Increased public spending and improved investment climate benefits Algeria's economic performance

Recovering international oil prices and a loosening of the government’s purse strings have afforded Algeria some breathing room after a number of challenging years for the economy. As Africa’s most important gas exporter, Algeria remains highly dependent on the hydrocarbons sector for the majority of its government’s revenues and almost the entirety of its exports. Despite reforms to encourage private sector development, promote diversification and attract foreign direct investment (FDI) in recent years, the state still plays a preponderant role, meaning that changes to government expenditure and investments continue to have a significant impact on overall economic performance.

Policies

The drop in global oil prices since 2014 is at the root of Algeria’s most recent economic challenges, giving rise to large twin deficits in the fiscal and current accounts. The correction of such imbalances typically requires actions such as fiscal consolidation and currency devaluation, which can compound economic weakness in the short term. Though the authorities embarked upon this strategy in mid-2016, it was abandoned in October 2017. Instead, increased public spending became the goal for 2018, and the target date for balancing the budget was pushed back from 2020 to 2022.

To this end, the authorities have adopted an “quantitative easing” policy, whereby the central bank, the Bank of Algeria, would purchase sovereign bonds directly from the government. This eases the financing pressure on the government by reducing their imperative to issue bonds on the primary market (see analysis). No further significant changes to monetary policy is expected before the next presidential election, which is due to take place in April 2019. Failure to rein in unorthodox macroeconomic policies thereafter could postpone unfavourable circumstances, but may also eventually require stricter financial management measures in the future. When it restarts in earnest, fiscal consolidation is expected to weigh upon growth over the medium term.

GDP

Algeria has been able to cushion the impact of falling oil prices since mid-2014 on economic growth by drawing down on the savings from its oil stabilisation fund to support public finances and investment. However, these funds were depleted in early 2017, and since then the authorities have embarked on a path of fiscal consolidation to rein in the budget deficit. This had a predictable impact on real GDP growth, which had held up reasonably well at 3.7% and 3.2% in 2015 and 2016, respectively, before slowing markedly to 1.4% in 2017, according to the IMF. Although the non-hydrocarbons sector – which accounted for about 77% of GDP in 2017 – accelerated modestly from growth of 2.3% in 2016 to 2.6% in 2017, this was swamped by a dramatic swing in the hydrocarbons sector, which contracted by 3% in 2017 after a 7.7% gain in 2016.

According to the National Statistics Office, year-on-year (y-o-y) growth continued to weaken in the second quarter of 2018, with real GDP expanding by 0.7% compared to 1.5%. The performance of the hydrocarbons sector dulled significantly, contracting by 8.2%, while non-hydrocarbons activity grew by 2.8%. The latter was led by the agriculture sector, which expanded y-o-y from 0.7% to 8.9%, although it was somewhat muted by the industrial sector, which moderated from growth of 4.4% to 2.1%. The continued recovery of oil prices in 2018 should help the hydrocarbons sector regain lost ground, while supportive monetary and fiscal policies should see the rest of the economy gain momentum through to the end of 2018 and into early 2019.

In its latest World Economic Outlook, published in October 2018, the IMF forecast real GDP growth to increase to 2.5% in 2018 and 2.7% in 2019, before trending lower each subsequent year to a growth rate of less than 1% by 2022 as efforts to correct public finances weigh increasingly on demand. The impact of fiscal policies is expected to be channelled largely through the non-hydrocarbons sector, with greater flexibility in public expenditure to drive a 3.4% expansion of the sector in 2018, which would be its fastest growth in three years, before declining to 2.9% in 2019, 1.8% in 2020 and less than half that rate in the following years, according to the IMF’s 2018 Article IV Consultation for Algeria. The recent recovery in oil prices, together with a modest increase in the volume of extracted oil and gas, is expected to result in a rebound in the hydrocarbons sector, with 1.3% growth in 2018, 2% growth in 2019 and a modest acceleration thereafter.

Oil & Gas

Although the hydrocarbons sector accounted for only 23% of GDP in 2017, it constituted 96% of total exports and roughly 60% of government revenue. Thus, its importance is magnified as the public sector still plays such a central role in the economy. Production of hydrocarbons jumped from 141m tonnes of oil equivalent (toe) in 2015 to 153m toe in 2016, before falling slightly to 152m toe in 2017. The IMF projected that production would advance gradually over the following years to reach 159m toe by 2020, the vast majority of which is likely to continue to be exported. Crude oil exports are expected to remain steady at 500,000 barrels per day between 2017 and 2020, while natural gas exports are expected to increase modestly from 53.4bn cu metres to 56.2bn cu metres.

