August 10, 2006

Document of the World Bank

Report No. 33115-DJ

Republic of DjiboutiCountry Economic Memorandum

(In Three Volumes) Volume I: Summary Report

Social and Economic Development GroupMiddle East and North Africa Region

Unlocking Djibouti’s Growth Potential: The Road AheadPub

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REPUBLIC OF DJIBOUTI Country Economic Memorandum

Summary Report

Table of Contents

Introduction ....................................................................................................................... 1 Country Background ........................................................................................................ 3 The Growth Challenge ..................................................................................................... 5 Critical Bottlenecks to Growth ........................................................................................ 6

Conclusion ....................................................................................................................... 19 Growth Strategy: The Road Ahead .. ............................................................................... 7

Vice President: Christiaan Poortman Country Director: Emmanuel Mbi Sector Director: Mustapha K. Nabl i Sector Manager: M i r ia Pigato Task Team Leader: Paloma An6s Casero

ACKNOWLEDGEMENTS

The report was prepared by a core team comprising Paloma A n o s Casero (Task Team Leader), Ganesh Kumar Seshan, and Ingrid Ivins, and benefited f rom parallel analytical and sector work led by Jean-Charles Crochet (Transport Sector Review) and Anna Bjerde (Power and Water). Kouassi Soman, Omer Karasapan, Sameh El-Saharty, Fatouma Toure Ibrahima, and Carmen Niethammer provided useful comments. Mustapha K. Nabli, Carlos Silva-Jauregui, Emmanuel Mbi, Gaiv Tata, Habib Fetini, and M i r i a Pigato provided helpful guidance. Muna Abeid Salim and Khal id Alouane provided valuable support in the production o f the report. Helene Talon translated the manuscript into French. Within the Bank, the report was formally reviewed by Edgardo Favaro and Pedro Alba.

Valuable support f rom the counterpart team in the Ministry o f Finance, Economy, and Planning i s gratefully acknowledged. The counterpart team was led by Simon Mibrathu, head o f the External Financing Division, and Nouh Omar Miguel, senior technical adviser to the Minister o f Finance. Strategc guidance was received from M. Awaleh, director o f Cabinet, at the Prime Minister Office. In April 2006, a preliminary version o f this report was discussed with high-level government officials, including: the Minister o f Finance, Economic Planning and Privatization, H.E. M. Ali Farah Assoweh; the Governor o f the Central Bank, H.E.M. Djama Mahamoud Haid; the Prime Minister’s Director o f Cabinet, M. Mohamed Ahmed Awaleh; the Secretary General, at the Ministry o f Finance, Economic Planning and Privatization, M. Mohamed Abdi Dougsieh; and the Secretary General at the Ministry o f Employment, M. Ali Yacoub Mahamoud. The report was also discussed with senior technical staff f rom the Central Bank and the Ministry o f Finance. In particular, we are indebted to: Almis Mohamed Abdillahi, head o f the Budget Directorate; Simon Mibrathu, Director o f the External Financing Directorate; Mar iam Hamadou Ali, Sub-director o f Planning, at the Economy Directorate; Ide-Souleiman Abdi, advisor, at the Budget Directorate; Mohammed A. Cheik, Treasury Directorate; Said Ismael Hassan, sub-director o f Debt at the External Financing Directorate; Aboubaker Houssein Doualeh, Head o f Disbursements, at the Directorate o f External Financing; Amina Ibrahim Elmi, economist, at the Directorate o f External Financing; Mahdi Darar Obsieh, head o f the Debt serving department, at the External Financing Directorate; Abdil lahi Guedi Iltireh, Director, Finance Directorate; Othman Moumin Badar, Director o f Statistics; Salah Waiss, Sub-Director o f the department on c iv i l service employment data. The report, particularly the chapter o n Finance, benefited f rom comments from: Ahmed Osman, Executive Director; M a l i k M. Garad, Head o f the Research and External Relations department at the Central Bank; Ali Daoud Houmed, Head o f the Financial Information department at the Central Bank; Fathia Mohamed, economist, Financial Information Department; Rahma Abdi, economist, Research and External Relations department.

The report also benefited f rom earlier reports by colleagues at the International Monetary Fund (IMF) in the Middle East and Central Asia Department (Ugo Fasano, Jemma Dndi, and Emmanuel Kumah). Comments f rom the resident representatives o f international partner institutions in Dj ibout i are also acknowledged (particularly the IMF, European Commission, Uni ted Nations Development Program [UNDP], Uni ted Nations Children’s Fund [UNICEF], Wor ld Health Organization [WHO], U.S. Agency for International Development [USAID], and Agence Franqaise de Cooperation [AFC]. Finally, the report benefited f rom useful discussions held during the field mission with Dj ibout i officials and managers o f public enterprises and private f i rms. Their ideas and views have been instrumental in shaping the scope and contents o f this report.

SUMMARY REPORT

INTRODUCTION

Djibouti is at a critical historical moment. After a decade o f polit ical unrest and c iv i l conflict and high economic volatility, the country has enjoyed a sustained period o f macroeconomic and political stability. On April 8, 2005, Djiboutian voters reelected their president for a second six-year term (constitutionally his last). H e appointed a career c i v i l servant to improve fiscal management and adopt a more participatory approach to build consensus o n pol icy reforms. The president and the new government have a clear vision o f the country’s growth potential. Djibouti’s long-term vision was articulated in the country’s Poverty Reduction Strategy Paper (PRSP). The PRSP was prepared following a countrywide consultative process and was endorsed by the Boards o f the Wor ld Bank and the International Monetary Fund (IMF) in June 2004. Dj ibout i pol icy makers would l ike to see their country become a regional trade and service center drawing on i t s comparative advantages: strategic location, polit ical stability and a natural deepwater port.

Djibouti’s fundamental development objective is to rapidly improve living conditions of its population and meet the Millennium Development Goals by 2015. T o achieve i t s development objectives, the government has taken some critical policy choices: be an open economy (with liberal banking and commerce regimes) while maintaining a fixed exchange rate regime; be a service-oriented transit center (taking advantage o f the port’s natural strategic location and i t s increased geopolitical importance) while recognizing the country’s weak resource endowment; and, as a post-conflict country, Djibouti-policy makers also recognize that there i s a need to consolidate peace and social stability (reintegrating demobilized combatants and sharing o f benefits o f peace across al l groups in society).

Yet, as this report argues, Djiboutipolicy-makers are caught in a dilemma. On the one hand, they would need to maintain macroeconomic stability and fiscal sustainability over the medium- term to sustain growth and poverty reduction efforts. On the other hand, with growing demographic pressures and the current l o w levels o f service delivery, i t i s clear that meeting the MDGs will require a substantial increase in public expenditure. The report illustrates this dilemma by showing the implications o f achieving the education MDG .Given the current service delivery levels (with gross enrolment rate o f 53 percent and a primary completion rate o f less than 60 percent), present levels o f teacher salaries and efficiency o f public expenditures, if the government i s to attain the education MDG by 2015, the education sector will face a substantial financing gap (estimated average annual deficit o f about DF 2411 million). Whi le the donor community can help the government in Dj ibout i in financing i t s public investment needs it cannot finance current expenditures, particularly teacher salaries. The report points to alternative pol icy reforms that could help the Dj ibout i authorities in solving this dilemma.

Two important recent developments provide the government of Djibouti with a good opportunity to materialize its vision. First, Dj ibout i has recently benefited from a sharp increase in military-related revenues f rom France and the United States that helped maintain macroeconomic stability. These revenues increased from about 2 percent o f GDP in 2001 to 6.3 percent in 2004, and they are expected to remain at 2004 levels for the next 10 years. Second, the Emirate o f Dubai has played a growing role in the Dj ibout i economy since the early 2000s, taking advantage o f the country’s privileged location. In 2001 the Dubai Port Authority was given a 20- year contract to manage and operate Djibouti’s port and airport. In 2004 Jebel Ali Free Zone International was given a 30-year franchise to run Djibouti’s Free Zone. In early 2005, the Dubai

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Port Authority was awarded a 21-year contract t o run Djibouti’s customs. A subsidiary o f Emirates National Oil Company i s constructing an o i l terminal in Doraleh and intends to invest about US$300 mi l l ion (about ha l f o f Djibouti’s GDP) in building a new deepwater port and free zone. These developments provide a unique opportunity to accelerate pol icy reforms aimed at improving the country’s prospects for growth and j o b creation.

