Morocco: A packed reform agenda

The Moroccan economy is bustling with activity. This stands in stark contrast to economic output in 2005 when GDP growth slumped to 1.8%. Growth last year was stunted by a soft performance in the agricultural sector, which accounts for around 15% of GDP. Cereal output fell from an average of 6 million tonnes to just above 4 million tonnes as a drought wilted output. The
abolition of quantitative restrictions on exports and textiles that came into effect in January 2005 also adversely affected Morocco's textile sector. The associated reduction in consumer spending further compounded the weak growth cycle. Now, the official 2006 GDP growth forecast is estimated at 5.6%, fuelled by better weather conditions, close to our GDP growth forecast
of 5.9%. Recent comments from Moroccan officials even suggest growth may top 7% driven by a bumper crop.

Agriculture aside, policymakers will be cheered by improvements in other sectors of the economy. The services industry is likely to receive a boost from increased tourism inflows. In Q1-06, total tourists to Morocco rose by over 11% y/y and tourists spending increased by 15% y/y. Despite Morocco's pervasive unemployment, recent figures have shown a 1.5% rise in employment as at end Q1-06 compared to the same period last year. The unemployment rate is now estimated at 9.8%, the lowest jobless rate in 35 years. Additionally, inward remittances from Moroccans abroad is expected to swell the FX reserve position and keep the current account positive,
despite the burgeoning trade deficit. Over the last 5 years, worker remittances have averaged USD 3.7bn. This is expected to reach USD 5bn in 2006 as Moroccans abroad are encouraged by an improving business and regulatory environment.

Economic reform is now the primary concern for the government as it seeks to reduce the country's reliance on a volatile agricultural sector. One immediate beneficiary of this drive is the tourism industry. Here, the government intends investing USD 12bn to attract 10 million holidaymakers and boost revenue to USD 7.0bn per year. It is currently estimated that the
sector earns around USD 4.5bn per year. Fiscal reform is being undertaken and authorities are trimming the public-sector wage bill and instituting measures to simplify and eliminate distortions in the tax system. One other important facet in Morocco's reform agenda is trade liberalisation as policymakers hope to stimulate stronger export-led growth. In this regard, bilateral agreements were signed in 2004 with Turkey and the US. Morocco also hopes to meet the conditions required to join the Euro-Mediterranean Free Trade Area in 2010. However, there is some concern that trade liberalisation will fall short of expectations without the appropriate financial sector reforms.

While the reform drive is laudable, markets are likely to focus on ongoing financial sector changes. Initial results have been encouraging. For one, the central bank has made significant progress towards improving banking supervision. Consequently, non-performing loans have fallen to around 14% from 19.4% in December 2004. Commercial banks have also begun diversifying their activity away from public sector clients. Recently, the government agreed to repay around USD 630mn of loans from the central bank by end-07. It is hoped this will facilitate government disengagement from the central bank and help create conditions necessary for more independent setting of monetary policy. Although we forecast any change on this front to be slow, this is an encouraging sign. In March, the central bank dropped the ceiling on commercial borrowing rates by 14bps to 12.9%. This helped lift private credit extension to 8.5%y/y in March, its strongest rise since October 2005. A recent report by S&P confirmed Morocco's banking sector was strengthening and should benefit from nascent business momentum.

Exporters would also like to see faster currency reform. Morocco currently has a conventional peg arrangement. The central exchange rate of the Moroccan dirham (MAD) is pegged to a basket of currencies representing Morocco's principal trading partners, mainly the euro. The central bank fixes daily rates for the rated currencies on the basis of variations in the value of the basket. Current account transactions are free but capital account transactions are restricted. Although authorities have long resisted pressure to weaken the currency, there are reasons making arguments for a change of regime more compelling. Renewed euro strength has lifted the dirham to its strongest level since December 1993, on an export weighted exchange rate basis. This will weaken competitiveness. The need, therefore, to render Moroccan exports more competitive in light of more open international trade, means currency reform cannot be ignored.

In May 2005, we argued that market fears for a devaluation of the currency were overdone. Our view then was that a change in the currency regime would have been premature. One of the reasons we cited was the lack of a nominal anchor for inflation if a strong currency were removed. Now, we endorse policymaker's desire to move to a more flexible exchange rate regime in 2010 given the important changes to monetary policy and financial sector supervision. However, markets should expect piecemeal rather than blanket dirham convertibility. On their part, policymakers must persist in improving the regulatory environment. The progress achieved so far is encouraging and suggest that authorities can increase the attractiveness of the economy and achieve even higher growth rates if the right policy mix is in place.