Peru - Program Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-2504-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROGRAM LOAN TO THE REPUBLIC OF PERU April 9, 1979 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS The exchange rate is being adjusted daily roughly in line with the difference between domestic and international inflation. The exchange rate and currency equivalents in effect on March 29, 1979, were as follows: Currency Unit = Sol (S/.) Calendar 1978 March 29, 1979 US$1 = S/. 160 S/. 210 S/. I e US$0.0062 US$0.0047 FISCAL YEAR January 1 to December 31 ABBREVIATIONS BIP - Banco Industrial del Peru (Peruvian Industrial Bank) CERTEX - Tax Credit Certificate ERP - Economic Recovery Program FENT - Fondo de Exportaciones No Tradicionales (Non-Traditional Exports Fund) PETROPERU - Petroleos del Peru (National Oil Company) PSIP - Public Sector Investment Program RNM - Registro Nacional de Manufacturas (National Registry of Manufactures)  FOR OFFICIAL USE ONLY SUMMARY OF THE PROPOSED LOAN Borrower: Republic of Peru Loan Amount: US$115 million Terms: Repayment in 17 years, including 4 years of grace, at 7.9 percent interest per annum Loan Description: The proposed loan would make available US$114.9 million to help meet foreign exchange requirements for high priority imports in support of an Economic Recovery Program (ERP) agreed upon with the Government. The loan would also finance US$100,000 in'technical assistance. The counterpart funds generated would help finance priority public investment projects except that, if warranted by demand, up to US$15 million in counterpart funds may be used to establish a dollar denominated revolving fund to finance imports used in the production of non-traditional exports. The main risk which the program loan faces is whether political developments in Peru might impede the Government's efforts to carry out the stringent ERP. Estimated Disbursements: The loan would be disbursed in four tranches. US$40 million would be available for disbursement after effec- tiveness. US$30 million of the loan would be disbursed after a first review of progress on execution of the ERP in July 1979 and another US$30 million would be disbursed after a second performance review in October 1979. The final US$15 million would be disbursed after a third performance review, in January 1980. Because 120-day foreign financing is currently required for most imports, in order to begin disbursement promptly, goods imported under licenses issued up to 120 days before signature of the loan would be eligible for reimbursement provided the Central Bank has not released foreign currency for this purpose prior to loan signature. Procurement Arrangements: Only goods purchased from Bank member countries and Switzerland would be eligible for reimbursement. Purchases would be on the basis of normal commercial practices, except that contracts of over US$5 million would be procured by international competitive bidding. Purchases of health supplies would be made through the Pan American Health Organization which buys in large quantities and can, therefore, obtain favorable prices. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Consultants: Up to US$100,000 will be made available from the loan to finance technical assistance necessary for carrying out the ERP. About US$30,000 of this will finance the design of a tax enforcement program. This study is already underway and approximately US$25,000 used to initiate the study will be financed retroactively from the proposed loan. Appraisal Report: None.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROGRAM LOAN TO THE REPUBLIC OF PERU 1. I submit the following report and recommendation on a proposed program loan to the Republic of Peru for the equivalent of US$115 million. The loan would have a term of 17 years, including 4 years of grace, with interest at 7.9 percent per annum. PART I - THE ECONOMY 2. A basic economic report entitled "Long-Term Development Issues: Peru" (Report No. 2204-PE, dated April 13, 1979) is being distributed to the Executive Directors. This Part is based on the report's findings as well as those of the mission which appraised the proposed program loan in December, 1978 and of a follow-up mission in March, 1979. Annex I contains the basic country data and a Statistical Appendix is attached as Annex VII. Background 3. Peru, the fourth largest country in Latin America, is divided by the Andes mountains into three distinct regions. The coastal region (the Costa), constituting about 10 percent of the country's territory, is home for about 46 percent of the population. It consists of a narrow belt of dry plains, intermittently irrigated valleys and Andean foothills. Modern economic activity is concentrated in the Costa, particularly in Lima. The Sierra, with 44 percent of the country's population, encompasses the highlands above 2,000 meters which occupy one-fourth of the country. The remaining two-thirds of the area is occupied by the sparsely populated Selva, vast tropical lowlands east of the Andes. The rugged topography limits trade between the three regions. 4. Peru has abundant natural resources. These include large deposits of varied minerals located mainly in the Sierra and the southern coast. Petro- leum resources, particularly in the jungle areas of the North and offshore, are believed to be substantial but their full extent has not yet been ascer- tained. Another major natural resource asset is the large fishing potential in coastal waters, although the magnitude of this potential is subject to sharp fluctuations. In contrast to mining and fishing, agricultural land is limited. Most of the soils suitable for intensive agriculture (3.5 million ha or 3 percent of the country's total area) are already being farmed. The remaining land with good agricultural potential is concentrated in higher parts of the Selva, with high costs of access and land clearance.  -2.- 5. After three decades of rapidly falling mortality rates (1930-1960) the rate of population growth had risen to 2.9 percent p.a. Since the early 1960's, birth rates have started a gradual fall, mainly caused by the urban- ization process and by improved education. But since death rates have also fallen, population has continued to grow at about 2.9 percent p.a. Since death rates are expected to continue falling, population growth is likely to remain at around 2.9 percent p.a. over the next 25 years, unless an effective demographic policy is adopted. In any case, since there is a lag between the drop in birth rates and its impact on the growth of working-age population, the labor force is expected to grow well in excess of 3 percent per year during the next 15 years. Past Development Policies 6. Since the military came to power in 1968, the Government has followed a development strategy directed at achieving economic growth and at narrowing the sharp differences in wealth and opportunities between population in various income classes and geographical regions. The Government has tried to correct class and regional imbalances by expanding the role of the State in the economy, changing the pattern of asset ownership, reducing foreign ownership of national resources, orienting industry and agriculture toward producing essential goous for the domestic market, stimulating the deconcentration of economic activity out of Lima, and reforming the educational system to make it more responsive to local economic and social needs. Through nationalization and creation of new enterprises, the State has taken direct control of over 150 enterprises in key economic sectors, and its share in total capital formation has risen from less than one-fourth in 1968-70 to over one half in 1974-76. By imposing complex legislation, the Government has also strictly controlled the operations of the private sector. 7. As a result of these actions, the pattern of asset ownership in the economy has changed drastically. Through nationalization, the share of assets owned by foreigners fell sharply. A sweeping land reform redistri- buted 45 percent of the country's best farmlands to workers' cooperatives benefitting some 25 percent of all rural families. Through other laws, industrial workers were given shares in the firms which employed them and, in the mining sector, a share in profits. The Government has also given a strong autarkic orientation to its agricultural and industrial sector policies and strengthened the incentives for industries outside of Lima. 8. The Government's programs have benefitted large numbers of Peruvians, but they have hardly reached the poorest half of the population which continues to live in abject poverty. It is estimated, for example, that 70 to 75 percent of rural families, including the "minifundistas" (those farming less than 2 ha) and the seasonal landless workers, have not been reached by social programs. The Government imposed controls on prices of a number of domestically produced goods and heavily subsidized imported petroleum and foodstuffs. Most of the subsidized products, however, were more important in the consumption basket of the rich than in that of the poorest groups. Moreover, the maintenance of artificially low prices in some cases--such as meat and cereals--hurt the poor who produced these items and negatively affected production.  -3- 9. In the final account, one of the most significant achievements of the Government was the promotion of the cultural and political integration of the country. Owing in great part to the land reform, the rural population has become better organized and able to communicate its priorities in a more forceful and articulate way. Unfortunately, although many of the policies and structural changes carried out since 1968 were meant to achiev- rapid growth and more equality, the cost of these measures proved to be excessive and their implementation inefficient. The Present Economic Crisis 10. The current crisis is the consequence of a combination of external factors and internal developments. Until 1977, the military Government fol- lowed expansionary fiscal and credit policies. A rapid increase in spending by the public sector (including large defense outlays) was not matched by a parallel increase in revenues. Pricing, interest rate and foreign exchange policies until 1976 encouraged consumption and discouraged savings, exports and, sometimes, overall production. As a result of these policies, aggregate demand considerably exceeded aggregate supply. This excess demand, in turn, led to widening external gaps and to strong inflationary pressures, with a resulting loss of international reserves and a massive build-up of external debt. 11. This imbalance was aggravated by circumstances beyond the control of the authorities. Anchovies, the fishing industry's principal product, virtually disappeared as the annual catch dropped from around 10,000 metric tons in 1968-71 to an average of 2,300 metric tons in 1975-78. Since 1974, furthermore, Peru's terms of trade worsened sharply. Export prices, particu- larly for copper and sugar (which together accounted for almost one-fourth of merchandise exports) plummeted at a time when import prices soared. The terms-of-trade index fell by nearly 30 percent between 1974 and 1978, resulting in a foreign exchange loss equivalent to US$330 million in the latter year. Petroleum reserves, which in the early 1970's were predicted to lead to a quick, major expansion in export earnings, have thus far turned out to be much less than expected, and with high access cost. 12. Public sector savings dropped steadily in relation to GDP from 4.4 percent in 1970 to dissavings of 2.6 percent in 1977. A major cause for this was a massive erosion of the tax base owing to excessive tax incentives, loopholes in the tax system and weak enforcement. At the same time, there were rises in the budgetary cost of subsidies for foodstuffs and petroleum products, and sharp increases in military imports and local expenditures. Much of public investment, furthermore, was increasingly concentrated on capital-intensive projects with long gestation periods and little contribution to the growth of output or employment.  -4- Table 1: PERU - Public Sector Finances, 1968-1978 (percentages of GDP) 1968 1970 1972 1974 1976 1977 1978 a/ I. USES 7.8 7.4 8.3 11.1 10.8 9.9 11.3 Capital formation 5.4 5.4 6.0 9.2 8.9 7.0 5.9 Amort. Ext. Debt 2.4 2.0 2.3 1.9 1.9 2.9 5.4 II. SOURCES 7.8 7.4 8.3 11.1 10.8 9.9 11.3 A. Dom. Resources 4.2 4.2 4.5 3.5 4.9 1.4 4.4 Public Sector Savings and Capital Revenues 1.8 4.6 2.9 2.9 -0.9 -2.6 1.0 Net Dom. Borrowing 2.4 -0.4 1.6 0.6 5.8 4.0 3.4 B. Gross Foreign Borrowing 3.6 3.2 3.8 7.6 5.9 8.5 6.9 Memo: Net Foreign Borrowing 1.2 1.2 1.5 5.7 4.0 5.6 1.5 a/ Estimated Source: Central Bank and Bank staff estimates. 13. Inflation accelerated from 5 percent per year in 1970 to 38 percent in 1977. Interest rates on domestic banking system loans, however, remained substantially negative in real terms, discouraging financial savings and stim- ulating capital flight. Moreover, the exchange rate remained practically constant between 1968 and 1975, thus contributing to the overall disequilibrium. National savings fell dramatically from 16 percent of GNP in 1970 to 8 percent in 1977, when they financed only about one-half of investment. Following a period of rapid expansion in 1968-74 during which GDP grew by more than 6 percent per year, the growth rate dropped progressively and became negative in 1977. 14. The growing disequilibrium described above was reflected in the balance of payments. The current account deficit averaged US$1.1 billion per year in 1974-77, equivalent to nearly 9 percent of GNP. To finance this deficit, Peru accumulated a massive external debt. Peru's total private and public external debt--including short-term indebtedness--stood at almost US$8.3 billion by year end 1977, equivalent to two-thirds of GDP and four times exports. Much of this debt was contracted on fairly short maturities with three-fourths of the public sector long-term debt scheduled to be repaid over the 1978-82 period.  -5- Stabilization Efforts and The IMF Program 15. Beginning in 1975 successive economic teams made several efforts to cope with the mounting economic crisis. A major stabilization program was initiated in June 1976, when the sol was devalued from SI. 45 to SI. 65 per U.S. dollar, fiscal and credit policies were tightened and interest rates were raised . This program was initially successful in reducing the fiscal deficit and the loss of foreign exchange. Nevertheless, it was abandoned later in the year as a consequence of strong popular opposition and a lack of consensus within the Government regarding the gravity of the financial situation. Further attempts to stablize the economy were initiated in March, July and September 1977 but they were not successful. A stand-by arrangement was negotiated with the IMF and approved in November 1977, but its targets were not met. While these efforts proved to be false starts, they succeeded in somewhat reducing the gap between national savings and investment from a peak of 11.5 percent of GNP in 1975 to 8.5 percent in 1976 and 7.4 percent in 1977. 16. By mid-1978 the economic crisis had reached grave proportions. The drop in GDP had intensified and inflation had further accelerated to an annual rate approaching 100 percent. Moreover, the private sector was finding it increasingly difficult to open letters of credit for new imports and the banking system's net international reserves had dropped to a negative level of US$800 million. This excludes a medium-term US$396 million balance-of-payments support loan made by commercial banks in 1976 which the Central Bank considers as a further negative item in its international reserves and which is included with Peru's external public debt in this President's Report. It had become clear that the public sector was fast approaching the point where it would no longer be able to fully service its external debt. Peru was no longer credit- worthy. Financial instability had reached the point that practically all economic activities were adversely affected. 17. A new economic team was named in May 1978. Since then, the Govern- ment has adopted a number of important measures aimed at strengthening public finances, stimulating exports and stemming the loss of international reserves. By means of a crawling peg, the sol was devalued from S/. 130 to the U.S. dollar in May to almost S/. 200 to the U.S. dollar by year-end 1978. Most subsidies were eliminated, thus closing an important drain on public savings. Other price controls were relaxed. In addition, a number of tax measures were adopted and Government expenditures were restrained. Interest rates on bank loans were raised from 16 to 31.5 percent per year. Peru reached agreement with foreign commercial banks to reschedule US$185 million of principal payments due in the second half of 1978 until January 1979. The Government also negotiated a new stand-by arrangement which was approved by the IMF on September 15. Finally, it refinanced the bulk of the public external debt due in 1979 and 1980. 18. The Government's program, supported by the stand-by, aims at a dramatic improvement in public sector finances in 1979. Public sector current account savings are to rise from -1 percent of GDP in 1978 to 5.6 percent of GDP in 1979. To this end, the Government has adopted a 1979 budget that aims at a 10 percent real increase in tax revenues, while severely holding down current outlays. Payments for wages and salaries are budgeted to fall by some  -6- 12 percent in real terms, partly as a result of a planned reduction in excessive civil service employment. The elimination of subsidies on food and petroleum products, initiated in mid-1978, will further contribute to the control of current expenditures. The largest cut, almost 40 percent in real terms, is for defense outlays. On the revenue side, measures already adopted--includ- ing a 10 percent import surcharge, a higher tax on traditional exports and an increased tax on interest charged on bank loans--are expected to permit attainment of the revenue target. On the other hand, real capital expenditures are budgeted to rise by over 20 percent, as analyzed in Part II. Inflation, which averaged 73.5 percent in 1978 (December 1977 to December 1978), is targeted to drop to 40 percent in 1979. 