The main message emerging from this report is that, in the absence of sustained structural policy reforms, Djibouti will not reap the benefits of recent windfall revenues and will remain locked in a trap of slow growth, high poverty, and high unemployment. The recent windfal l in military-related revenues and new investments in the port may have a l imi ted impact in the rest o f the economy in the absence o f pol icy reforms. Increased poverty and unemployment i s the legacy f rom almost two decades o f slow growth, lackluster private investment, and a fast-growing unslulled labor force. Maintaining the status quo, or muddling through, would at best lead the country to grow at 3.5 percent per year over the next decade. With annual population growth averaging 2.8 percent, this economic growth will be insufficient to make a substantial dent in poverty. By contrast, sustained efforts to implement key pol icy reforms proposed in this report could help Dj ibout i achieve an average real GDP growth o f 4.5 percent, reach the education Millennium Development Goal (achieving 100 percent primary completion rates by 20 15), and strengthen the confidence o f private investors and donors.

This Country Economic Memorandum (CEM), the first carried out in Djibouti since 1991, provides an analytical contribution to the government’s growth strategy. B o t h the government (in i t s PRSP) and the Bank have articulated the need for greater understanding o f the growth process in Djibouti. In the past 15 years, the Bank has not carried out detailed analysis o f Djibouti’s investment climate, labor markets, or financial sector (such as standard Investment Climate Surveys and Financial Sector Assessment Reports). Thus, this report f i l l s a knowledge gap. I t sheds light on a number o f questions that feature prominently in Djibouti’s current pol icy debate: What are the sources o f long-run growth (growth-sustaining factors)? What are the most binding constraints o n short-run growth (growth-accelerating factors)? Which sector(s) should Dj ibout i expect i t s growth to come from? What roles should the state and the private sector play to address current government and market failures that deter growth and j o b creation?

The main purpose of the report to inform the policy debate on the growth reform agenda in Djibouti. Given the government’s init ial pol icy choices, the report aims at explaining the inevitable trade-offs and explaining what policies need to change to meet Djibouti’s fundamental development objectives. When data permit, it assesses their potential economic and social impacts as wel l as their polit ical and administrative feasibility. Some o f the reforms discussed in the report can be implemented in the shorter term; others are longer term. But the report stresses that the reform efforts need to begin soon.

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COUNTRY BACKGROUND

A small and resource-poor country with a main asset-its strategic location

Djibouti is a small, resource-poor country of 23,200 square kilometers, strategically located at the Horn of Africa at the southern end of the Red Sea. . Dj ibout i i s poorly endowed with natural resources (limited arable land, rainfall, and underground water). Djibouti’s population i s estimated at 700,000, o f which 84 percent l ive in urban areas. Dj ibout i i s essentially a city-state- about two-thirds o f town dwellers l ive in the capital city. The hinterland, an extension o f the deserts o f Ethiopia and Somalia, i s sparsely occupied by a poor pastoral and nomadic population. Dj ibout i has a large expatriate community o f foreign military personnel, technical assistance staff and their families, and private business personnel. Dj ibout i has a relatively young population, with about 40 percent under age 15 and only 15 percent over age 40.

I n spite of considerable investments made over recent years in improving the education and health status of its population, Djibouti’s human capital base remains weak The country’s education and health standards are below MENA and Sub-Saharan Afr ican standards. The literacy rate i s estimated to be approximately 57 percent. The gender gap i s wide: w h l e 73 percent o f men older than age 10 are literate, only 45 percent o f women in the same age group are literate. Households with lower levels o f education are at a higher r i s k o f being poor: a one-year increase in the average education o f the household reduces the probability o f the household being poor by six percentage points. Enrollment ratios are s t i l l low. Only 55 percent o f students 6 t o 11 year o ld complete primary schooling. Children f rom poor households are the least l ikely to be in school. Health indicators are also below regional standards. L i f e expectancy at birth i s l o w at 49 years. The infant mortality rate, at 85 deaths per 1,000 l ive births, i s one o f the highest among Middle-Eastern and Sub-Saharan countries. Diarrhea and malnutrition together constitute the leading cause o f death among children under age 5. High maternal mortality, estimated at 570 deaths per 100,000 l ive births, i s attributed to high fertility rates, anemia caused by malnutrition, and the widespread practice o f female genital mutilation.

The country’s main asset is its strategic location. Historically, Djibouti’s strategic location at the southern entry to the Red Sea has proven critical for foreign military operations in Afr ica and the Middle East. Dj ibout i hosts the largest French foreign legion base outside Europe-about 8,000 French military personnel and their dependents. Since 2002, the country also hosts the only U.S. air base o n the African continent. The presence o f foreign military personnel has brought significant budgetary support to the government and has generated employment opportunities in low-skil l jobs (housekeeping, food service, construction services, and security). The strategic location o f Djibouti’s port o n the Red Sea’s international shipping routes, at the crossroads o f Asia, Europe, the Gulf region, and the A f i x a n hinterland, offers a comparative advantage as a regional hub for international trade, telecommunications, and finance services. However, because o f high production costs (transport logistics costs, high labor costs, and the high cost o f local finance); a paucity o f skilled workers, and infrastructure deficiencies, Djibouti’s potential as a regional service hub has not been fully tapped.

A service-oriented economy with a segmented labor market and little productive activity

Since its independence from France in 1977, Djibouti has evolved from a nomadic pastoral tradition to a more modern but dualistic economy. The economy i s characterized by a dualistic, segmented labor market, with the formal sector formed by a bloated public sector administration and a handful o f foreign-owned businesses. This formal sector contrasts with the growing

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informal sector, made up o f small entrepreneurs and unskil led workers, most involved in construction and trading activities.

Local production remains limited, owing to the arid climate, high production costs, and the paucity of skilled workers. There i s l i tt le natural agncultural and mining potential and only one major manufacturing plant-a Coca-Cola bottl ing facility that also produces bottled water. The country’s small internal market and high factor costs limit i t s manufacturing potential. The tertiary sector dominates the economy, contributing nearly 70 percent to gross domestic product (GDP), concentrated on services provided to the expatriate community and on trade with neighboring countries.

Djibouti faces the constraints of most small states-vulnerability to shocks, high reliance on external aid, and limited production capacity. The country depends heavily on external aid, which finances more than 80 percent o f public investment. Merchandise exports o f local origin are insignificant, and the country relies almost entirely o n imported food and consumer goods. I t s main sources o f foreign exchange earnings are official grants, mi l i tary aid, receipts f rom services to the expatriate community, and port revenues from re-exporting goods to foreign military personnel and neighboring countries.

A rent-based economy with a highly skewed income distribution

Djibouti is essentially a rent-based economy,* with rents deriving from its strategic location: military revenues, foreign aid, and port receipts. Foreign aid per capita, at about US$77, i s among the highest in Sub-Saharan Afnca. The country’s security and i t s strategic location are also attractive for military purposes. Dj ibout i has France’s largest overseas military base. The base provides a staging post between France and i t s outposts in the Indian Ocean, Afnca, and the Middle East. In 2003 France agreed to pay US$34 m i l l i on (about 5 percent o f GDP) annually until 201 1 for the right to station troops in Dj ibout i and use various facilities. More recently, in the wake o f heightened security concerns in the region, Djibouti was chosen by the United States and i t s allies as a strategic base for their military operations. A German naval base was established in March 2002 to monitor sea traffic between Somalia and the Arabian Peninsula. In October 2002, the United States signed a military agreement with the government o f Dj ibout i to provide budgetary support (amounting to 6 percent o f GDP per year) in exchange for stationing i t s base in the country. The US. Agency for International Development (USAID) has recently opened an office in the country. As a result o f i t s new geopolitical strategic importance, Dj ibout i n o w receives more development aid f rom the United States than any other country in Sub- Saharan Afnca.