Since mid-2014 the challenging oil price and macroeconomic backdrop has constrained investment, in turn hampering efforts to ramp up production. Data on the first quarter of 2018 suggested that investment in the oil and gas sector dropped by 9.9% y-o-y, while aggregate production of hydrocarbons declined by 0.9%, as the 1.4% increase in natural gas production was insufficient to offset a 4.1% decline in crude oil and condensate output.

Hydrocarbons production continues to be dominated by Sonatrach, the state-owned oil and gas company, which exploits its own fields as well as collaborates with foreign partners. As part of ongoing efforts to attract higher levels of foreign investment to the sector, the authorities plan to finalise a new hydrocarbons law reform in early 2019 to this effect. It is expected that the revised hydrocarbons law will include a wider range of contracts – in addition to the production-sharing arrangements already in play – and possibly new tax incentives to encourage foreign investors. “Domestic demand for hydrocarbons is increasing faster than production, so much so that the amount of oil and gas available for export is falling,” Rachid Sekak, senior advisor on commercial and investment banking at BRS Consultants, told OBG. According to Sekak, this imbalance is exacerbating the country’s twin deficits.

In the longer term Algeria has significant non-conventional shale reserves of both oil and gas, which should further support increased production of hydrocarbons. Although not currently commercially exploited, Algeria has the third-largest shale gas reserves in the world, estimated by industry players to stand at 20trn cu metres, which is around four times greater than its conventional reserves.

Growth Model

Taking stock of the perennially hydrocarbons-dependent economy, the government outlined a new growth model in mid-2016, setting up a strategic vision for economic development and diversification by 2030. This was accompanied by a medium-term fiscal consolidation plan that originally sought to reach a balanced budget by 2020. However, these budget cuts worsened the slowdown in economic growth in 2017, prompting the government to reverse course later that year. In October 2017 the authorities launched a new macroeconomic strategy that is based on four pillars: increased fiscal spending in 2018 and a revised consolidation trajectory that seeks to reach a budget balance by 2022; looser monetary policy, whereby the central bank is permitted for a period of five years to directly finance the government, purchase outstanding sovereign debt and inject money into the National Investment Fund; restrictions on certain imports to correct external imbalances and foster domestic production; and commitments to a range of structural reforms that are aimed at improving the business climate and broader economic performance (see analysis).

State Budget

Under the revised medium-term budget framework adopted in October 2017, nominal budget spending for 2018 was increased by 12%, with the most notable expansions in capital investment. As a result of these changes, the budget deficit is expected to widen modestly from 8.8% of GDP to 9%, which is still an improvement compared to the budget deficit high of 15.7% of GDP in 2015. The government signalled its intention to push back their target year for balancing the budget from 2020 to 2022, expecting deficits as a share of GDP to slow down to 4.8%, 3% and 1.7% in 2019, 2020 and 2021, respectively.

The 2019 Finance Law, which was adopted by the government in September 2018, sets out tax and spending measures for the coming financial year, which suggest that the start of any meaningful fiscal consolidation is to be further postponed until 2020. The 2019 Finance Law did not contain increases in taxes or charges for public services, which notably ruled out further contentious changes to the energy subsidy regime for the time being. Government revenue is projected to increase modestly by 0.2% to AD6.5trn (€47.2bn) in 2019, while spending is expected to be reduced moderately to AD8.6trn (€62.4bn) following a large increase in the 2018 budget. Given that inflation is expected to reach 4.5% in 2019, with the government projecting GDP growth at 2.6%, these changes suggest only a very modest fiscal consolidation in real terms, from a deficit of 10.8% of GDP in 2018 to 10% in 2019. At nearly AD2.2trn (€16bn) in nominal terms, the 2019 budget deficit is significantly higher than the AD580bn (€4.2bn) which was estimated at the time the 2018 budget was approved.

The 2019 draft budget dedicates approximately one-fifth of public spending, equal to AD1.8trn (€13.1bn), to social programmes, while the cost of public services was expected to increase to nearly AD5trn (€36.3bn), attributed to greater border security costs. The government is budgeting for a small decrease in capital investment in 2019, and will not be allocating AD300bn (€2.2bn) for the payment of arrears to suppliers as it had done in 2018.

