Morocco prepares to grasp nettle of subsidy reform
* Surge in subsidy spending kept peace politically
* But left state finances in unsustainable position
* Reforms could start as early as June
* Would replace subsidies with cash payments to poor
* But government may choose slow, partial reform
RABAT, Jan 16 (Reuters) - The alleys of Rabat's old city resound with the shouts of street vendors advertising Chinese consumer goods such as fabrics and electronic gadgets. But the area's vegetable sellers, from whom many residents buy dinner on the way home, are unusually quiet.
"Prices have increased since the winter began, so we don't have anything positive to shout about," says Hassan Hansali, whose shop offers carrots, onions, tomatoes and green peas.
Abdelhaq Jbili, a neighbouring vegetable trader, agrees that rising prices are making business more difficult but suggests a different reason.
"Vegetable prices have risen since the government raised oil prices," he says, referring to a 20 percent hike in subsidised petrol prices last June. More expensive petrol has pushed up harvesting and transport costs, making food dearer too, he says.
Morocco's cash-strapped government is preparing to launch its biggest economic policy change in years: root-and-branch reform of the system of food and energy subsidies which it uses to keep down the living costs of millions of people.
The reforms are needed to prevent heavy government borrowing from destabilising the economy, and could serve as a model for the governments of other Arab countries, such as Egypt, which need to repair their finances after the region's wave of unrest.
But as the conversation in Rabat's old city suggests, the reforms are politically risky. Even a relatively minor change to the system, such as the petrol price hike, can affect Moroccans' living standards; major reform could prompt a backlash against the government.
Last month, New Year festivities in the tourist city of Marrakesh were disrupted by a clash between police and demonstrators protesting an electricity price rise. Thirty people were arrested.
"The risk of the reform is the impoverishment of the middle class," finance minister Nizar Baraka has said in a parliamentary debate.
Najib Akesbi, an economist at the Hassan II Institute of Agronomy and Veterinary Science in Rabat, said changes would have to be designed carefully to avoid disaster.
"For bread and sugar, there isn't a real danger, but cooking gas prices will triple if the subsidy system is completely abolished. The government has to think how to protect" the people most affected by the reform, he said.
Morocco's subsidy system began heading towards crisis in early 2011, when the government started sharply raising its spending on subsidies to buy social peace as uprisings engulfed other countries in the region.
Politically, the strategy worked; the country saw street protests demanding democracy and better economic management, but there was no sustained challenge to King Mohammed's government. The protests faded after the king introduced constitutional limits to his powers and let an Islamist party form a cabinet after elections.
But economically, the policy has left the government in an unsustainable position. State subsidies on food and energy jumped from 29.8 billion dirhams ($3.56 billion) in 2010 to 48.8 billion dirhams in 2011 and 53 billion dirhams, or nearly 7 percent of gross domestic product, in 2012.
Morocco does not face any immediate financial crisis; the government's gross debt is 58 percent of GDP, according to the International Monetary Fund, lower than levels for several other Arab States.
Last month Morocco raised $1.5 billion with an international bond issue, a sign that international investors still have confidence in it.
But signs of financial stress are emerging. Since the international bond sale, the Treasury has borrowed about 15 billion dirhams by issuing short- and medium-term bills in the domestic money market.
This has drained funds needed for bank lending and private investment, pushing the interest rate on 26-week T-bills up to 4.06 percent from its level early this month of 3.59 percent.
"The state borrowed 10 billion dirhams in the domestic market in one day. This is unprecedented," wrote local analyst Omar El Hyani. He said liquidity created by the central bank was flowing to the Treasury, bypassing the private sector.
Morocco is also under pressure from the IMF. Last August the multilateral lender approved a $6.2 billion precautionary line of credit for Morocco but urged action to reform subsidies, though it did not formally tie the reform to the aid.
The country needs the aid because it is running a large deficit in trade of goods and services; its foreign currency reserves are worth about four months of imports, which economists say is an uncomfortably low level.
Reforms could start as soon as June, the state news agency quoted general affairs and governance minister Mohamed Najib Boulif as saying this month.
"Technically, the reform of the subsidies system is quite ready," he said. "Once talks are concluded and the political decision is taken, it will be launched."
Nabila Mounib, head of the opposition Unified Socialist Party, said he believed that meant the government was waiting for approval from the royal palace, which still plays a key role in decisions on major issues.
Under draft plans released by officials, the government would fully or partially replace the current subsidy system with monthly cash payments of 1,000 dirhams to as many as 2 million of Morocco's most needy families.
If the plan proceeds in full, it would cut the state's annual bill to 24 billion dirhams. The process would take around four years and could eventually raise inflation, now officially running under 2 percent, to 7 percent, officials calculated.
The government may see a 7 percent inflation rate as politically too risky, however, so it may implement the reforms only in part. Boulif himself has said prefers "the intermediate way", which would involve initially cutting the state's financial burden by about a third.
Despite the IMF's pressure, analysts say the government may not, in the first stage at least, touch subsidies for wheat and cooking gas - which are socially very sensitive - and merely begin with sugar and electricity.
"I'm not really confident about this reform," said economist Akesbi, warning that changes to the system might be used by corrupt suppliers to manipulate prices for their own profit.
"The government cannot launch such reforms without thinking about how to control inflation. Success depends on it."