’ The theory o f rent-based economies dates to the classical economists Adam Smith and David Ricardo, who in the late 18th and early 19th centuries described rent as a distinct source o f income. Classical economic theorists argued that rentier states benefit from the rent without contributing any effort to obtaining it. For rent-based economies, rents (wealth) are windfall gains, unlike conventional economies where reward is integrated in a process as the end result o f a long, systematic, and organized production circuit. Not al l economies qualify as rentier states. Buchanan (1960) eliminates ambiguity by defining a rentier state as “one where rent situations predominate”. Other political economists add that a dependence on external rent i s the key element in a rentier state. Luciani (1 990) says a state “whose revenue derives predominantly (more than 40 percent) from foreign sources o f revenue i s dependent on external rent and thus is a rentier state. Since the economic fortunes o f a rentier state do not rest on domestic efforts, the governing elite tends to neglect the development o f a strong domestic productive sector. As a result, the majority o f i t s citizens are almost entirely dependent on the government for employment and welfare” (Beblawi 1987).

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These rents are channeled through the government budget and captured by the civil service elite in the form of high public sector wages and other fringe benefits. Since the country’s independence, Dj ibout i c iv i l servants have continued to be paid high real wages. The high nominal wages inherited f rom the French colonial administration were protected f rom inflation by Djibouti’s currency board arrangement. The high wage bill i s also explained by past government employment policies. Most o f the wage bill i s the mi l i tary bill, a remnant o f the turmoil in the 1990s. At the height o f the c i v i l war in 1993, the government claimed to have more than 15,000 men under arms. I t has received foreign funds for demobilizing these forces since 1994, and significant progress has been achieved. But in 2004 close to 4,000 Government mi l i tary personnel remained to be demobilized, and their wage bill i s a major burden o n the overall wage bill.

High wages and other fringe benefits form the bulk of current expenditures, limiting thefiscal space to redistribute income to the poor. In Djibouti, nonwage allowances (pensions, health and family allowances, and other stipends) benefit primarily the upper-middle class. Access to the social security benefits depends o n formal sector employment (mostly public sector employment), which i s reserved largely for the middle class. The bottom decile, which includes the indigent population, receives only 4 percent o f total government cash transfers-that is, 60 percent less than an average person. T h i s contrasts with the eighth decile, which receives twice the average, and the tenth decile, which receives about the average amount o f transfers. In Djibouti, virtually n o formal safety nets (government-financed cash or in-kind programs targeted to the poor) protect the poor other than those financed by international agencies directed to refugees and victims o f natural disasters. Although the size o f private transfers in Dj ibout i i s relatively high (approximately 50 percent o f government transfers), private remittances from abroad are received by the richest deciles, with the bottom two deciles receiving almost n o remittances. Reflecting these trends, income inequality in Dj ibout i remains relatively high, with a Gini coefficient close to 40.

THE GROWTH CHALLENGE

The story of Djibouti’s economic growth over the last two decades is essentially one of a sharp decline in real per capita GDP caused by a sustained fall in productivity - this fall in productivity was mainly the result ofpolitical unrest and badpolicies. Economic growth and per capita GDP fel l sharply in the years fo l lowing Djibouti’s independence. As a result, per capita income i s today about 50 percent o f what i t was two decades ago. The main reason explaining the sustained impoverishment o f Djibouti’s population has been the fa l l in productivity. Fol lowing the fal l in productivity, the marginal productivity o f capital declined and the desired stock o f capital per worker fell too. The decline in productivity was associated with the formation o f fledging national institutions, the polit ical unrest associated with the clashes between the two main ethnic groups in the country, and government policies that did not help develop private sector activity and sustain investments in human capital. The country went through a decade o f c i v i l war involving large recruitments into the regular army, whose size jumped f rom 4,000 to 16,000 in 1992 alone. War in neighboring countries brought a large influx o f refugees, putting an extra burden on already stretched public services. Mismanagement o f public finances and a sharp decline in foreign aid and port receipts compounded the effect o f these shocks. Under a currency board arrangement that limits monetary financing o f the deficit, the government built up domestic payment arrears (salaries for the public sector employees, utility bills, and payments to private sector suppliers) amounting to 28 percent o f GDP by 2000.

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The recent economic recovery is explained in part by exogenous positive shocks (including the increased geopolitical importance of the port) and in part by jiscal consolidation efforts. The real turning point was the signature of the peace agreement and the subsequent period of political stability. Since 1998, the government initiated reconstruction efforts and achieved significant progress in improving macroeconomic stability. I t took fiscal adjustment measures to restore fiscal balances, including: downsizing the c iv i l service through a mi l i tary demobilization program, and reducing the overall wage bill by 20 percent in nominal terms, and instauring a hiring freeze on non-priority sectors, strengthening public expenditure institutions and implementing a far-reaching pension reform that placed the system o n a much stronger financial footing. I t also improved port and airport management by entrusting the facilities to a private international investor. In M a y 2001 the government signed what i s termed the final peace accord in exchange o f a power-sharing deal between the two main ethnic groups, officially ending the decade-long c i v i l war. At the same time, the geopolitical importance o f Dj ibout i increased, and so did the port activities, which led to increased foreign aid, military-related revenues and port receipts. Since 2001, economic growth resumed, reaching 3.4 percent in 2004.

However, the recent growth performance has not made a substantial dent in poverty or unemployment. Djibouti remains locked in a trap of low growth, high unemployment, and high poverty. Despite i t s relatively high per capita income (with a gross national income (GNI) per capita o f US$1,040 in purchasing power parity [PPP] terms), which places it in the ranks o f lower-middle-income countries, Dj ibout i has some o f the highest rates o f illiteracy, morbidity, and maternal and infant mortality in the developing world. Over the past two decades, real GDP growth averaged about 1 percent per year. With an average annual population growth rate o f 2.5 percent, this weak economic performance led to a continued decline in real income per capita. The stark decline in per capita income explains the impoverishment o f the Djibouti’s population. In 2002,42 percent o f the population l ived o n less than US$1.8 a day. The unemployment rate i s close to 56 percent, with the most disadvantaged economic groups having unemployment rates higher than 60 percent. Mos t households that are able to escape poverty do so because o f their earnings f rom employment. Fifty-five percent o f the very poor l ive in households where n o member i s employed. Given the growing size o f the informal sector in the country, unemployment in this report means ‘ low productivity employment’ rather than the traditional definition. L o w productivity employment i s the result o f a l o w capital-labor ratio and l o w productivity in the economy, and will only change gradually as a result o f physical and human capital accumulation.

Djibouti’s growth challenge is to create conditions that will spur private investment and human capital accumulation which will improve overall productivity. These conditions can be categorized broadly as a stable macroeconomic and fiscal framework; an efficient public administration with lower costs o f service delivery; and efficient factor markets (flexible labor markets, skdled labor, deep financial markets, and high-quality and cost-efficient infrastructure services), underpinned by a legal and institutional framework that ensures adequate contract enforceability and predictability o f rules and regulations.

CRITICAL BOTTLENECKS TO GROWTH

The report identijies a number of policies and institutions that affect private investment and human capital accumulation in Djibouti. Distorting government pay and employment policies drive up labor costs in the economy and limit fiscal space to reallocate expenditures to productive and social expenditures. Lack o f education and vocational training opportunities contribute to the paucity o f slulled workers. Remaining labor market rigidities affect labor productivity.

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Weahesses in the investment climate, high costs o f finance, and inefficiencies in the provision of infrastructure services affect firm productivity, investment and growth.

