000square km. Large areas still lack all-weather connections to administraive and economic centers,and there is an evident case to be made for eading the road network into productive mralam. The public road network consists of just over 22,500 kn of main and rural roads. Of themain roads, about 3500 km are paved. The msndard of mral roads varies comiderably. Onvage, for all classes of roads in Ethiopia, about 65 percent of the road network can be

classified as poor - that is, deteriorated to the extent resealing (or re-gaveling in the case ofunpaved roads) is no longer a satisfactory egnering solution and some form of more expensiverabilation/reconstruction is required. Only 10 percent of the road network may be classifiedas in good condition, and only in need of routine and periodic mantenance. Accident statstcs,meanwhile, indicate that road safety is a major issue.

61. Qvd Aviation. The civil aviation sector is much more extensive in Ethiopia than in mostcounties in Africa. The size and topography of the country, combined with the very limited roadntwork, rendefs domestic air transport quite important. Edtiopia is served by one major

-Interational aiport and an extensive network of domestic airports and airstrips. The civil warruled in considerable damage to both the physical infrtruc of several domestic airportsand to the critical weakness of navigational, cmications and security systems within thecountry. Replaement of critcal spare parts and equipment for the civil aviation sector has beenfi.ed under ERRP, but this financing falls well below the needs of the sector, which has beenneglected, excpt for military purposes, for a very considerable period. Bole International Aiporthas receved very lte investment since it opened 30 years ago and now has sub-internationalstandard auside facilities and passenger facilities, which are congested at peak periods and thusret in ificient aift operations.

62. Raiways. The 781 km, meter gauge railway which linss Djilouti with Ethiopia wasconstructe around the turn of the cetury. In terms of normal railway operations, the -CDE-is not dsgned for heavy taffic. Trffic has either stagnated or fallen in recent years; over thepast ten years it has averaged about 0.3 million tons and i million passengers annaiy, or theequivalent of a daily flow f -,ss than 40 tmrcks and 40 buses. Despite its limited movementcapacity, the CDE has movea about 7 percent of Ethiopia's foreign trade during most of the1980s, and it serves an important local transport need between Dire Dawa and Dewhli, an areawhich has traditionally not had adequate road access but will soon be served by an all-weathergravel road being constucted by the Ethiopian Roads Authority (ERA).

63. Road Trasport Serices. Until late 1992, road freight transport was under the totalcontrol of Government. When the sector was deregulated the commercial trucking sectorconsised of roughy 8000 vehicles. The Ethiopian Freight Transport Corporation (EFFC) ownedand operated a relatively young fleet of approximately 1,000 heavy trucks, and the private sectorabout 6,000 vehicles of various sizes and an average age of over 18 years. In addition, largefRet wre also established by relief organiztions which ran a combined fleet of approxiaely1,000 trucks. The overall size of the fleet has been maginaly adeWquate, although sigificatpivate sector investm in new trucks and repair of old ones is envsaed. The passeansport sector is domiat by private operators although a public compay, the Ethiopian

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Pasenger Transport Corporation (PTC), also operates both inter-urban and urban bus services.After deregulation, bus operators were free to form their own associations and regulation of thesector passed from PnC to the Road Transport Authority. Passenger tariffs are still controlledby Government and, although present rates are affordable to the consumer, operational costs aresuch that there is no incentive for the private sector to invest in either new or replacementcapacity.

64. Marine Transport Services. Assab remains Ethiopia's primary port although it is nowoperated by the Eritrean authorities and the previous administration, the Marine TransportAuthority, has been dissolved. The parastatal Ethiopian Shipping Lines Corporation (ESL) is themajor liner servicing Assab; it owns 11 vessels with a combined DWT of 80,000 tons. Two ofits vessels are now almost 30 years old, while the remainder are less than 20 years. Theprofitability of ESL has been declining steadily since 1988 and it registered losses in both 1991and 1992, partly as a result of a significant drop in tonnage.

65. Transport-Related SerWces. Despite the Government Proclamation of May 1992announcing that private freight forwarding/clearing companies, shipping agents, and transportagents would be allowed to operate in Ethiopia, no operating licenses have been issued to theprivate sector. Clearing and forwarding and booking agency activities thus remain a de factomonopoly of the Maritime and Transit Services Corporation (MTSC). The profitability of MTSChas declined substantially and its latest financial statements indicate that it is only just breakingeven.