National Debt Levels

The country was reasonably well positioned financially before the onset of the oil price drop-induced challenges in 2014, with low debt levels, at 7.7% of GDP, as well as significant savings that had built up in its hydrocarbons stabilisation fund. This allowed the country to weather against large budget deficits of 15.7% of GDP and 13.5% of GDP in 2015 and 2016, respectively. However, the hydrocarbons fund ran out in early 2017, which led to national debt reaching 27% of GDP by end-2017.The IMF has forecast further deficit increases of over 40% of GDP by 2020, before budget adjustments put it on a declining path. The postponement of fiscal consolidation implied by the 2019 budget suggests that the debt-to-GDP ratio is likely to peak at a level even higher than the 34.8% that was envisaged by the IMF in mid-2018.

The country’s exposure to global financial markets and currency depreciation is reduced by the authorities’ long-standing avoidance of foreign financing. Gross external debt in 2017 amounted to only 2.4% of GDP, equal to $4.1bn, and is projected to decline gradually over the coming years. Despite suggestions from the IMF and other industry observers to consider tapping foreign sources of financing in the future, particularly as the country tries to wean itself off monetary financing, no near-term changes to this policy stance are expected. “The authorities are still dogmatically opposed to seeking foreign financing, partly due to Algeria’s history of over-indebtedness in the 1990s when they had to deal with the Paris Club and the London Club of international creditors,” Sekak told OBG.

In order to finance budget deficits, as well as capital investment by state-owned enterprises and those made via the National Investment Fund, the government adopted a policy of monetary financing, whereby the Bank of Algeria would be permitted to purchase sovereign and quasi-sovereign debt. The IMF estimated that by the end of 2018 this monetary financing would reach 23% of GDP. Although the policy would facilitate large budget deficits and restore liquidity to the banking sector in the short term, some concerns have been raised that continuation of this approach could lead to significantly higher inflation and increase the risks of a future economic crisis (see analysis).

Inflation

With economic growth slowing and liquidity in the banking sector drying up, inflation moderated from an average of 6.4% in 2016 to 5.6% in 2017. The government’s revised economic strategy, notably including looser fiscal and monetary policies, was not only expected to support economic growth, but also to lead to a spike in inflation.

Average prices during the first seven months of 2018 were 4.5% higher than prices during the corresponding period in 2017. Food prices, which make up nearly half of the basket of goods used to calculate the consumer price index, inflated by around 4%, while the cost of housing, which makes up one-10th of the basket, advanced by only 0.9%. “Inflation has not yet picked up as much as some had feared when the government introduced monetary financing, which is partly because the index is out of date and does not fully reflect the cost of living, and partly because there has not yet been a big increase in public sector wages,” Sekak told OBG.

According to October 2018 World Economic Outlook, the IMF projects a pickup in headline inflation to 6.5% in 2018 and 6.7% in 2019. Of greater concern, however, is the fund’s longer-range projections that expect inflation to continue accelerating to double figures by 2022. This indicates that, even on the current trajectory, assuming the government gradually withdraws fiscal and monetary policy accommodation, there are long-term risks that consumer price inflation and expectations may become unanchored.

Reserves

In the face of a large current account deficit and market pressure for the dinar to depreciate more than it has, foreign reserves at the Bank of Algeria have declined precipitously from $177bn at 33 months’ of the following year’s imports in 2014 to $96bn at 19 months of imports in 2017 and $87bn by mid-2018. Although the pace of decline has slowed, the IMF is still projecting further deterioration to $64bn in 2019 and as low as $12bn at only three months’ worth of the following year’s imports in 2023. According to two adverse scenarios included in the fund’s 2018 Article IV Consultation, Algeria’s international reserves could reach dangerously low levels even sooner in the event of either lower-than-anticipated oil prices or higher-than-anticipated government spending.

The authorities also signalled that the level of reserves is an area of concern in February 2018, and stated that further efforts are needed to better match internal demand and supply so as to help stave off or minimise further declines. Protecting reserves by reducing the trade deficit was one of the motivations cited for imposing a raft of import restrictions in January 2018.

Depreciation

The Algerian government initially resisted market pressures to devalue the dinar following the drop in international oil prices. In January 2015 the currency even strengthened slightly to nudge below AD100:€1. By early 2018, however, the dinar experienced a cumulative depreciation of nearly 30% to surpass AD140:€1.