Distorting government pay and employment policies. The average public sector wage in Dj ibout i i s 9 t o 10 times the country’s income per capita and 5 t o 10 times the average public sector wage in Ethiopia and Yemen. The wage bill absorbs ha l f o f the government budget, crowding out public resources that could otherwise been used to promote private investment and human capital accumulation. In addition, high public sector wages imply high taxes o n the rest o f the private sector and make the delivery o f key public sector services expensive.

Labor market rigidities, paucity of skilled workers, and high costs of doing business. Looking ahead, the large pool o f unemployed and underemployed workers will remain a major issue for Dj ibout i and a diff icult challenge to pol icy makers. Djibouti’s economy i s characterized by high unemployment, at 56.1 percent and l imi ted j o b flows. L imi ted labor demand i s explained by four broad sets o f factors. Public sector workers earn comparatively more than private sector workers, even after controlling for other factors (education, age, gender). A weak investment climate has stifled the entry o f job-creating new f i r m s and dampened incentives for existing f i r m s to invest expand and hire. A paucity o f sh l led labor coupled with work ethics and socio-cultural factors (the consumption o f the khat), which lead to laxity and worker absenteeism, has negatively affected labor productivity.

Underdeveloped financial sector. Despite Djibouti’s financial openness, the country’s financial sector remains underdeveloped and has played a l imited role in at promoting private investment and growth. The banhng system i s small and dominated by foreign-owned banks. The costs o f local finance remain high. Financial intermediation i s hindered by the lack o f diversification in terms o f both institutions and financial products, and by lending practices. Banking soundness indicators show a mixed picture: banks seem to be wel l capitalized and profitable, but nonperforming loan ratios continue to be high. Recent financial reforms have helped in alleviating the effect o f these factors.

Infrastructure inefficiencies. Djibouti’s port i s well-managed, although a number o f infrastructure deficiencies remain. Roads and railways sector, critical links in the port logistics chain, suffer f rom inadequate maintenance and inefficient management. The high costs o f public utilities coupled with deteriorating quality o f electricity and water services affect business operation and expansion. The high wages and benefits o f employees working in the public utilities, overstaffing, and the l o w productivity o f unshl led workers are common concerns that cut across infrastructure sectors, including railway, roads, energy, and water.

GROWTH STRATEGY: THE ROAD AHEAD

Growth that can be expected in the coming decade. Given i t s current structure, and in the absence o f pol icy reforms, Djibouti’s economy can be expected to grow about 3.5 percent on average over the next ten years. This i s the base case scenario, which may be considered as a ‘ low case’ scenario for some countries. The report also presents a high case scenario, with an average economic growth rate o f 4.5 percent. I t assumes the implementation o f fiscal pol icy reforms that address the high factor cost problem in the economy under the context o f the fixed exchange rate regime. The high case scenario i s also based o n improved investor confidence and stronger donor support. The growth pay-of f o f the proposed fiscal pol icy reforms represents 1 percentage points o f GDP in the period o f analysis. However, since these reforms wil l create the fiscal space needed

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to achieve the education MDG by 2015, higher growth pay-offs could result f rom the increased accumulation o f human and physical capital and the improved country’s competitiveness.

To accelerate growth in the short term and sustain it over the long term, Djiboutipolicy makers will need to rise to a multifaceted challenge: supporting a stable macroeconomic framework and fixthering fiscal consolidation efforts; and pressing ahead with pol icy reforms aimed at energizing private investment and support human capital accumulation, by strengthening the investment climate (lowering transaction costs associated with regulatory uncertainties); enhancing labor productivity through stronger labor market flexibility; attaining the education MDGs and expanding the formation o f high-slulled labor; mobil izing finance for investment; and improving the efficiency and competitiveness o f backbone infrastructure services.

Supporting a stable macroeconomic framework and reforming government pay and employment policies

The continuation and deepening of sound macroeconomic policies are prerequisites for sustained economic recovery. The report identifies as a critical short-term priority the need to ,

create the fiscal space needed to meet the government’s fundamental development objectives. Under the fixed exchange rate regime, reforming government pay and employment policies remains the only option for addressing the high factor cost problem and creating fiscal space to reallocate expenditures to meet the MDGs. Reducing the wage bill by reforming public sector pay and employment policies will help attain a sustainable fiscal path over the next 10 years, whi le malung fiscal room to finance human capital investments (that is, to attain the education MDGs) and other poverty-reducing expenditures. I t wil l also increase budget flexibil i ty so the government can better manage economic volatility. And it will lower unit labor costs in the economy, because public sector wages serve as a benchmark for private sector wages.

Evaluating civil service wages and salaries entails examining three key dimensions: the total wage bill, civil service pay, and civil service employment. The report reveals anomalies pertaining to the size o f the wage bill and average pay. But anomalies in c iv i l service employment are also present, mainly because the government continues to be the employer o f last resort (with public wages being more attractive than private sector wages) and also because informal quotas are determined along ethnic lines.

Despite considerable progress over recent years, Djibouti still has one of the largest wage bills among comparator countries, particularly considering the low level of service delivery. It represented nearly 14 percent o f GDP in 2004, 60 percent o f total fiscal revenues, almost 50 percent o f total current expenditures, and more than 40 percent o f total government expenditures. The driving factor behind the exceptionally large wage bill i s the high level o f c iv i l service pay. The annual average pay o f a c iv i l servant i s about 10 times the country’s GNI per capita. There i s also a wide dispersion in wages within the public sector. The ratio o f the highest earning worker to the lowest i s 10.3 for permanent employees and 15.6 for contractual employees.

This report discusses alternative options to reduce the public sector wage bill and create the fiscal room needed for the attainment of the education MDG by 2015, while maintainingfiscal sustainability over the medium term. The proposed scenarios assume a higher annual real GDP growth (consistent with the high-case medium-term macroeconomic scenario) and the achievement o f the education MDG by 20 15. The report draws on a wage and employment model that allows Dj ibout i policy-makers to examine the impact o f various fiscal adjustment scenarios on the overall wage bill and o n unit labor costs. There are different ways to reduce the public sector wage bill: through price effects (i.e. reducing nominal wages), quantity effects (i.e. hiring

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freezes; demobilizing mi l i tary personnel), or a combination o f both. A nominal wage cut o f 10 percent across the board would allow the wage bill to decline by 4.5 percentage points o f GDP by 2015 and the average unit labor cost would fall by almost 5 percent. Demobilizing 4000 military personnel would lower the wage bill by 3 percentage points o f GDP by 20 15. But it puts upward pressure on the unit labor cost (average public sector wage), which would rise by 35 percent over the period. Introducing a hiring freeze pol icy while maintaining constant nominal wages would allow the overall wage bill to decline by 9.5 percentage points o f GDP by 2015. But unit labor costs would rise by 7 percent over the period.

The social impact of the reforms is expected to be positive in the long-run while their potential short-term negative impact on poverty would be marginal. In principle, the adjustment measures would make it possible to attain the education MDG by 2015 and to reduce unit costs o f service provision which should have a positive social impact. Preliminary analysis for the potential distributional impact o f a nominal wage cut o f 10 percent reveals that the potential short-term negative impact on the poverty headcount appears to be marginal. A 10 percent reduction causes the overall national poverty l ine headcount ratio to rise by one percentage point.

Three factors may affect the outcome of fiscal policy reforms. First, reducing the public sector wage bill can have a negative social impact, even i f marginal, which would come at a fiscal cost. Second, the polit ical feasibility o f these reforms varies according to the magnitude and pace o f reforms. Third, measures that reduce public employment or wages do no t guarantee either that workers will be absorbed by the private sector or that the measures wil l have a,direct impact on growth. Other government failures can sti l l lead to imperfect labor markets and weak private investment. Complementary pol icy actions need to be taken to address the distorted incentive structure and resulting labor market segmentation in Djibouti. Revamping Djibouti’s education and training system would expand the pool o f trainable workers. Strengthening the investment climate to promote the creation and expansion o f small businesses would directly address employment creation objectives. A l lowing private competition in infrastructure service delivery can also lead to more efficient allocation o f labor between the public and private sectors.