Sector Stratey and Expendr Policy

66. Road Ifrastructure. Government strategy for the sub-sector is to safeguard the existingroad n;rwork and expand rural roads. Given the limited financial resources, however, theseobjectives are in conflict in the short run. Government will, therefore, need to evaluate thedemands of maintenance versus expansion with regard to the relative merits of asset protection,on the one hand, and the need to reduce marketing costs, open new areas to production andensure equitable transport, on the other.

67. On average, the condition of as much as 65 percent of the road network in Ethiopia canbe classified as poor; poor roads are those that have deteriorated to the extent that resealing isno longer a satisfactory engineering solution and some form of more extensive rehabilitation isrequired. However, total real recurrent expenditure measured in FY93 constant prices havedeclined substantially. The FY94 allocation for road maintenance is only half of what is neededunder ideal conditions, while rural roads will consume close to 40 percent of the total sub-sectorbudget. Government recognizes that delaying work on maintenance will undoubtedly result inmuch higher cost in the future towards the restoration of the road network. Thus, the proportionallocated for new rural roads needs to be sharply reduced so it would average less than 15 percentover the next five-year period in favor of maintenance and rehabilitation. Correspondingly, amulti-year financing strategy for the road sub-sector should be developed. Starting with FY1995, the road maintenane component will be the fastest growing category in the sector. Viewedfrom a longer-term perspective, Government strategy elements for the subsector are to: (i)increase road maintenance allocations; (ii) eliminate the backlog of periodic maintenance over 7years; (iii) eliminate the bacldog of rehabilitation work over 10 years, and (iv) expand the ruralroads network in line with available resources.

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68. A feature of Govermnent strategy for the sub-seaor is the greater emphasis which willbe placed on participation by the private sector. The role of ERA will change; a key function ofthe Authority will be to regulate standards, plan, design, and manage contracts. The contractmanagement unit will be strengthened, and training will be required in selected fields such ascontract management and supervision, contract disputes and arbitration and procurementprocedures for works and services. Major works, such as new construction, rehabilitation andmost periodic maintenance, will be carried out by private contract. All rural roads activities willevenalaly be the responsibility of the Regional Governments. ERA will continue to carry outperiodic maintenance.

69. Civil Aviaon. Civil aviation and air transpon will remain under state control. Thestrategy for this subsector is to strengthen the domestic air transport system by improving keyairports and eventually expanding them to accept larger aircraft. The costs of the initialinvestments in the five airports are expected to be around birr 20 million per airport. Governmentexpects to direct the major expenditure in civil aviation infrastructure over the next few years toBole International Airport where large expendit will be needed to bring the airsideinrastructure up to standard. As for the landside investment, Government will explore low-costalternatives including the rehabilitation of existing facilities, in view of the very large costestimate and the competing public expenditure demands on Government resources.

70. Railways. Railways will remain within the state economic sector. It is apparent that thereare major issues that have to be resolved which concern not only transport efficiency but alsoEthiopia's transit security as a landlocked country. No investment in the CDE is scheduled forthe present year and a detailed long term investment program has not been prepared. A study ofCDE's short- and long-term requirements will be undertaken in the near ftmre with funding fromthe European Union. It is hoped that some increases in capacity, at modest investment cost, willbe identfied.

71. Road Transport. The Government strategy for the road transport sector is to foster thedevelopment of private operations in a competitive environment. The competitiveness of thetrucking market and the ability of the private sector to charge commercial prices for truckingservices is key to realizing increased private investments in the sector. EFTC, which still has asubstantial market share, however, continues, in some instances, to undercut private pricing andundm intended policies. Government intends to withdraw from this sector by progressivelyselling EFTC fleet, but will continue to provide assistance to areas served by very poor roads andwhich thus face very high transport costs. Apart from this, EFTC and PTC will be required tooperate on a commercial basis.

72. Marine Transport. Aithough Government assumes that private participation in the marinesector is unlikely, the strategy for the sector will place no restriction on such participation andwill require ESL to act as a commercial enterprise without government subsidy and to obtaininvestment funds from the commercial sector.