With foreign reserves dwindling and the current account deficit set to remain relatively wide, pressures are likely to remain in the direction of further depreciation in the coming years, particularly if the backdrop of a strong dollar and a complicated environment for emerging markets persists, or if the upward trend in oil prices were to reverse. To the extent that the authorities continue to resist more than modest depreciation, there is likely to be increased divergence between the official exchange rate and the effective exchange rate on the informal currency market, a premium running at 45% by mid-2018 (see Financial Services chapter). This would further increase the incentives for economic actors to engage in rent-seeking activities by, for example, over-invoicing in foreign currency for imported goods and using the excess to sell at a profit on the parallel market.

Foreign Trade

Of total exports in 2017, oil and gas accounted for 96%, with the share edging back upwards, largely supported by the recovery in oil prices. Despite government efforts to promote diversification and domestic production, no great progress has been seen in the medium term as non-hydrocarbons do not account for a significant share of exports. Algeria’s top-three non-hydrocarbons exports in 2017 consisted of inorganic chemicals (1.1% of total exports), fertilisers (0.9%), and sugar and sugar confectionery (0.6%).

Algeria is a key supplier of natural gas to the EU market, with Italy accounting for a 16% share of total exports in 2017, France with 12.9% and Spain with 11.9%. Meanwhile, the US made up 9.8% of total exports that year. In terms of imports, China is Algeria’s biggest source market making up 18.1% of total inbound trade, followed by France (9.4%), Italy (8.2%), Germany (7%) and Spain (6.8%).

Balance of Trade

The relative price of Algeria’s exports to the price of its imports, known as the terms of trade, fell by approximately two-thirds during the 2014-16 period due to the decline in global oil prices. Total export volume fell by a similar magnitude, while import volume only fell by approximately one-10th over the same period. This resulted in a dramatic swing in the trade balance from a surplus of $30m in 2014 to a $20.4bn deficit two years later before narrowing to a deficit of $14.3bn in 2017. The IMF projected that the trade deficit would narrow to $9.4bn in 2018, but widen again to $11.6bn in 2019, before contracting to 9.5% and 7.5% in 2020 and 2021, respectively. This will depend to a large extent on the trajectory of oil prices over the coming years, given the significant role that hydrocarbons play in Algerian trade.

Since trade balance is the most important component of the current account, it is not surprising that the latter followed a similar pattern, with the deficit ballooning from 4.4% of GDP in 2014 to 16.5% in 2016 before narrowing to 12.9% of GDP in 2017. The IMF projected that the current account deficit would also remain elevated in the medium term, widening slightly from 9.7% of GDP in 2018 to 10.1% of GDP in 2019, before narrowing gradually yet remaining greater than 5% of GDP through to 2023.

Foreign Investment

Between 2008 and 2017 Algeria’s inward stock of FDI nearly doubled as a share of GDP from 8.5% to 16.7%, peaking at 17.3% in 2016. Progress has slowed in more recent years, with annual inward FDI flows averaging less than 1% of GDP between 2012 and 2017. Algeria remains the lowest recipient of inward FDI stocks in the Maghreb region, with barely more than half the level of Libya, the next lowest in the region with 29.9% of GDP, let alone the 72% of neighbouring Tunisia, the regional leader on this metric. While Algeria has been a relatively closed economy for some decades, this stance has shifted in more recent years, with successive economic development strategies explicitly targeting the attraction of FDI.

Efforts are also under way to diversify the sources of foreign investments, as evidenced by Algeria signing a memorandum of understanding in September 2018 to join China’s Belt and Road Initiative, for example. Increased FDI could also be a valuable source of not only capital, but also of the technology and know-how that is needed to boost productivity levels and support economic diversification and domestic production (see analysis).

Investment Environment

The country’s investment climate has become gradually more complicated in recent years, particularly for foreign investors. This evident in the country’s rankings in international indices. For example, in 2008 the World Bank ranked Algeria 134th globally out of 178 economies in its ease of doing business index; however, in 2018 the country’s rank dropped to 166th out of 190 countries. For comparison, neighbouring Morocco and Tunisia ranked 69th and 88th, respectively, in 2018. Algeria registered particularly weak performances in the categories for protecting minority investors (170th position), getting credit (177th) and trading across borders (181st).