19. The stand-by has formal quantitative requirements affecting net domestic banking system credit to the non-financial public sector, net domestic credit granted by the Central Bank, the build-up of Central Bank net interna- tional reserves, and net foreign borrowing by the public sector on maturities of up to ten years. In drawing up quantitative ceilings and targets, the stand-by took into account a certain level of expected balance of payments support from various sources, including a Bank program loan, in 1979. Further- more, the stand-by establishes that the Central Bank's international reserves target is to be adjusted in case actual 1979 balance of payments support is different from the assumed total amount. Peru's debt outstanding to the IMF as of April 30, 1979, is expected to reach SDR 440 million distributed as follows: (i) SDR 123 million under the Compensatory Financing Facility; (ii) SDR 53 million under the Oil Facility; and (iii) SDR 264 million under tranche policies. The last item includes SDR 44 million disbursed under the present stand-by. The stand-by also provides for an additional SDR 140 million to be disbursed between May 1979 and December 1980. A Fund team will visit Peru in late April 1979 to conduct Article IV consultations. This team will also discuss Peru's possible access to the recently established Supple- mentary Financing Facility. Peru's present drawings under the tranche policies are within the third credit tranche. Debt Restructuring 20. Major debt-relief operations carried out in late 1978 enabled Peru to reduce substantially the debt-service burden for 1979 and 1980, postponing it to the 1982-1986 period. In May 1978, the Soviet Union rescheduled the equivalent of about US$140 million of maturities originally due in 1978-80. These amounts are to be repaid over a 10-year period including three years of grace. In November at a Paris Club meeting, the OECD countries agreed to reschedule 90 percent of principal payments due by the public sector to governments and guaranteed suppliers in 1979 (US$250 million) and 1980 (US$263 million). These amounts are to be repaid over a period of eight years, including three years of grace. The Paris Club agreement states that 1980 maturities will be rescheduled provided that Peru agrees with the IMF, by December 31, 1979, on a financial program for 1980. The Paris Club creditors also agreed to reschedule 90 percent of the principal payments due in 1979 and 1980 (about US$30 million in each year) on private sector debt guaranteed or insured in the creditor countries. In addition, Peru is in the process of negotiating similar debt relief with non-OECD countries. This includes Latin American Governments (US$57 million in 1979 and US$28 million in 1980) and East European countries (about US$30 million in each year).  -7- 21. As regards the large medium-term public debt to commercial banks, an agreement concluded in December 1978 provides that Peru will repay, in 1979, the bulk of the US$185 million rolled over from 1978 (para. 17 above). The banks will refinance 90 percent of the maturities due in 1979 (US$321 million) to be repaid between 1982 and 1986. The commercial banks considered the program loan an important part of the overall economic rec^very effort and, therefore, made the Bank program loan a condition of this refinancing agreement. The agreement implies that the commercial banks would reduce their exposure in Peru's public debt by almost US$200 million in 1979, equivalent to about one-tenth of the debt owed them as of year-end 1978. Practically all of this reduction, however, would result from delayed repayment of loans initially due in 1978. As far as debt originally due in 1979 is concerned, the commercial banks have accepted terms similar to those negotiated at the Paris Club. The agreement reached between the Government of Peru and the commercial banks also gives the Government the option of refinancing part of the maturities currently due in 1980. Social Situation 22. The economic crisis of recent years has been reflected in two conse- cutive years of negative growth. Total GDP fell by 1.2 percent in 1977 and a further 1.6 percent in 1978. In this two-year period GDP per capita dropped by over 8 percent. This situation, in turn, has been reflected in incomes and employment. Nearly one-half of Peru's labor force is believed to be unemployed or underemployed, i.e., earning less than the minimum wage or working less than 35 hours a week and wishing to work more. According to government esti- mates, the purchasing power of salaries had fallen 40 percent by 1978 compared to 1970 and that of wages by over 16 percent. In these circumstances, the social situation has been unavoidably tense, and several general strikes have taken place during the past year. 23. The military Government has formulated a political calendar that calls for general elections and the transfer of authority to a civilian Government within the next year. An elected Constituent Assembly, in which the major political parties are represented, is completing the drafting of a new constitution. At present the authorities are maintaining an informal dialogue with the leaders of these parties in an effort to ensure the contin- uity of economic policies following the political transition. PART II - THE GOVERNMENT'S ECONOMIC RECOVERY PROGRAM 24. With the financial stabilization program and the debt restructuring described in Part I, the Government has begun to close the fiscal and external gaps. These efforts, however, have not yet helped to overcome the deep economic recession. To this end the Government has conceived an Economic Recovery Program (ERP) which would reverse the decline in GDP and lay a basis for a financially sound economic recovery. The ERP includes, in addition to the above-mentioned stabilization actions, measures to open up the economy, stimulate industrial sector efficiency, promote non-traditional exports, strengthen the tax system by broadening its base, and generally improve the efficiency of resource allocation in the private and public sectors. A summary description of the ERP is set forth at the end of Part II.  -8- a. Opening Up the Economy and Stimulating Industrial Efficiency 25. The Government has begun to dismantle the absolute, non-tariff protection granted by the National Registry of Manufacturers (RNM). As explained in Part III, under previous legislation the RNM prohibited the import of manufactured products that compete with those produced in Peru. This absolute protection has already been eliminated for about one-half of the products previously included in the RNM. The Government intends to complete this process within two years and to replace import prohibitions by a reason- able tariff. This is expected to stimulate greater industrial efficiency, lead to generally lower prices for consumers and contribute to the expansion of non-traditional exports. 26. A Government team, working with Bank technical assistance, is formulating a new import tariff that should rationalize and generally reduce tariff protection. As explained in Part III, the new tariff structure would be enacted in July 1979 and gradually implemented over a four and one-half year period. On average, effective protection for manufactured products would be cut by about one half. This action would complement and strengthen the positive effects of dismantling non-tariff protection described in the preced- ing paragraph. b. Promoting Non-Traditional Exports 27. One of the most important elements of the ERP is a correction of the anti-export bias that has contributed to the present crisis. To this end, a realistic foreign exchange policy was adopted in mid-1978 (paragraph 17). The Government's policy is to maintain the real exchange rate at the present level. This is to be attained by means of a crawling peg. 28. In addition to adopting an export-stimulating exchange rate, the Government has recently enacted a new non-traditional exports promotion law which streamlines export procedures, guarantees the continuation of existing incentives and establishes new incentives (discussed in Part III). c. Strengthening the Tax System 29. The Government has recently adopted--and continues to design and introduce--a number of tax measures aimed at broadening the tax base and improv- ing the equity and allocative effectiveness of the tax system. These include redesigning the personal income tax (brackets, deductions and exemptions) to broaden its coverage, establishing minimum presumptive incomes for independent professionals and taking into account personal assets to estimate a minimum taxable income. Corporate income taxes and taxes on wealth are being rede- signed to reduce loopholes and to continuously adjust assessments in line with inflation. Other measures to be adopted during 1979 include: (i) reducing the presently large number of minor special taxes; (ii) streamlining collection procedures for the remaining special taxes; and (iii) extending the coverage of the value-added tax. In addition, the Government has begun to adopt measures aimed at improving tax administration and at reducing widespread evasion. For all these purposes the Bank is providing technical assistance, which would be financed under the proposed program loan.  _9 d. Interest Rate Policy 30. The Government has already taken significant steps to reduce the gap between inflation and interest rates. As indicated in Part I, the basic bank lending rate was raised from 16 percent per year in July 1978 to 31.5 percent in December. While this was still below the average rate of inflation in 1978, the Government action represents a determination to reach and maintain realistic financial policies. In early February, a further adjustment was made and the tax on interest rate charges (paid by the borrower) was raised from 10 to 17 percent. As commercial banks tend to discount part of the interest charges from short-term loans (i.e. part of the interest charges are paid in advance) and also charge commissions, the effective cost of prime loans actually exceeds 45 percent. Because inflation is expected to slow down to 40 percent in 1979, the authorities prefer to hold interest rates at present levels for the time being. The Government will, however, review interest rates on a quarterly basis, and the intention of the monetary authorities is to reach positive real levels--including taxes and other charges to the borrower-- before the end of 1979. e. Public Investment Program 31. Public investment in the late 1960s and early 1970s averaged around 4-5 percent of GDP. Investment began to increase rapidly starting in 1973 and rose to a peak of 8.5 percent of GDP in 1975. However, several of the large scale projects undertaken as part of this expanded investment program were not economically justified. Such projects have contributed to Peru's current economic difficulties by absorbing a large amount of financial resources and indebtedness capacity without making a significant contribution to the country's economic development. 32. The 1978-1982 Medium-Term Public Sector Investment Program (PSIP) is the product of a process of close consultation between the Government and the Bank (see Annex VII for a summary of the PSIP). The 1979 investment budget is in line with this program. Because of the country's serious fiscal problems, the Government has put great emphasis on optimum utilization of the limited resources available for investment. Fixed investment expenditures in the PSIP, equivalent to 5.7 percent of GDP in 1978, would rise to 7.4 percent in 1979 with assistance from the proposed program loan and to 8.5 percent in the 1980-82 period. New projects which did not have clear economic justification or whose implementation periods were so long that they would contribute little to the current recovery effort have been postponed or eliminated. Although the program still contains several marginal projects because their execution is well advanced and because they are politically important (i.e. the Majes Irrigation/Power project and the Cajamarquilla Zinc refinery), their 1979 investment levels have been cut back. On balance, the Government has made good progress in developing an investment program which concentrates scarce resources on those projects most likely to provide benefits in the near term  - 10 - or resolve critical structural problems. In drawing up the 1978-82 PSIP, the Government has pursued the following objectives: (i) to accelerate execution of on-going projects (see Part IV for a description of actions taken on Bank financed projects); (ii) to begin to redirect new investment towards high yielding small- and medium-sized projects which promise a relatively rapid economic return; and (iii) to give greater priority to investment in transport and power where serious problems are developing because of underinvestment in the past years. The PSIP's main features are outlined in the following paragraphs. Productive Sectors 33. Productive sector investment represents about 48 percent of total public investment and concentrates on continued development of agriculture and mining, the country's most important natural resources. This is a sig- nificant reduction from the 75 percent level of the 1975-76 period, when such large scale projects as an oil pipeline and newsprint plant were under con- struction. With the completion of these projects and the elimination or postponement of a number of large new operations, greater emphasis will be given to completing on-going projects, increasing power and transport invest- ment and initiating smaller directly productive projects with relatively short payback periods. 34. The agricultural sector accounts for about 16 percent of public fixed investment in the 1979-82 period, the largest sectoral allocation except for the electric power sector. The strategy for agriculture is (i) to continue development and rehabilitation of irrigated coastal areas; (ii) to begin an effort to develop the potentially rich jungle highlands, or Ceja de Sierra, east of the Andes; and (iii) to introduce smaller high yield projects. Also, it was agreed that the Government would provide US$40 million equivalent in 1979 to the National Agricultural Bank to expand its agricultural credit program (Sections l.Ol(m) and (n) and 5.01 of the draft Loan Agreement). Finally, the Government has requested Bank assistance to test an integrated rural development approach for the agrarian reform communities in the Sierra. 35. A number of major coastal irrigation works are to be financed in the 1979-82 period including the continuation of the Chira-Piura project in the north, for which the Bank is considering a loan (see Part IV below), and the dual purpose Majes power/irrigation project. Together these projects account for 72 percent of the public investment program in agriculture for 1979. All except Majes are being carried out in important existing agricul- tural areas where there is already significant infrastructure. 36. The Majes project, begun in 1973, accounts for over 30 percent of public investment in agriculture in 1979-82 period. It has absorbed expendi- tures of about US$330 million to date and is expected to cost an additional US$1.2 billion in constant 1978 dollars by the time it is completed in the late 1980s. There has never been a complete economic analysis of this project.  - 11 - However, in view of its expected benefits in relation to its cost, it appears that its economic return will, at best, be marginal. Because of its political significance (it will benefit the important Arequipa area) and the substantial amount already expended on the project, the Government is not prepared to terminate it. It has, however, held down expenditures for the project in 1979 to US$34 million, which is below the 1978 level, despite a requested budget of US$65 million. The Government will also complete an economic analysis of the project this year in order to optimize project phasing. 37. To assist the Government in the development of a sound agricultural lending program that is responsive to the needs of the economy, a Bank sector mission will visit Peru this year to continue the dialogue begun in the context of preparation of the proposed program loan. 38. The mining sector would account for almost 15 percent of public investment in the 1979-82 period. As in the agricultural sector, most of the major projects being undertaken are economically justified expansions of existing installations. These include a major expansion of the Cobriza Copper mine being financed by the Bank and the IDB and the second phases of several other copper projects. 39. The only entirely new project is the Cajamarquilla zinc refinery whose construction in the Lima area began last year. This project, which is highly capital and energy intensive, is expected to cost about US$200 million. An economic analysis indicates that the project is marginal even when optimistic assumptions regarding project cost and the price of electricity are used. But its construction has begun, a substantial amount has been invested and cancel- lation of the project now would result in large financial penalties. The Government will, nevertheless, slow down project execution in 1979. 40. Since the Government intends to rely increasingly on private invest- ment and mixed enterprises to develop mineral resources, there are no new large scale mining projects in the PSIP in the 1979-82 period. The Government has, however, included in the PSIP medium sized and economically attractive expansions of three mines to increase the production of silver and other metals. 