73. Transport-Related Services. Government strategy will consist of rest rng MTSC andthen alUowing it to compete with private companies. There will be no major investment in MISC,save Japanese grant-funding of some handling equipment.

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CoNs NCY BrwEEI STRATEGIES ANm ExPENDnTRES.

74. The overall direction of strategies for the sectors appears to be on the right track, andpublic funding is generally consistent and supportive of the sector strategies. Within the sectors,however, the funding has yet to match with the sectoral priorities. In part, this is due tocompeting demands in the social and infrastructure sectors for the creation of new assets, on theone hand, and rehabilitation of existing assets, on the other. In some sectors, for example,although the strategic position is one which stresses the preservation of existing assets as toppriority, new investments are initiated and the allocated expenditures for maintenance fallsignificantly short of meeting objectives. This is explained partly by the fact that a one-yearbudget does not reflect the medium- to long-term orientation of sectoral expenditure policies. Inother sectors, allocations for operauions and maintenance have fallen lower as a ratio of totalinvestments within the sector. Again, this can be explained in the context of existing budgetypractices, where ongoing projects are automatically afforded funding priority, and maintenance,as a result, is allocated a residual amount. These seeming deviations from the strategic outlookof the different sectors must be corrected in future budgets as projects under implementation areconmpleted and as the three-year rolling plan is introduced.

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U. REFORM MEASURES (FY9419S AND 95196)

ltroduction

A. FY94 budget signalled a significant shift in the emphasis of public expenditure policy inEtiopia. Allocations for defence spending continued to decline, while those on "core"govenmnent activities, most notably infrastructure, education, and health increased significanly.At the same time there was a noticeable attempt to reduce government involvement in productivesectors. Allocations for the industrial and agricultural sectors, in general declined.

Broad Policy Issus.

B. At about 19 percent of GDP (excluding grants) the budget deficit continues to be verylarge. Although non-inflationary financing of the deficit has been achieved, medium and longterm sustinability of the budget deficit must be treated as a central issue. Government,therefore, will intensify resource mobilization efforts and put them in place as soon as possible,in the context of a medium term plan for a sustainable fiscal deficit, to mitigate a possible fiscalcisis over the medium tenn.

C. As for the expenditure policy, the broad focus of Govermment over the immediate andmedium term will cover the following issues:

D. First, although government expenditure on core activities has increased, funding ofpriorities within these sectors needs further improvement. In the Education sector, for example,the funding of material and supplies continues to be deficient. The same is true of the roadtransport sub sector, where funding for maintenance continues to be inadequate in view of themassive backlog of periodic maintenance and rehabilitation works.

E. Second, despite the reduction in allocations for productive sectors, such as industry, andthe State Farm subsector in Agriculture, significant resources continue to be devoted to"productive activities" in such sectors, and, therefore, furEter reductions could be realized. Thereduction in allocations in these sectors ina the FY94 budget will be viewed as the beginning ofa phased approach towards a comprehensive withdrawal of goverment from such activities. Theobjective is to cease government involvement in sectors where it does not have a comparativeadvantage and free public resources for more urgent needs, which crowd-in, rather than crowd-out private investments.

F. Third, it is crucial that the issue of private sector environment is addressed. Presently,public investment in Ethiopia is about 10 percent of GDP (if we take into account the averagecapital budget implementation rate and account for non-nvestment expenditures in the capitalbudget). Figures on private investment are less accurate, but at any rate are unlikely to exceed3-4 percent of GDP. With limited public resources, and the need to sustain growth rates overthe medium term of at least 6 percent (given a population growth of 3 percent), total investmentneeds to be in the range of 25 to 30 percen of GDP. Private investment, therefore, needs to riseto at least the range of 15 to 20 percent of GDP. Achieving such rates of private investment isa difficult matter. It is furfther complicated in the Ethiopian context, given low saving rates am

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a private sector with dismal investment tradition (as opposed to speculative/trade activities).Presently, foreign savings, in the form of grants and loans provide for the financing of thesignificant investment/savings gap. It is thus particularly important, if Ethiopia is to reduce itsdependence on official external financing, that domestic savings are mobilized and private foreigninvestment encouraged. This effort will be complemented with policies aimed at improving theoverall envirownent for private sector development.