Improving labor market flexibility, lowering business costs, and improving labor quality

Djibouti’s labor market is dualistic and segmented on account of remaining labor market rigidities and high labor costs (wage and non-wage costs) in theprotected or formal sector. The formal sector comprises the public sector and a handful o f large private enterprises mostly managed and owned by foreigners. The informal sector i s segmented between Dj ibout i employees and foreign employees. The latter usually accept lower wages and harder work conditions. The formal sector offers better workmg conditions than the informal sector: it pays better, provides fi inge benefits such as pension and health care, and offers virtually absolute j o b security. By contrast, workers in the informal sector (self-employed, wage earners, and unpaid family workers) are largely unprotected by labor legislation and outside the social insurance and social safety nets. The informal sector plays a key role in the economy, comprising about ha l f o f a l l private sector enterprises engaged in semi-organized, small-scale, unregulated activities. The growth in employment in the informal sector has not compensated for the stagnation or negative employment growth in the formal sector. I t may have led to low-skilled production arrangements, thereby contributing to Djibouti’s below-potential performance.

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Djibouti’s labor market offers limited employment opportunities in the formal private sector. Labor force participation i s l o w and unemployment has been extremely high (particularly long- term unemployment). The unemployment rate has increased. The worrisome feature o f Djibouti’s labor market i s the sk i l l s gap. Young, low-educated persons, especially women, face the highest risk o f unemployment (or underemployment). There i s also a pool o f young and educated individuals who are currently unemployed because they have a higher wage reservation (or excessive wage expectations) than foreign workers f rom neighboring countries. Persistently high levels o f unemployment would normally reduce wage levels, absorbing some of the unemployed. Instead, the high level o f wages paid by the public sector apparently has educated youth queuing for public sector jobs. High unit labor costs and remaining labor market rigidities restrictions limit any downward adjustment in private sector wages in the private sector, giving rise to the dual labor market and high unemployment rates. Another factor explaining the inconsistencies in wages and unemployment trends could be the shortage o f qualified manpower. It i s estimated that each year, more than 4,000 young people who have had n o access to a general secondary education or to any kind o f professional training or qualification enter the labor market.

Djibouti is characterized by low labor force participation and high long-term structural unemployment (or underemploymenq. Labor force participation rose f rom 41.6 percent in 1996 to 57.4 percent in 2002. T h i s rate i s l o w compared with those o f Sub-Saharan A f i xa . Education i s a key factor determining participation in Djibouti’s labor market. Unemployment rate rose by 12 percentage points between 1996 and 2002 and remains one o f the most significant economic problems in Djibouti. High unemployment rates, in conjunction with l o w labor participation rates, imply that only a small fraction o f Djiboutians engage in market work. Less than 20 percent in 1996 and 30 percent in 2002 o f the population aged 15 and above was employed. There are also clear differences in the gender composition o f wage earners more than 58 percent o f employed males work in the public sector while only 16 percent o f employed females are c iv i l servants; the majority (71.6 percent) work in the informal sector.

Earnings vary according to gender, location, education levels, and sector of employment. On average, males and residents o f Djibouti-vil le have higher wages. Public sector wage earners receive the highest monthly wages followed by the private formal sector. The narrow wage gap between public and private formal earnings does not fully capture the generous benefits and non- wage compensation that workers in the public sector receive. Informal sector workers have very l o w average wages. Females are overrepresented in this sector, which may explain the wage differential between men and women. Wage earners with university education earn 2.7 times more than those with only primary education.

The past seven years show a persistently weak labor demand. Labor supply has exceeded labor demand and the demand for employment by men has been o n average at least three to four times higher than women, while j o b offers to women have constituted about one-fourth that to men. These trends reflect gender disparities in education and cultural factors that affect women’s participation in the labor force. Positive net j ob creation has been occurring mainly in the service sector, particularly in the following sub-sectors: building and construction, maintenance and repairs, small-scale retail trade, hotels and restaurants, and consultancy services arising mainly f rom donor-funded projects.

The limited labor demand by the formal private sector in Djibouti could be explained by four broad sets of factors: distorting government and employment policies; a weak investment climate; labor market rigidities; and a paucity o f slulled labor.

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Distorting government pay and employment policies, under which public sector workers earn comparatively more than private sector workers, after controlling for differences in human capital endowment and other personal or household characteristics that influence earnings. The most important factor determining a positive wage differential in favor o f public sector wages i s a wage premium or rent. The results also seem to indicate that there are barriers to entry into the public sector. Public sector employees are more l ike ly to be male and to come f rom the elite class, with parents in the public sector. The pol icy implications f rom this analysis are that the public sector hiring and wage-setting practices are not efficiently allocating labor, and hence are wasting resources.

A weak investment climate that has stifled the entry of job-creating new firms and dampened incentives for existingfirms to invest, expand, and hire. Entrepreneurial activity remains l imited and Investors s t i l l encounter multiple bottlenecks across the entire spectrum o f conducting business (start-up, operation, and exit). Lack o f procedural transparency i s the most recurrent problem mentioned by investors in almost every stage o f the investment process. High taxation, burdensome tax administration, poor access to and high cost o f capital, cumbersome regulations, and lack o f transparency are top business concerns. A significant number o f f i r m s also consider contract enforcement and conflict resolution as major concerns.

Djibouti has liberalized employment protection legislation with the adoption of the new Labor Code (2005) but a number of labor market rigidities remain. The new labor Code authorizes free employee recruitment without recourse to the National Employment Service; and establish effective arrangements for regular consultations with the Association o f Employers on labor issues. However, payroll taxes and other non-wage costs (fringe benefits) make the overall price o f labor higher than in neighboring countries. Full-t ime permanent employment i s the norm, and workers are entitled to a wide range o f workplace benefits and protection. In addition, the costs o f court challenges to dismissals may act as an additional disincentive to firing workers.

A paucity of skilled labor and poor work ethics and standards, which lead to laxity and worker absenteeism, negatively affecting labor productivity. The key supply issue in Dj ibout i i s not the quantity o f labor but i t s quality. L o w educational achievement combined with fragile health indicators and the consumption o f qhat are key factors behind the l o w productivity o f the labor force. Dj ibout i has an education deficit and higher infant and maternal mortality rates than Sub-Saharan Afr ican countries and other countries at similar income levels. Despite progress in reducing this deficit, considerable challenges remain i f Dj ibout i i s to meet the MDGs by 2015.

Moving toward a well-functioning labor market that is sufficiently flexible to absorb a greater number of job seekers calls for more flexible labor market policies, reducing costs of doing business and improving the quality of the labor force. Improving labor market outcomes wil l entail pol icy reforms to improve the investment climate and remove a wide range o f constraints on business start-up, operation and exit. The report also proposes to revamp the country’s education and vocational training policies to expand the pool o f trainable workers.

Given the extremely limited size of its domestic market, Djibouti’s long-term future depends on increasing its competitiveness. Because o f the country’s location, level o f infrastructure, l imi ted natural resources and lack o f arable land, the service sector i s the main source o f growth-with particular focus o n the Ethiopian market. In this regard, labor costs (both wages and social

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security payments) represent a major determinant o f the competitiveness o f Djibouti’s private sector. Any strategy to increase competitiveness will need to concentrate o n two key elements: reducing wages paid by the formal (especially public) sector, and implementing policies to facilitate entry in the labor market and creation o f new jobs. The report suggests some specific short-term recommendations to spur labor demand:

Simplijjing the regulatory framework for investment coupled with less discretionary power for the bureaucracy - which will help reduce regulatory uncertainties and bureaucratic red tape. In particular, the Dj ibout i authorities should a im to reduce the number o f permits, simplify procedures, improve coordination between agencies interacting with businesses, and lower administrative barriers to firm formation and growth.