Nevertheless, some important progress has been made in recent years. In July 2016, for example, Algeria adopted Law No. 16-09, also known as the Revised Investment Law, as well as accompanying decrees, which updated the legal framework governing investments in the country. One important innovation was the removal of the obligation that foreign investments generate a foreign exchange surplus for the host country over the course of that investment. This made it easier for foreign investors to repatriate profits generated in Algeria.

Meanwhile, the reported burden on foreign minority investors was eliminated in cases where the stake held does not exceed 10% of the Algerian firm’s capital. At the same time, a wide range of new investment incentives were also introduced, and these are open to all investments that are not included on the negative list of 110 economic segments published in March 2017. Additionally, a number of extra incentives have been introduced for investments that are deemed to be of special or strategic interest to Algeria, so long as an investment agreement is signed between the investor and the National Investment Development Agency.

While there was some speculation that the 2016 Investment Law or its subsequent legislative initiatives would row back the restrictions of the 49:51 rule – which prohibits foreign investors from taking majority stakes in Algerian companies – this has not yet transpired. Irrespective of the macroeconomic backdrop or the investment climate, this restriction on ownership remains one of the most important roadblocks for foreign investors.

Public-private Partnerships

According to the World Bank’s Public-Private Partnership (PPP) Knowledge Lab, a total of 26 PPP projects were undertaken in Algeria between 1990 and 2017, with corresponding investment commitments amounting to $8.3bn. The largest of these projects was the $2.3bn Maghreb-Europe Gas Pipeline, which came on-stream in 1996, followed by a number of projects in the utilities sector relating to the provision of electricity and water and sewerage management. However, there have been no new PPP developments since 2012. Additionally, the government’s stated intent to promulgate a dedicated PPP law had still not been realised as of December 2018, despite extensive preparatory work and consultation having been carried out in recent years.

Increased reliance on the PPP model could help to diversify sources of funding for capital investment as well as reduce pressure on public finances. While the adoption of a dedicated PPP law and a supportive institutional framework would improve the attractiveness of the Algerian market for potential concessioners, PPP projects face other challenges as well, such as high levels of unemployment, which need to be addressed for an investment-friendly environment to be established.

Employment

Algeria has been challenged by double-digit unemployment figures for most of the past decade, with the headline rate ranging between 9.5% and 12.5% in the 2008-18 period, while the employment rate has hovered just above 40%. The unemployment rate was 11.1% in April 2018, down from 12.3% a year earlier, while the rate of participation in the labour force remained steady at 41.9%.

This relatively weak long-term labour market performance can at least partly be explained by the lower participation and employment rates among youth and women. The labour force participation rate among men was 66.7%, some four times higher than among women (16.6%), with a similar divergence in employment rates – at 60.7% compared to 13.4%. Meanwhile, the unemployment rate among women stood at 19.5%, close to double the rate among men. Similarly, the unemployment rate in the 16-24 age range, regardless of gender, was 36.4%, roughly four times higher than those in the range of 25 years and over. The divergence is even more striking by gender, with unemployment rates among women more than twice as high in both age cohorts. Twice as many men work in the private sector (67.4%) as the public sector (32.6%), whereas women are more likely to work in the public sector (57.4%). Social unrest due to labour market conditions is not prevalent, although there were a series of strikes in early 2018 among doctors and teachers who were protesting pay rates.

Outlook

Algeria’s change in macroeconomic strategy in late 2017 has bought some breathing room, and should ensure reasonable economic growth and macroeconomic stability through to early 2019. The sustainability of this approach is not without risks, however, and rests on the adoption of the necessary corrective measures from 2019 onwards. Unless there is a significant and sustained increase in global oil prices to offset the impact of medium-term fiscal consolidation, economic growth is set to slow over the coming years until the twin budget and current account deficits are brought closer to balance. Even as inflation begins to moderate, weak growth per capita suggests that living standards will continue to stagnate.

Meanwhile, the government’s capacity to confront any future balance of payments crisis is likely to be constrained by the expected medium-term rundown in central bank reserves. The quantitative easing approach has also raised the risk of a more adverse scenario if, for example, the global economy were to witness another drop in oil prices. Given that oil prices continue to be the main driver of Algeria’s economy, the country’s long-term challenge remains to further diversify the economy and seek more stable sources of income, while at the same time better translating its oil and gas revenues into broadly shared improvements in living standards.