G. Finally, putting the correct policies in place is an important step. However, it is not verymeaningful unless these policies are implemented. In this regard, strengthening theadministrative capacity of implementing agencies is crucial. This is particularly so in view of theregionalization process.

Broad Measures for lIorporation in FY95 Budget and beyond.

H. To consolidate the gains already achieved in the reorientation of public expenditure policyand help achieve improved efficiency of expenditure policy, a number of recommendations andmeasures will be implemented in this coming fiscal year and subsequent years. These includethe following:

1. A. Allocations for Operations and Maintenance:

(i) During the course of FY95, the Government will identify priority fimctionsand programs within each sector, estimate their funding re,unents, andallocate funds in indicative future budgets to sustain such fimctions and programs.This has to be done both functionally, and sectorally with a view to establish the"correct mix" between the capital outlay of the project and their O&M cost andensure the sustainability of the project. The development of "norms" for non-wage O&M for all sectors will be completed (with assistance from IDA) duringFY95, and incorporated no later than the FY96 budget.

(ii) For FY1995, this can be done quantitatively for some sub-sectors (eg. roadsub sector, where it would appear that the ratio of O&M to capital outlay shouldincrease significantly), and projects, and programs for which recent economicappraisal exists. But in most instances it will have to be done "subjectively"because unit cost data is largely absent. The FY 1995 budget must reflect,therefore, some significant increases in the allocations for O&M.

B. Productive Sectors: For FY 1995, the Government's current stance of notembarking on new "productive" inv em, particularly in the industial sector wherethe private sector can play the dominant role, will be maintained. Government will alsoidentify additional projects/programs and the time horizon for phasing out public fundingin sectors where government intends to reduce its involvement.

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C. Civil Service: The Governmnent is in the midst of preparing its study on thesubject. Based on available data, analysis indicates that there is a strong case forincreased wage rates. Although some of the increase in the wage rates will be financedby reductions in aggregate civil service employment, estimates of net effect of payincreases and retrenchment of civil servants are yet to be completed, but indications areit will result in a net increase in the wage bill. Government will introduce, beginningFY95, pay increases and retrenchments with financing obtained either through increasedrevenue mobilization or a reduction in allocations to productive sectors. No increases inthe wage bill will be financed at the expense of further squeezing out O&M, or byincreasing the deficit and its financing. If necessary, a phased approach for the salaryincrease will be adopted (i.e spread the cost over 3-5 years).

D. Public Investment Program:

(i) For FY95 the Government will introduce a three-year rolling investmentplan. The process of 'qualitatively' assessing the project content of the PIP,which was put in place last year, will be reinforced with quantitative assessmentbeginming with FY95. Within the next three years, all projects in the PIP wouldhave undergone economic appraisal. Those projects which will be included in thePIP must have an estimate (which will be gradually made more accurate as perpoint A above) of the recurent cost arising. The totals of the investment oulayand the recurrent cost associated with it must match available resources, andMinistries must present and defend a priority-based list of programs and projects,which is consistent with the sectoral strategy. MOF and MOPED will then cut"non-priority" projects if funding is short of needs. In the course of the year,the project appraisal process nmst be strengthened, if necessary with IDAassistance. Also, Ministries will be instructed to start preparing data on theirpriority programs and projects, if they are to make a stronger case for includingthese in future budgets.

(ii) For FY95, all projects and programs above 10 million birr, which number76 and account for more than 50 percent of the total capital budget, will beappraised before inclusion in the budget. The large number of projects in thePIP, which have not been appraised is a serious problem across sectors. InFY94, for example, 94 percent of all agricultural programs and projects above1.3 million birr each, were retained in the FY94 budget from the FY93 budget.70 percent of these never had a feasibility study. This problem which is commonacross sectors is particularly acute in the agricultural sector.