Strengthening the judicial system. T h i s entails the preparation and enactment o f a true statute for the judiciary, the recruitment o f new judges with advanced training, and the provision o f such training to judges already o n the bench. There i s an urgent need to improve the efficiency o f the system o f justice and to accelerate the pace o f judges’ decisions. This step i s necessary to bring down transaction costs l inked to random judgments that are often diff icult to enforce.

Relaxing labor market regulations. While the new labor Code (2005) introduces greater f lexibil i ty in the labor market, a number o f proposals have been recommended by foreign investors that would help further liberalize the labor market. These include: lower severance pay and relax suspension o f employment provisions in the Labor Law.

The medium-term labor market agenda includes measures to improve the quality o f the labor force:

Improving the education base of the workforce has to be at the top of the agenda for enhancing labor productivity and stimulating labor demand. The education and training pol icy reform agenda has three main building blocks: expanding the pool o f trainable workers; promoting the upgrading o f worker sk i l l s in the workplace; and developing a pool o f highly skilled professionals l inked to the port activities. Basic education i s a pre- requisite for producing trainable workers. Improving the quality o f labor will require achieving universal primary education (MDG goal met by 2015), increasing the number o f years o f schoolinghaining o f the labor force, and improving the quality o f education and training programs.

Deepening financial markets to mobilize investment

Djibouti’s financial system remains underdeveloped and has not sufficiently contributed to growth. Financial reforms introduced in 2005 have improved the legal framework for banhng supervision, including regulation o f microfinance institutions and increased supervision o f money changers (that are n o w subject to annual controls). In spite o f these reforms, Djibouti’s financial sector remains underdeveloped. The share o f the financial sector in GDP remained at about 11 percent between 1990 and 2004, while the assets o f the banking system stagnated at about 11 percent o f GDP. During this period, the size o f the financial sector dwindled as the number o f commercial banks declined from f ive to three, and the number o f insurance companies declined from eight to two. At the end o f 2005, Dj ibout i had 11 money changers, 2 active commercial banks, and two new foreign-owned banks (their respective shareholders are f rom Malaysia and

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Yemen) that have recently been established in the country and will be operational by the end o f 2006. Djibouti 's banking system i s dominated by foreign-owned banks. Financial intermediation i s s t i l l hindered by the lack o f diversification in institutions, financial products, lending practices (which a im to minimize risk), and a weak judicial structure to enforce contractual and property rights.

Djibouti has had a currency board arrangement (CBA) since 1949, when it still was a French territory. The C B A has enabled Djibouti to maintain full convertibility into the U.S dollar at a fixed exchange rate despite economic uncertainties throughout the 1980s and 1990s. I t also allowed the country to emerge, o n occasion, as a regonal commercial and financial center. Over the years, the C B A has lent credibility to the country. Operating under a 100percent foreign reserve requirement and using rule-bound monetary policy, transparency, and protection f rom polit ical pressure, the CBA has helped Dj ibout i maintain a relatively strong currency. By binding i t s supply o f base money closely to i t s holdings o f reserve assets, the C B A has also served Dj ibout i wel l in keeping inflation at a l o w level, as it has in most countries where such an arrangement has been adopted.

Financial intermediation is costly to those soliciting funds, and lending practices aim at minimizing risks. For instance, the banks demand marketable collateral in a country where assets are few and illiquid. Bank lending distribution i s highly concentrated in terms o f beneficiaries, activities, and maturities, and the customer base remains modest. Short-term lending represents about 75 percent o f total lending, and long-term lending averages about 10 percent. Banks lend primarily to the trading community and loans are not easily available to other customers such as small businesses. Also, the spread between lending rates and deposit rates i s high-almost twice that prevailing in Ethiopia and apercentage point higher than spreads in Yemen and in other small states. As a result, the two large commercial banks operate very much l ike traditional savings banks (caisse d 'kpargne), with a focus on collecting deposits and only very l imi ted credit activity.

Although commercial banks have a comfortable liquidity position, credit extended to the private sector has been low and declining since end-2000. These developments reflect o f l imi ted opportunities in the real sector, commercial banks' cautious approach in view o f the high level of N P L s and weaknesses in the judiciary system that impedes recovery o f NPLs, as wel l as uncertainty about the economic situation. 011 the demand side, high lending rates practiced by commercial banks discouraged the development o f credit to the private sector. The spread between the domestic lending and deposit rates widened, and the lending rates have been only partially responsive to decline in international rates.

Currency substitution has increased. Foreign currency deposits represent only part o f foreign currency holdings in Djibouti, and the data do not distinguish between domestic residents and foreign holders. With a substitution ratio (foreign currency deposits to broad money) o f about 36percent in 1995, Dj ibout i already stood among the highly dollarized economies such as Argentina, Nicaragua, and Croatia. Currency substitution may benefit the economy by enhancing financial intermediation and promoting financial deepening. However, by inducing a reduction in the real demand for domestic currency, i t may involve the loss o f seigniorage, the profits accruing to the monetary authority f rom i t s rights to issue legal tender. Although these negative impacts may be limited, their growing importance raises some concerns. The evolution o f these ratios may suggest that despite a fixed-exchange rate regime, progress achieved through financial sector reforms, a l o w level o f inflation, and continued polit ical stability, the Dj ibout i people are sti l l not fully confident about domestic developments. This corroborates the declining trend o f net domestic credit, which may suggest that banks s t i l l see investment abroad as a safer prospect.

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Notwithstanding the improvements in recent years, the banking sector still exhibits a few vulnerabilities that need to be addressed. First, one o f the commercial banks s t i l l fails to meet a number o f prudential regulations and the other fails to meet most o f them. Second, the large share o f interest income from foreign assets in revenues might involve some r isks over the medium term, particularly if competition in the banlung sector increases. Third, the liquidity and solvency o f the banlung system could also be threatened by a banlung crisis in the parent institutions’ home countries or in a major trading partner. Whi le not very likely, such a crisis would have a large impact o n the Dj ibout i banlung system.

I n addition to the two commercial banks, Djibouti has 11 currency exchange and transfer agents. Some have been in operation since 1948, beginning as small enterprises focused o n serving the businesses o f their owners. They often operate informally, and their operations are traditionally l imited to the subregion and the Arabian Peninsula. Their worlung procedures remain largely outdated despite the increasing volume o f their activity. They often operate informally, and their operations are traditionally l imi ted to the subregion and the Arabian Peninsula. Their worlung procedures remain largely outdated despite the increasing volume o f their activity. The money changers offer currency exchange and international transfer services, even to clients with n o bank account and play an important role in financial intermediation. The money changers are appealing because they perform several useful functions: They operate o n somewhat smaller spreads and charge lower commissions than the commercial banks. They deal with a l l types o f customers and have more flexible worlung hours than banks. And they are more specialized in their operations than banks, which conduct a broader range o f activities. Annual on-site supervision ensures that the money changers broadly operate in full compliance with the regulations. Most o f the money changers re ly o n correspondent networks that impose sufficient financial guarantees and soundness.

Outside the formal sector, informal finance exists in the form of traditional arrangements. Informal finance i s understood in this context as contracts or agreements conducted without reference or recourse to the legal system, to exchange (primarily) cash in the present for promises o f (primarily) cash in the future. These arrangements are used by low-income participants to pool small savings and extend small credits.The success o f these informal systems stems principally f rom ensuring l o w transaction costs; a supply o f loans, savings, and impl ic i t insurance; services that are sensitive to constraints faced by women, in particular their inabil ity to obtain formal financing; the substitution o f confidence in character for physical collateral; and socially enforced or self-enforced contracts. But they have several weaknesses that should not be overlooked, including a lack o f deposit insurance; operation within a l imited group, solely o n the basis o f individual savings and inabil ity to satisfy the financing demands for economic activities that exceed available savings; the l imi ted proportion o f savings invested and the short-term basis; and the impossibility o f recourse to a legal system that enforces contracts.