41. At this time, the petroleum sector investment program would only continue on-going activities and secondary recovery operations in the Talara and Selva areas. Because of its financial difficulties, PETROPERU, the national oil company, is currently not in a position to undertake any major new investment. In view of the oil production potential in the selva area, however, a somewhat more ambitious development program should be planned. A Bank mission visited Peru recently to discuss with the Government an expanded sector investment program. 42. The investment program for the industrial sector has been reduced substantially for the 1979-82 period. A number of very large projects have been dropped from the PSIP, and the government is trying to encourage greater private sector participation. Substantial cutbacks in public investment are also proposed for other productive sectors. In both fishing, where a large investment program has been carried out in recent years, and tourism the emphasis is on completion of projects which are well advanced.  - 12 - Infrastructure 43. The level of investment in infrastructure has been declining over the past ten years. The power and transport sectors were particularly hard-hit. In transport, few new road projects have been started and road maintenance and rehabilitation have lagged badly. The result has been a significant deterioration in the country's roads and little expansion of the overall road network which is one of the more inadequate ones in Latin America. In electric energy, the country faces the possibility of serious shortages over the next decade because new investment projects have not been started at a sufficient rate. 44. These serious problems are addressed in the PSIP. Infrastructure investment for the 1979-82 period would be increased to about 35 percent of public investment, primarily as a result of increases in road and electric power investment. In transport, only one major new road project will be started. This will allow for the prompt completion of projects now underway and for a road maintenance and improvement budget which will be adequate for the first time in many years. In electric power, the increase will permit the initiation of several new hydro and transmission line projects to help meet projected growth in demand. An optimizatior study for all the electrical systems of Peru is now underway and should be completed by the end of the year. On this basis, the Government will be in a position to develop an adequate power sector investment program for the coming years. 45. Finally, with financing from the Bank's recent Water Supply and Power Engineering Loan (S-ll of December 22, 1978), final studies are beginning on a water transfer project which would insure adequate water supply for Lima through the end of the century and also provide the basis for a large scale hydroelectric project. The PIP includes these projects for initiation in the early 1980s. Social Sectors 46. Investment in health, housing, education and other social projects would account for about 13 percent of public investment in the 1979-82 period. This represents a needed increase from recent years when investment in these sectors had fallen to around 10 percent of total public investment. In health, there has been emphasis on hospital construction while primary care and pre- ventive programs have been allowed to lag with serious health consequences. A Bank mission recently visited Peru to begin exploring sectoral problems and needs. Programs to provide public services for low-income urban areas will continue to receive priority. Finally, in education the PSIP continues to give priority to the educational reform which the Bank has been assisting with its first education loan. Conclusion 47. The 1979-82 PSIP is a significant improvement over public investment in the early and mid-seventies and in general reflects a major Government effort to allocate scarce resources to projects that respond to Peru's invest- ment needs. It is essentially a sound program although further improvements  -13 - in it are possible, particularly in identifying or firming up attractive new investment possibilities in the PIP's outer years. The Bank will work closely with the Government in this task. In this regard, the Peruvian authorities will update the PSIP towards the end of 1979 and the Bank would review it in the context of its monitoring of the ERP (Section 3.06 and Schedule 5 of the draft Loan Agreement). Financing Public Investment 48. The recovery of public fixed investment in the 1979-82 period from its sharp drop in 1977-78 is predicated on a significant improvement in public sector savings and a renewed flow of external assistance. Table 2: FINANCING OF PUBLIC INVESTMENT 1978-1982 SOURCES AND USES OF FUNDS (in percentages of GDP) 1978 1979 1980 1981 1982 I. USES 11.3 14.9 16.2 15.3 13.9 Capital formation a/ 5.9 7.8 8.8 8.8 8.5 Amort. Ext. Debt b/ 5.4 7.1 7.4 6.5 5.4 II. SOURCES 11.3 14.9 16.2 15.3 13.9 A. Domestic Resources 4.4 8.6 9.8 9.1 7.8 Public Sector Savings 1.0 5.0 6.1 5.5 5.0 Net Domestic Borrowing 3.4 3.6 3.7 3.6 2.8 B. Gross Foreign Borrowing 6.9 6.3 6.4 6.2 6.1 Borrowing for projects 2.6 3.7 4.2 4.1 4.2 Other borrowing 4.3 2.6 2.2 2.1 1.9 Source: Central Bank and Bank staff estimates. a/ Includes capital transfers to financial enterprises. b! The "Amortization on External Debt" figures for 1979 and 1980 include amounts originally scheduled to be repaid in these years but which were rescheduled in late 1978. The Government's policy is to have the public sector pay these amounts into a special Central Bank account according to the original schedule. The purpose of maintaining this account is to ensure fiscal restraint in 1979-80. The Central Bank will use these Soles to purchase foreign exchange and thus help replenish Peru's inter- national reserves.  - 14 - 49. As shown in Table 2, public sector savings are expected to rise from one percent of GDP in 1978 to five percent in 1979, which is in line with the stand-by program. Thereafter, savings would remain at the 5-6 percent level through 1982. This expectation is based mainly upon what has already been achieved in eliminating public sector price subsidies and in reducing Central Government expenditures, particularly for defense. Recourse to domestic borrowing during the 1979-82 period would be considerably below the 1976-77 levels and is also consistent with the stand-by for 1979. 50. No significant new external borrowing is expected in 1979 except for electric power where there is an urgent need to begin projects and for an irrigation scheme which is being financed with a soft loan from Germany. Disbursements of existing external loans should, however, accelerate in 1979 with the expansion of local resources made available by the proposed program loan. Thereafter, new commitments of external loans are projected to average about US$420 million annually in order to help finance the PSIP. This level of external assistance is feasible given Peru's improving creditworthiness. f. Balance of Payments and Creditworthiness 51. The improved economic management since mid 1978 has led to a marked turnaround in balance of payments performance. The resource gap, which had reached nearly 5 percent of GDP in 1977, turned into a surplus in 1978 and the drop in net international reserves of recent years has been reversed. This was mainly due to a drop in imports--owing to the economic recession--but lower defense purchases also contributed significantly. Non-traditional exports rose owing mainly to the adoption of a more realistic exchange rate, which led to strong export growth. The capital account, in turn, strengthened owing to the beginning of debt relief operations and to some repatriation of Peruvian capital. 52. The Government's program is expected to lead to strong balance of payments performances in 1979 and 1980, which is essential for economic recovery and to restore net international reserves, now at negative levels. This will be achieved by continuing to maintain an export-oriented foreign exchange policy, realistic interest rates and by the promotion of non-traditional exports. The Peruvian Government has also undertaken to improve foreign debt management by, inter alia, making use of aid from official bilateral and international donors to the extent possible. Moreover, the bulk of Peru's public debt due to commercial banks in 1980 is expected to be refinanced along the lines of the agreement reached for 1979 (para. 21). Furthermore, most of Peru's large foreign short-term debt (estimated at over US$2 billion as of year-end 1978) is expected to be rolled over or refinanced as the gradually improving economic situation permits new trade-related credit lines to be opened. The trade balance should also be strengthened by a further sharp drop in military imports in 1979 and by the emergence, for the first time, of a net petroleum surplus for export. The recent completion of the Trans-Andean pipeline should allow Peru to export an average of nearly 80,000 barrels per day in 1979-82, adding some US$500 million per year to gross export earnings. Even though about one half the projected gross petroleum exports would leave the country as profit remittances, this still implies a major improvement over recent years when Peru was spending in excess of US$200 million per year on fuel imports. On balance, although Peru can be expected to enter the 1980's with a strong trade surplus, its balance of payments situation will still be tight as evidenced by the fact that net international reserves would hover around zero.  - 15 - 53. In the early eighties, if economic activity recovers to an annual growth rate of 5 to 6 percent, the imports needed for sustaining the develop- ment effort may exceed somewhat the pace of exports. This is particularly so because the exportable petroleum surplus may start to decline in 1982 unless important new discoveries are made soon. In addition, the debt restructured in 1978-80 will impose a heavy payment burden in 1981-86. Balance of payments support will likely continue to be needed, therefore, in the early 1980s unless a further debt restructuring operation takes place. Assuming the ERP is successfully carried out, Peru's medium term balance of payments situation is expected to be tight but manageable. 54. Table 3 below contains balance of payments projections for Peru. It is followed on page 16 by a summary of the ERP's key features. Tadle 3: PERU -BALANCE OF PAYMENTS, HISTORICAL (1975-78) AND PROJECTED (1979-85) (in US$ Millions) 1975 1976 1977 1978 1979 1980 1981 1982 1985 Exports of Goods and Non-Factor Services 1,674 1,744 2, 137 2,400 3,081 3,367 3,851 4,280 5,868 (Merchandise FOB) (1,291) (1,360) (1,726) (1,941) (2,569) (2,806) (3,232) (3,598) (4,954) Imports of Goods and Non- Factor Services 3,022 2,628 2,694 2,071 2,252 2,587 2,974 3,399 5,128 (Merchandise FOB) (2,390) (2,100) (2,164) (1,601) (1,755) (1,985) (2,299) (2,638) (4,021) Resource Balance -1,347 -884 -557 329 830 780 877 881 740 Net Factor Services -240 -366 -426 -578 -851 -900 -928 -925 -982 (Interest on Public Debt) (193) (275) (300) (420) (485) (503) (498) (499) (501) Current Transfers 49 58 57 56 59 61 64 6ti 78 Current Account Balance -1,539 -1,192 -926 -192 37 -59 13 21 -164 Net Public Borrowing 793 943 611 388 387 479 113 12 239 (Disbursements) a/ (1,077) (1,242) (1,007) (867) (637) (693) (977) (876) (1,372) (Amortization) (284) (299) (396) (479) (250) (214) (865) (864) (1,133) Net Private Capital 342 128 63 39 -23 -24 -11 38 36 Short-Term & Other Capital -126 -399 -98 -153 -160 -50 -50 - - Change in Reserves (-:Increase) 530 520 350 -82 -241 -346 -65 -7: -111 Memorandum: Level of Net International Reserves- End of Year 165 -355 -705 -623 -382 -36 29 101 387 Balance of Payments Support - 396 - - 115 b/ - - - - Need for Balance of Payments Financing c/ -- - - - 241 61 260 Debt Rescheduling Obtained (Shown in Above Calculations) - - - 250 676 629 - - Debt Service Ratio (%) 28.2 32.9 32.6 37.5 23.9 21.3 35.4 31.8 27.8 Net use of IMF Resources - 22 12 107 159 74 a/ Exceeds borrowing needed to finance public sector investment by amount of 'Need for Balance of Payments Financing" below. E/ Program Loan cl Amounts needed to reach a level of net international reserves equivalent to one month's imports by 1985. -/ This amount results in part from a need to repay debt restructured in 1978 .. Not Available Source: Central tank and Staff estimates.  - 16 KEY ASPECTS OF PERU'S ECONOMIC RECOVERY PROGRAM MAIN ECONOMIC ISSUES RECENT SITUATION AND GOVERNMENT'S RESPONSE, EXPECTED EFFECTS ON CONTRIBUTION EFFECTS ON THE ECONOMY RECENT OR EXPECTED THE ECONOMY OF THE PROGRAM LOAN A. EXTERNAL Exchange Rate Policy Overvaluation and erratic Adoption of realistic ex- Strengthen balance of large adjustments. change raLte with periodic payments. Stimulate ex Effects: discouraged ex- adjustments (since May, ports. Encourage capital port daversification. En- 19T8) inflows. Stimulate labc,r couraged imports and ca- use in industry pital flight. Capital in tensive investment High Protection to Import prohibitions and Gradual elimination of im- Lower internal prices cf 1) Provide foreign Industry high import tariffs. port prohibitions (RNM) manufactures; improve in- exchange to Effects: high cost, in- starting in March, 1979. dustrial efficiency; finance transi- efficient domestic in- Implementation of new re-allocate resources tion to open dustry Tariff starting July,1979 to industries with import policy comparative advantage. 2) Technical as- sistance for formulation of new tariff Legal barriers for Cumbersome export permit Streamlining of export pro- Upsurge of non- Provide foreign Non-Traditional Ex- procedures and restrict- cedures. Flexible labor traditional exports. exchange for ports ive labor legislation hiring practices for ex- Increase in employm short-term export that discouraged hiring port-oriented industry. ent and tax revenues. credit through new workers. Instability Stability assured for ex- Strengthened balance FENT if need of export incentives. In port incentives. Provi- of payments should arise. adequate credit for work sion of foreign exchange ing capital and lack of and credit through FENT foreign exdhange for in- (since November, 1978) termediate imports in export-oriented industry. Effects: low growth of in dustrial output; manufac- tured exports below their potential B. INTERNAL Ineffective Tax System Low elasticity of tax reve- Tax reform. Elimination of Strengthen public finances.. Technical noes. Widespread loopholes small, low--yield taxes. Re- Improve resource al- Assistance and tax evasion. duction of iax rates. Reduc location Effects: narrow tax base. tion of legal loopholes. Im Heavy tax burden for those proved evas:on control individuals and firms not (since December, 1978) exempted. Unbalanced public sector accounts. Public Sector Investmert Emphasis on large projects Review of itvestment priori- Higher GDP growth. More Advice on Program with long gestation period ties. More emphasis on eco- labor-intensive activi- public invest- and marginal economic re- nomic justii'ication, employ- ties. Lower debt burden. ment decisions turns. ment and cono ribution to out- Faster disbursements on Effects: Inadequate con- put. Accelerate project exe project loans tribution to growth and cution. (siT.ce December, employment. Hleavy debt bur 1978) den. Slow project execu- tion. Interest Rate Policy Wide gap between infla- Major incree ses in interest Stem capital flight. Discussions tion and local interest rates. Poliy of positive Encourage financial during periodic rates. effective rsal interest rates savings. Lower relative reviews of econeami Effects: Discouraged sav- (since July, 1978) price of labor. performance at ings. Encouraged consump the tion and capital flight. tranche Stimulated capital-inten- sive private investment  - 17 - PART III - THE MANUFACTURING SECTOR Growth and Structure 55. Peru's manufacturing sector is small but quite diversified. Manufacturing value added accounts for about 21 percent of total GNP, but the sector employs a much smaller share of the country's economically active population, about 5 percent. A substantial proportion of manufactured output originates outside the traditional consumer goods industries. The shares of food, beverages, tobacco, textiles, clothing, leather and footwear have been decreasing over time and currently account for only 40 percent of total manufactured output. Intermediate industries--particularly chemical products and metals--on the other hand, are growing in importance. 56. Manufacturing value added grew substantially during the 1960s and early 1970s, with average growth rates of 8.5 percent per annum from 1960 to 1974. This rate of growth was well above the 5.5 percent experienced by GDP during the same period. Industrial growth was induced mainly by sharply growing domestic demand for industrial products--fueled by rising incomes and government redistribution policies after 1970--and was based on import substi- tution. When Peru's economic activity began to slow down in 1975, industrial growth dropped to 5.4 percent in 1975 and 4.8 percent in 1976. As the economic crisis became more severe in 1977, physical industrial output decreased by 6.5 percent and continued falling in 1978 with a further decrease of 3.2 percent in the index of industrial production. Import Dependence 57. The direct import component of industrial output (packaging, raw materials and intermediate goods) has averaged 20 percent during the 1971-1976 period with a constantly increasing trend. Thus, in 1976 imported industrial inputs came to about US$750 million, accounting for 24 percent of industrial output. During the last two years, the acute shortage of foreign exchange has forced imports of industrial inputs to remain approximately constant in nominal terms, adding another limitation to the already depressed manufacturing sector. In 1979, availability of sufficient foreign exchange to meet the imported input requirements of the industrial sector will be a crucial element in determining the sector's overall performance, particularly the growth of manufactured exports. Protection from Imports 58. Tariff protection in Peru has been constantly increasing during the last two decades. In 1958 the unweighted average of nominal official tariffs was 38 percent. It increased to 42 percent in 1964, 55 percent in 1967 and 69 percent in 1973 by which date Peruvian tariff protection ranked highest among all Andean Group member countries. Since 1973, no major changes have taken place in the tariff system although the use of a mixed system combining specific and ad-valorem rates, together with a growing exchange rate overvaluation, has produced some reductions in total tariff protection.  - 18 - 59. While the protective impact of the tariffs was somewhat eroded, non-tariff protection--operating through a complex system including import licenses, prohibitions, state monopolies and the National Register of Manufactures (RNM)--offered more protection than tariffs during the last decade. In 1978, one third of the total number of items in the customs classification were included in the RNM and thus received practically unlimited protection. The cost of non-tariff protection has been very high. In 1973, for example, domestic prices for 100 products subject to import prohibition or included in the RNM increased by 40 percent compared with an overall price increase of only 9.5 percent in the same year. 60. The combined effects of tariff and non-tariff protection have given high levels of effective protection to Peruvian industry. Effective protection from tariffs alone averaged 90 percent for the goods produced by the manufac- turing sector. Export Incentives 61. The Peruvian Government started to actively promote exports of manufactures in 1968, establishing a tax credit certificate (CERTEX), at a flat rate of 15 percent of the FOB value of exports. In 1972 there was an increase in the CERTEX rates and two new mechanisms were set up: (i) the Non-Traditional Exports Financing Fund (FENT) of the Banco Industrial del Peru (BIP) to help finance the production and sale of non-traditional export products; and (ii) the Export Credit Insurance scheme to protect exporters against political, commercial and other exports risks. Between 1972 and 1976, there were only minor changes in the non-traditional exports promotion system. In mid-1976 an increase in CERTEX rates and a devaluation of the sol shortly afterwards, facilitated an increase in exports. 62. Financing for exports of non-traditional products is provided by FENT. Loans are made to exporters either directly by BIP or through commercial banks and are available in local or in foreign currency, depending on the kind of operation and the origin of FENT resources. Total available resources for pre-shipment financing (FENT's most important activity) as of December 15, 1978 were about US$34 million equivalent in local currency and US$10.5 million in foreign currency. 63. While the total volume of FENT resources grew substantially in the last two years, it failed to keep up with the high rate of growth of non- traditional exports, covering less than 40 percent of the total in 1978. As a result, the availability of export credit has been a constraint to further export growth. To overcome this constraint, the Government has agreed to pro- vide FENT with an additional US$20 million equivalent in 1979 (Sections 1.01(m) and (n) and 5.01 of the draft Loan Agreement). 64. On November 21, 1978 the Government approved a new Non-Traditional Exports Promotion Law which incorporates all export incentives discussed above and establishes a new set of fiscal incentives, export promotion activities, and greater flexibility under the existing labor legislation. The law's major provisions with respect to existing incentives include (i) the continuation of the CERTEX mechanism for ten years; and (ii) the establishment of a one percent surcharge on most imports to be allocated to the FENT. During 1979,  -19 - the surcharge is expected to increase FENT resources by about US$6.5 million. Enactment of the Law demonstrates the Government's determination to support the exporting sector and has been very favorably received by the Exporters' Association. Industrial Capacity Utilization 65. During the last decade, industrial legislation increased indirect labor costs, lowered the relative cost of capital with respect to labor and created incentives to reinvest profits and expand installed capacity. A recent study estimates that during the 1970-1975 period, real installed industrial capacity grew by 62 percent, with investment in machinery and equipment increasing at a real annual rate of 25 percent. However, industrial output grew at an annual rate of only 6.5 percent during the same period. 66. After 1975, decreasing levels of domestic demand led to low capacity utilization in most manufacturing industries. While serious underutilization became widespread, certain industries were particularly hard hit and were operating at only 40 to 60 percent of capacity by 1976. These included the furniture, footwear, printing and publishing, shipbuilding, motorcycle, bicycle, leather products and clothing industries. Capacity utilization continued to drop through 1978, as overall industrial production contracted. Recent Export Trends 67. Peru's non traditional exports rose in 1976 to US$137 million as a result of a devaluation of the sol, the increased level of CERTEX and other export incentives, the recovery in world markets and domestic recession. The increase continued during 1977 with non-traditional exports reaching US$238 million. In 1978, exports of non-traditional products reached an estimated US$340 million of which about US$280 million were manufactures. 68. The most important non-traditional exports are food products (mainly frozen and canned fish), textiles and clothing, non-ferrous metals, chemicals and transport equipment (mainly fishing boats). Until 1976, the single most important subsector was food products which contributed slightly above 25 percent of the total, followed by textiles and clothing with another 25 percent. In 1977, the share of textiles and clothing jumped to about 32 percent of the total. Copper wire accounts for about 50 percent of total non-ferrous metals exports. Exports of fishing boats (US$8.2 million in 1976 and more than US$20 million in 1977) consist mainly of tuna, anchovy and shrimp boats exported to other Latin American countries including Mexico, Colombia, Chile and Panama. Exports of other metal products and machinery are limited to a few items, including electric transformers, telephone cables steel wire and drilling machines going to the Andean Market under preferential schemes. Exports of wood products have also been growing very rapidly in the last two years.  - 20 - 69. About half of Peruvian non-traditional exports are directed to other Latin American countries. Between 1970 and 1976, Andean Group countries alone accounted for over 25 percent of non-traditional exports followed by the EEC (20 percent) and the United States (15 percent). Remaining exports are directed to other European countries and Japan. Sectoral Outlook and the Government's Economic Recovery Program 70. The ERP includes as one of its key elements a complete reformulation of industrial policies, particularly industrial (tariff and non-tariff) protection and export promotion policies (through the recently approved Non-Traditional Exports Promotion Law). 71. A detailed timetable of policy measures has been prepared with the assistance of Bank staff. It includes dismantling--over a period of two years, beginning in January 1979--the quantitative (non-tariff) protection granted by the RNM. This process has already begun and the Government will make further adjustments every six months until December 31, 1981, by which date non-tariff import restrictions will have been completely eliminated. The Bank will review progress in this area in connection with the proposed program loan (Section 3.06 and Schedule 5 of the draft Loan Agreement). 72. As mentioned in paragraph 26, a Government team is also preparing a new import tariff law that would rationalize and generally reduce tariff protection. The new tariff is expected to be proposed in June 1979, enacted in July 1979 and gradually implemented over a four and one-half year period. Under the new tariff, average effective protection would decrease from the present 90 percent to 50 percent. Moreover, protection would not exceed 90 percent for any category of goods. Adoption of the law, which the Bank would monitor in accordance with Section 3.06 and Schedule 5 of the draft Loan Agreement, would constitute a satisfactory starting point for the Peruvian tariff reform exercise. 