E. 'Transfer System: The elimination of most direct and indirect subsidies, whichfailed in the past, and the introduction of a limited Social Safety Net (250m birr in FY94or 3 percent of total budget) for retrenchees, orphans, and displaced soldiers andrefugees, is a reasonable approach and is consistent with Bank recommendations.Improvements, however, may be necessary with regard to the pension system, which canbe viewed as a component of a broad social safety net. The main problems are presentedin the PER, and they include the system's coverage, administtion, and efficiency. TheGovernment will produce a comprehensive study pertaining to these problems andproposals for addressing them during FY95 for incorporaion in FY96.

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F. Regional Devolution: Depending on the outcome of the new Constitution, therevenue/expenditure functions of the regions will have to be reviewed, and Govenmentwill put in place a clear and tranparent transfer fomWula from the center to the regions.To strengthen the knowledge base and assist the Govenmment in this area, the Bank,during FY95, will expand the study on this subject (chapter 4 volume II) and provide thenecessary advice for incorporation in FY96 budget. In the meantime, a very importantaspect of the devolution of significant expenditure funcions to the Regions, is ensuringthat the implementation capacity at the Regional level is strengthened, in line with itsincreased responsibility. This is particularly relevant for the social sectors, whereimplementation will be primarily the fimction of Regional Governments. In this regard,the Government will strengthen the regional capacity-building program it has put inplace, and continue efforts at enhancing its effectiveness.

Sectoral

J.Agriculture

A. Expenditures on productive activities have been reduced in FY 1994, but thereis still room for further reductions. There will be zero allocations, or very close to it,on the State Farm sub-sector in FY95, with the corresponding "savings" allocated toresearch/extension/irrigation.

Industry

A. For FY95, the share of the sector as a percent of capital expenditures will bereduced from 8.5 to 7.5 percent. For FY96, budgetay funding of the sector will besharply cut as "pipeline" projects are completed, while no new industrial projects will beintroduced. The bulk of activity in the sector will be left to private investors.

ENducaton

A. The cost of the new (multilingual) education policy and the recurrent cost arisingfrom the large capital investments will be estimated.

B. Allocations for supply and material cost, which are curently 6 percent of therecurrent budget for the sector, will be increased while keeping the sectors' wage bill toa minimum.

C. The budgetary burden of the sector will be reduced through: (i) allowing privateparticipation in the sector; (ii) keeping teacher hiring to a minim;m and (iii) introducecost-sharing measures at the upper secondary and higher education levels.

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Health

A. Allocations to the recurrent budget of the sector will be increased to eliminateunderfunding of current allocations. (In a phased manner starting with FY95).

B. Clear priorities of programs within the sector will be introduced in accordancewith the sector's strategy and the cost of funding will be estiniated. (during FY95)

C. Alternative financing sources of urban hospitals will be sought in favor ofincreasing allocations for rural health facilities. (during FY95)

Transport

A. Roads: Allocation for the sector will be doubled (phased over three years startingwith FY95), and allocations for maintenance will be increased starting with the FY95budget. The medium term target ratio of O&M will be 1:2 instead of 1:12.

B. Railways: No major investment in FY95 is envisaged.

C. Civil aviation: Cheaper alternatives and encouragement of private financing forthe land side investment of Bole International Airport will be sought. The projectwill also be spread over several years to minimize its budgetary impact.

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Specfic Meses Agreed For Jucorporat In FY95 Budget.

Sector Measure from to

AgricWture ElMiminate allocation to the 26m 0State Fas subsector.

Industry Reduce the sector's allocadon 8.5 % 7.5%as a share of capital budget.

Education bncrease overall allocation 6% 9%for supply of materials as %of education recurent budget.

Increase allocation for supply 2% 3%of materials for prim schoolsas % of recurrent budget for thesubsector.

Health Increase the sector's recurrent 6% 6.5%budget aUlocations by at least15% in nominal tenms.

Roads Increase total allocations to 11% 14%the subsector by at least 40%in nominal em.

Increase the ratio of O&M to 1:12 1:10capital expenditures.

The net effect of the combined msurs above on the total budget is estimated to producean incrase of about 500m birr in nominal tms. Tis is well within the expected nominlincrease in the FY95 budget.

BnwABUDGETARYAUA)CATXM

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RBCURREN4T CAPITAL TOMA_FY89 FY93 FY94 FY95 FY89 FY93 FY 94 FY95 FYII9 FY93 FY94 IFY95f

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