Microfinance corresponds, in this context, to formal schemes designed to improve the well- being of the poor through better access to saving services and loans. Thus, both informal finance and microcredit serve the poor. However, informal finance derives f rom the need o f those excluded from the formal finance for financial services and loans, while microfinance stems from a donor-driven supply o f financing. The development o f microfinance in Dj ibout i has been hindered by the lack o f a regulatory framework, a weak judicial and fiscal environment, resource constraints, and the lack o f institutional support. Microfinance activities remain largely unregulated. In addition, most microfinance institutions in Dj ibout i are largely subsidized, operate with insufficiently trained staff, and have not yet defined clear development plans. Furthermore, their accounting and management systems are poorly developed.

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To maintain the integrity and effectiveness of the financial system, the authorities took a number of measures in the last decade covering three main areas, namely the legal framework, supervision and prudential regulations, andfinancial intermediation. However, these measures were h v e n mostly by the requirements o f donor-supported programs and were not really part o f a comprehensive financial sector reform program. Furthermore, these measures were not very ambitious and their implementation was slower than in i t ia l ly envisaged. As a result, they have had only l imited impact.

Further measures are needed to help remove bottlenecks to the expansion of credit to the private sector, consolidate supervision practices, and encourage a generation of long-term savings. Such measures could include in the short-term:

Putting in place a training program for the supervisory staff at the BCD and the other financial institutions, thus reaping the full benefits o f new banking laws which go a long way toward ensuring a more efficient supervisory and regulatory environment.

Adopting an adequate legal and regulatory framework on microfinance. Expansion o f microfinance activities i s predicated on further reforming the regulatory and supervisory framework, whi le creating an environment conducive to small business development. There i s also a need to raise the awareness o f beneficiaries about the importance o f preserving the ability to take risks.

Strengthening the judicial system to enable the private sector to benefit from the comfortable liquidity position of commercial banks. The private sector has l itt le confidence in the court system. I t i s important to alleviate the perception that judges lack autonomy and that the court system i s slow to resolve disputes. By doing so, the great potential offered by the microfinance sector would be tapped and commercial banks would l ikely be more forthcoming in providing financing to the private sector.

In the medium-term, Dj ibout i could consider the fo l lowing pol icy reforms:

Developing new financial products to ensure greater mobilization of domestic savings and address thefinancing need of small and medium enterprises, whi le establishing an adequate regulatory framework so as to ensure the success o f this operation. The limited financial products available in Dj ibout i consist mainly o f deposits with commercial banks.

Promoting Djibouti as a regional financial hub by expanding the choice of financial products by developing innovative financial products that could be needed by some regional operators; establishing agreements with regional banking or insurances institutions, particularly in Ethiopia, including becoming a shareholder in these institutions; and promoting national banking products and services with neighboring countries and with regional economic institutions, such as COMESA.

Making backbone infrastructure services more efficient

Djibouti’s strategic location on the Red Sea’s international shipping routes, as well as in relation to its East African hinterland, makes it an excellent regional transport hub-but its growth potential in the transport sector has not been fully exploited. Because o f high transport logistics costs, a paucity o f sh l led workers, infrastructure deficiencies, and s t i f f competition f rom other regional ports, this potential has not been fully tapped. Still, although underperforming, the

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transport sector remains the mainstay o f the economy. Port and transit services and associated road and ra i l links are the main activities o f the services sector, which accounts for about 70 percent o f GDP. Some 10,000 jobs are in transport-related activity, including urban transport, 70 percent o f them being permanent jobs. Port transit-related employment i s approximately 15 percent o f total employment in Djibouti.

Transport sector

The sharp increase in Ethiopian transit traffic, combined with the improvement of the road link to Ethiopia and the transfer of port and airport management to a private operator, dramatically stimulated port activity in recent years. The new private operator, DPI, has managed to improve the port’s competitiveness. Until i t s arrival, Dj ibout i had lost i t s transshipment traffic to competing ports in the region. This boom in Ethiopian transit traffic could not have been handled without improving the transport link between the port and Ethiopia (rehabilitating the International Road Corridor). Trucks o n this road corridor carry more than 95 percent o f the transit traffic to and f rom Ethiopia.

The port is well managed, although a number of infrastructure deficiencies remain. Djibouti’s port tariffs are higher than those of other international ports but lower than regional competitors. The major technical constraint, particularly for import containers, i s the long port transit time, which limits the port’s abil ity to handle further trans-shipment activities and increases transport costs. Unable to handle further transhipment activities, Djibouti’s port has lost market share in the transhipment business. The main reason behind the long dwel l time i s related to cumbersome and lengthy customs clearance procedures at the Ethiopian customs gate. Port activity also slowed down in 2004. The government attributes the decline in port activity t o bottlenecks resulting f rom the port’s rapid growth in recent years and i t s l imi ted capacity. The impact o f the decline in port traffic spread to other sectors and to the economy as a whole in 2004.

The Djibouti-Ethiopia railway has experienced a continuous decline since the early 1960s. Its economic role is now marginal, and it faces severe technical and financial difficulties. The Djibouti-Ethiopia railway suffers f rom l o w technical standards and lack o f maintenance. The productivity o f the railway i s very low, compared with other A h c a n railways. In an attempt to revive the railway, the governments o f Dj ibout i and Ethiopia have decided to jo int ly grant a concession to the private sector for operating and managing the railway. The economic role o f the railway remains marginal. The railway has been unable to capture a significant share o f the international freight market. The gradual loss o f competitiveness o f the railway to the road network has been caused by the lack o f a commercial orientation, high turnover o f the management team, and deficiencies in financial and human resource management.

Djibouti airport traffic entails 5,000 to 5,500 movements of aircraf. I t generates a flow of 200,000 passengers, including 50,000 transit passengers, and 7,000 to 8,000 tons of freight. The decree o f 8 January 2001 established “open slues” over the airport, lifting restrictions o n the frequency o f flights and facilitating the development o f air links and the introduction o f service to new destinations. High wages increase production costs, hindering the productivity o f the airport. The share o f wages and salaries reached 77 percent o f value added generated by the airport in 2000. In June 2002 the airport was privatized under a 20-year management contract awarded to DPI. Total traffic volume has increased since 2002. Freight rose from 13.6 percent, o f which more than ha l f consists o f daily imports o f qhat. Passenger traffic increased by 8.5 percent whi le the number o f commercial flights rose by 28 percent.

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The Djibouti-Ethiopia corridor, a critical link in the port logistics chain, still suffers from inadequate maintenance, and the national road network remains inefficiently managed. The road sector in Dj ibout i consists o f a national network totaling 1,193 hlometers, and a district network o f 1,771 lulometers. These roads are the backbone o f the network, linking the main cities and providing access to the neighboring countries o f Ethiopia, Somalia, and Eritrea. Almost 60 percent o f the priority roads are paved compared with none o f the national secondary and district roads. The satisfactory condition o f the network can also be explained by two favorable natural conditions: the country’s overall l o w rainfall; and the strength o f the substructure and the availability o f good construction material. The rapid expansion o f informal settlements in the country’s urban centers, especially Djibouti-ville, has recently become a major issue for the country’s authorities. Large investments in road infrastructure and transport are n o w required to provide local population with adequate access to employment, education and basic health services.

Power and Water

Fifty-seven percent of the country’s urban population has access to electricity, but only a third of the population does in the rest of the country. Access is almost nonexistent in rural settings, with the exception o f a few small towns and some villages that have financed their own generators. The public electric company, EDD i s plagued by l o w labor productivity, overstaffing, and obsolete equipment which breakdowns frequently. On average, electric power in Dj ibout i i s far more expensive than in comparator countries. High operational costs, in particular fuel cost and wage bill, contribute to high energy tariffs. Overstaffing appears to be significant and l o w labor productivity i s apparent despite high wages.

