Algeria's enviable external liquidity position derives from its thriving hydrocarbon sector.

The Algerian government recently announced that it had repaid over half of its USD 763mn debt owed to Germany ahead of schedule. Algeria has concluded similar agreements with 15 other creditor nations, members of the Paris Club. Italy and France, Algeria's largest creditors, were among the countries repaid in full, getting back USD 1.7bn and USD 1.6bn respectively. Algeria has now reimbursed nearly 90% of its USD 7.9bn Paris Club debt. Algeria's external debt has now fallen to less than USD 10bn as at end H1- 06 from USD 16.4bn at end 2005. The Finance Ministry even estimates that the level of external debt will be slashed to USD 5bn by the end of the year. We find this forecast to be credible given the government's visible commitment in paying down its debt, the absence of any new external borrowing since 2005, but especially due to the country's buoyant external liquidity.

Algeria's oil bonanza

Algeria's enviable external liquidity position is tightly intertwined with its thriving hydrocarbon sector. Algeria currently produces around 1.3m barrels of oil per day and has around 11.4bn barrels of proven oil reserves, the second largest in Africa behind Nigeria. Algeria exports over 80% of its oil and gas and hydrocarbon revenues account for over 95% of the country's foreign reserves. Given the size of its oil reserves, the government has announced a production target of 2m barrels of oil per day and 85 cubic metres of gas per year by 2010. In May, oil revenues stood at USD 66bn at an annual rate from only USD 17bn in 2001 and FX reserves have increased to USD 66bn, equivalent to three years of import cover. The increase in hydrocarbon exports also accounted for Algeria's 15.3bn trade surplus in H1-06, up 41 %y/y.

Algeria's debt prepayment will go down well with international investors

In 2006, we expect the oil sector to boost output further, maintaining trend growth at over 5%. Growth will also benefit from the government's USD 80bn investment programme which is improving construction activity. Port activity, a bellwether for the country's economic performance, has grown over 250% in the last decade. We expect this momentum to continue with port activity growing by over 20% in 2006 as exports continue to accelerate. Despite this increase in economic activity, policymakers will be pleased that price pressures remain tame. Although reported inflation in H1-06 came in at 1.0% y/y, we still expect strong demand to push consumer prices nearer to x4% in the medium term.

One area that is benefiting from the combination of strong external liquidity and an improving economy is the local currency. Earlier this year, the central bank suggested, uncharacteristically, that the value of the dinar could benefit from Algeria's strong balance of payments position. Despite remaining fairly stable since the start of the year, the dinar has adopted a mild appreciating bias and could temporarily break past its year-to-date high of DZD68 to the USD before the end of the year. It is our view that although the dinar will benefit from Algeria's strong balance of payments position, longer term there will be a need for a more flexible currency. Algeria's accession into the Association Agreement and the subsequent liberalisation of its economy to trade with European and Mediterranean countries should give rise to a more competitive position.

Another positive development on the currency market deriving from Algeria's improving economic profile is the narrowing of the spread between the parallel and the official exchange rate. The Algerian Association of Banks and Financial Institutions reports that the parallel market spread over the official rate has decreased from 25% in September 2003 to 1% currently and sometimes even to zero. The erosion of parallel market spreads is likely to increase the volume of hard currency passing through official channels and should further boost currency reserves. Additionally, new government regulations that importers hold a minimum of DZD 20mn (USD 270,000) and the ban on the import of second hand cars have contributed to a decline in dollar demand on the informal market.

Structural problems persist

In spite of these successes, Algeria still has some way to go in redressing the structural imbalances that exist in the economy. Despite fairly strong economic output, recent figures released by the central bank suggest disappointing growth outside the hydrocarbon sector. The agriculture sector has been the worst affected, growing only 1.3% in 2005 from 3.4% in 2004.Agriculture now accounts for only 7% of the economy down from 10% in 2004, in spite of the fact that over 25% of the population is engaged in agriculture in either full-time or part-time employment.

Efforts to revamp the domestic economy are unlikely to be immediately palpable.

Unemployment is also a major concern for policymakers. Currently, official unemployment is reported at 15.3% from 17.7% in 2004. Whilst this is a decline in the unemployed rate, anecdotal evidence suggests that the actual rate is much higher partly due to the fact that the labour force is not fully accounted for by official statistics. Of even greater concern is the high level of unemployment among those under - 30 estimated at around 75%. The Algerian authorities are keen to improve youth employment given how easily this can increase social tensions. In July, the government unveiled a USD 13bn supplementary budget to fund public sector wage rises and development projects after an outcry of deepening poverty from unions. This is in addition to an ongoing 5-year investment plan to revamp and expand Algeria's transport links and social infrastructure including schools and hospitals.

The government is also attempting to channel some of the hydrocarbon sector's resources into other parts of the economy. Against this backdrop, the authorities have introduced a windfall tax on extraordinary profits 'to meet the needs of national development'. This tax will be applied to profits generated by oil prices above USD 30 per barrel. The government admits this move has been prompted by Algeria's failure to diversify its economy beyond the energy sector. Whilst it is true that Algeria's development needs are immense, the government's application and use of income generated from this new tax still has to be proven. So far, Algeria has taken the right steps towards improving its external creditworthiness and its debt prepayment to the Paris Club will go down well with international investors. The emphasis on domestic investment and development shows that authorities would like to improve the domestic economy. However, the scale of the imbalances within the economy suggests that public efforts are unlikely to be immediately palpable.

Structural problems dampen Algeria's oil bonanza