Half the population of Djibouti-ville is connected to the public water supply, and the other half draws water from connected neighbors or from public standpipes. I n rural areas it is estimated that less than 30 percent of the population have access to water within a reasonable distance, further weakening the already precarious food security. The quantity and quality o f water resources determine Djibouti’s economic prospects and social welfare. The country’s sustainable water resources are estimated at 50 cubic meters per capita per year, compared with an average o f 1,000 cubic meters per capita per year for the (water-stressed) Middle East and Nor th Afr ica region. Almost a l l o f Djibouti’s water supply i s sourced f rom underground wells, and most o f these wells are o ld and close to exhaustion. Djibouti’s public water supply systems suffer f rom inefficient organizational choices and a flawed institutional environment. Water losses are considerable o n account o f poor maintenance and illegal tapping into the water supply network. T o these two types o f loss must be added the lack o f income inherent in the nonpayment o f water bills, particularly by many government bodies. Water i s more expensive in Dj ibout i than in i t s comparator countries. In addition, the public water company, ONED employs 10 times as many staff per connection as the best-managed water supply and sewerage companies elsewhere in the world.

Telecommunications

Djibouti enjoys one of the most modern telecommunication systems in Africa. The country is connected by satellite and cable to the international automatic networks for telephone, telex, and facsimile. The level o f development o f Djibouti’s telephone local network, although l o w by international standards, i s higher than that o f i t s neighbors (Yemen and Ethiopia). The Dj ibout i telecommunications network could become the regional distribution hub for large volumes o f data transmission, mirroring the country’s potential as the major transportation hub for the region. Dj ibout i could also conceivably provide abundant bandwidth and telephone communications at

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very l o w prices to al l potential local users. Should the Doraleh port and free trade zone become a reality, Dj ibout i could offer world-class access to abundant bandwidth and very l o w prices, as a means o f attracting foreign investment and creating a cluster o f f i rms. Malung abundant bandwidth available to Djiboutians outside the zone could stimulate new economic opportunities for Djiboutian f i rms .

Potential for growth and policy implications

Djibouti’s economy could serve as a regional hub for transportation, energy, and digital information and communications. DPI may soon invest between US$300 mi l l ion and US$400 m i l l i on in the container port and free trade zone at Doraleh. The Djibouti-Ethiopia railway could regain an important economic role if it adopted an appropriate strategy and i f i t s management became prof i t driven and efficient. The railway could indeed enjoy a competitive advantage over road transport, especially for long-distance (international), regular, large-scale freight traffic moved in unit trains. The airport could become an important element o f the multimodal logistical platform on which a regional trade center can be built. The establishment o f a major free zone should attract industries and businesses f rom a l l over the region that can travel only by air and should be encouraged to relocate through a pol icy that would entail an increase in hotel capacity. The road and urban transport sectors are also key elements to make Dj ibout i a regional trade center and multimodal logistical hub. Access to electricity in Ethiopia and Dj ibout i i s n o w to be increased through regional cooperation in the energy sector. Power trade will give Ethiopians access to the relatively large electricity coverage in Djibouti, whi le it will give Djiboutians access to much cheaper electricity f rom Ethiopia. Private investment could also provide abundant and low-cost telecommunication services for Dj ibout i and the larger region by taking advantage o f the strategic SeMeWe3 fiberoptic cable, Djibouti’s two earth stations, and the current Chinese investment that i s ringing Djibouti-vil le with fiberoptic cable. More efficient and cheaper electricity, telecommunications, and transportation logistics can stimulate private investment and spur growth.

However, Djibouti will not be able to tap the growth potential in its infrastructure sectors unless it addresses a central issue: the high labor costs and low productivity of the workforce. High wages and benefits for employees in the public utilities, overstaffing, and l o w productivity o f unslulled workers are common concerns that cut across infrastructure sectors including railway, roads, energy, and water. Whi le the principal utility providers (EDD, ONED) arguably have adequate equipment (with the notable exception o f EDD) and personnel, their management and their tar i f f rate structures are excessive and insufficiently flexible to accommodate the particular needs o f commercial and industrial business operators. Overstaffing by workers who lack the necessary training to operate effectively i s also a serious concern. Dj ibout i has 10 times as many public workers per megawatt in the energy sector as international best practice norms. Similarly, i t s public water utility enterprise has 10 times as many staff per connection as international best practices would dictate. The road sector i s also plagued by overstaffing, especially considering the l imi ted size o f the network.

The report proposes two sets of medium-term measures to improve the efficiency and growth potential of infrastructure sectors. Firstly, contract out the management o f public utilities to the private sector to improve their efficiency. Such effects have been visible in the port and airport. Public utilities could introduce greater f lexibil i ty in the setting o f elec&city, water, and telephone tar i f f rates for commercial and industrial entities, and apply preferential rates for specific commercial and industrial sectors o f the economy so as to encourage corresponding private sector investments. Secondly, promote vocational education opportunities to improve the quality and

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productivity o f workers in the infrastructure sector and to expand the pool o f sh l led workers who could be employed in untapped activities in the sector.

Concessioning the management of public utilities to the private sector could bring efficiency gains in terms of management, pay, and employment policies and could favor a decline in tar@%, thereby enhancing external competitiveness. Such effects have been visible in the port and the airport. Concessioning the Djibouti-Ethiopia railway to a private operator i s the only practical solution for revitalizing the railway’s substantial assets and providing an economic alternative to road transport on the Addis Ababa-Djibouti corridor. The poor state o f telecommunications in Dj ibout i reflects an inabil ity t o compete at the international level that i s caused by inadequate services. The same concern i s reflected in the obsolete equipment operated by the state energy enterprise, which results in frequent blackouts. Any reduction o f tariffs hinges o n productivity gains, but also o n the timely settlement o f utility usage bills by the government and by public enterprises. The government can also introduce greater f lexibil i ty in the setting o f electricity, water, and telephone tariff rates for commercial and industrial entities, and apply preferential rates for specific commercial and industrial sectors o f the economy so as to encourage corresponding private sector investments.

Revitalizing the educational and training system to improve labor productivity in the infrastructure sector and to expand the pool of skilled workers. Even if Dj ibout i takes advantage o f opportunities for energy, bandwidth, and transport-related services and addresses the issue o f high labor costs, the paucity o f skilled labor raises an important challenge for firm productivity. The lack o f skilled workforce contributes to l o w labor productivity across infrastructure sectors. In the roads sector, for example, truck drivers are poorly trained in mechanics and therefore cannot undertake emergency repairs along the road. The Doraleh project calls for revitalizing the educational and training system if Dj ibout i workers are to benefit f rom j o b opportunities l inked to port-related services. The Ministry o f Education should seek to promote vocational education opportunities and provide fiscal incentives for f i r m s that offer on-the-job training opportunities.

CONCLUSION

Djibouti’s growth challenges are not too different f rom those faced by other small city-states. The experience o f small states that succeeded in sustaining high rates o f economic growth indicates that only those countries which have undertaken the necessary pol icy and institutional reforms could accrue some o f the key benefits f rom their relative comparative advantage. Singapore and Mauritius are good examples o f small states that took advantage o f i t s strategic location to transform their economies and achieved fast and sustained growth. Bo th countries are today regional hubs for commerce, financial and telecommunications services. In the 1960s, most observers thought that Maurit ius and Singapore’s economies were destined for prolonged poverty. These countries’ endowments and weak human capital were not too different f rom those o f Dj ibout i in the 1980s. The differences in performance can be traced to visionary polit ical leadership that carried out sustained pol icy and institutional reforms that l ed to sustained high rates o f economic growth. Dj ibout i could also become a regional service hub in the H o r n o f Africa. I t has the potential t o grow at about 4.5 percent o n average in the coming decade. This rate could help achieve the education MDG by 2015 and create jobs. But without sustained pol icy reform efforts, this growth i s not l ikely to materialize. Policy reforms are always polit ically diff icult to implement. But the cost o f inaction i s high, as illustrated throughout this report.

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