73. As a result of the export promotion measures and the greater avail- ability of foreign exchange for imports, the manufacturing sector is expected to begin to recover in 1979, mainly in several intermediate subsectors such as fishmeal, paper, wood products, industrial chemicals, oil, china and porcelain, non-metallic minerals and metals. The sector's recovery is expected to continue in 1980, when the consumer and capital goods industries--those with the lowest present levels of capacity utilization--would also start to grow. On balance, the manufacturing sector is expected to expand by 4.5 percent in 1980. 74. Non-traditional export growth is expected to continue in 1979 as a result of the recent policy measures, the increased availability of export credit from FENT and the continuation of a realistic foreign exchange policy. Total non-traditional exports are expected to reach about US$450 million in 1979, of which more than US$400 million would be manufactures.  - 21 - PART IV - THE PROGRAM LOAN 75. The proposed loan and the economic recovery program it supports have been developed through a close and continuing dialogue between the Bank and the Government, which began with a June 1978 Bank mission. At that time, the Government requested Bank consideration of a program loan in view of the critical economic situation. A program loan was seen by the Government and the IMF as an important supporting element for the stabilization and debt restructuring programs and for the economic recovery effort. It was therefore built into the stand-by agreement and became part of the Government's monetary and financial programs for 1979. 76. The Government has, with Bank assistance, gone beyond short term measures and formulated the ERP described in Part II and the Government's Letter of Intent (see Annex IV) to begin to deal with structural problems in the areas of industrial policy and export promotion; tax policy and administra- tion; interest rate policy and public investment. Development of the proposed loan has thus become an effective vehicle for a far reaching dialogue on economic policy between the Government and the Bank which has contributed to the adoption of a strong and ambitious economic recovery program. 77. In spite of recent improvements, Peru must still deal with a serious balance of payments and fiscal situation and high levels of unemployment. Net international reserves were negative by US$623 million at the end of 1978 and there was a serious shortage of resources to continue development projects. Furthermore, much of the country's industrial plant capacity remained idle. In this context, the proposed program loan would provide financing for essen- tial imports, primarily for the private sector. It would also help ease the balance of payments and domestic credit situation, and make it possible for capacity utilization and industrial employment to rise. In addition, through the allocation of counterpart funds, the program loan would enable Peru to reach a level of public investment required for its recovery in the medium term. 78. The loan was appraised in December 1978 and negotiations were held in Washington from March 29 to April 3, 1979. The Peruvian delegation was headed by Mr. Raul Salazar, Manager of the Central Bank. Allocation of the Program Loan 79. All but US$100,000 of the loan would be used to help finance imports of industrial raw materials, intermediate goods and spare parts; agricultural, electric generating, mining, and forestry equipment and spare parts; and inputs for on-going preventive health programs. Industrial inputs would constitute over 80 percent of the imports financed. Priority will be given to industries with underutilized capacity and the potential to generate exports with significant local value added. Annex VI contains the agreed upon list of eligible imports. It is estimated that imports of raw materials and intermediate goods in 1979 will total over US$900 million, so that the proposed loan would finance only about 10 percent of the total import bill, thus ensuring rapid disbursement.  - 22 - 80. Up to US$100,000 would be made available from the proposed loan to finance technical assistance necessary for carrying out the ERP. The Government plans to spend about US$30,000 to finance the design of a tax enforcement program which is now underway; approximately US$25,000 used to initiate the study would be financed retroactively under the proposed loan. The balance of the US$100,000 would be used to finance such additional assis- tance as may be agreed upon by the Government and the Bank (Section 3.03 of the draft Loan Agreement). Procurement and Disbursement 81. The loan would be disbursed in four tranches. US$40 million would be available for disbursement after the loan is declared effective. US$30 million of the loan would be disbursed after a first performance review in July. An additional US$30 million would be available for disbursement after a second performance review in October. The final US$15 million would be disbursed after a final performance review, in January 1980. Two weeks before each of these missions, the Borrower would submit a report detailing its progress in carrying out the ERP (Section 3.06 of the draft Loan Agreement). 82. The supervision missions undertaking these reviews would, with the support and assistance of the Central Bank and the Ministry of Economy and Finance, make a judgement as to whether progress had been adequate in carrying out the ERP described in Part II above and Annex V particularly in regard to adherence to the stabilization program, adoption and implementation of policy measures, and execution of the 1979 PSIP (Section 3.06 and Schedule 5 of the draft Loan Agreement). These elements would be monitored carefully in view of the difficulties the Government has had in the past in following through on economic recovery actions. In addition to the ERP, the Government has presented in its Letter of Intent medium-term projections of economic performance in key areas. These targets would provide the context within which the Bank and Government would discuss the direction and rate of improvement in the economic situation. 83. The proposed loan would reimburse the CIF cost of eligible imports on the basis of evidence that they were paid for by the Central Bank and imported. Import licensing in Peru is automatic for all goods on the Permitted Import List; however, a minimum 120 days foreign financing is currently required for most goods that would be imported under the proposed loan. This will be reduced to 90 days after July 1, 1979 and, in accordance with the requirements of the stand-by, will be eliminated in 1980. Because of the 120-day financing requirement, in order to begin disbursement of the proposed loan promptly, goods imported under licenses issued up to 120 days before signature of the loan would be eligible for reimbursement provided the Central Bank has not released foreign currency in payment thereof prior to loan signature. 84. The Central Bank would be responsible for the collection of the necessary documentation, the preparation and submission of withdrawal appli- cations, and the maintenance of necessary accounts for the loan funds.  - 23 - 85. All imports would be procured from Bank member countries and Switzerland. Aside from health supplies, all procurement would be through normal commercial channels except in the case of contracts costing over US$5 million which would be procured in accordance with international competitive bidding. Vaccines, drugs and DDT would be procured through PAHO, which would act as agent for the Borrower for this purpose because it buys in large quantity and can purchase at the lowest possible prices. It is expected that the entire loan would be disbursed by March 31, 1980. Counterpart Funds 86. The Peruvian Soles equivalents generated by the sale of program loan funds in the amount of about US$11.4 million (the loan funds allocated for technical assistance and for health imports will not generate counterpart funds) would be credited to a special account in the Central Bank and used to finance high priority development projects in the 1979 and 1980 PSIP (Section 3.02 of the draft Loan Agreement). Projects in agriculture, mining and infrastructure will be given priority. Alternatively, and if warranted by demand, the Government may use up to US$15 million to establish a dollar denominated revolving fund to finance imports used in the production of non-traditional exports. This fund would be set up under terms and conditions satisfactory to the Bank (Section 3.02 of the draft Loan Agreement). PART V - BANK GROUP OPERATIONS IN PERU 87. The Bank has made 34 loans in Peru for a total amount of US$561.1 million, net of cancellations. About 40 percent of the Bank lending to Peru has been for transportation (mainly highways and ports), 19 percent for agriculture, 19 percent for electric power, 14 percent for mining and industry, and about 8 percent for education and urban development. 88. Of the US$238.9 million undisbursed as of February 28, 1979 about 90 percent is attributable to six loans made in 1976 and 1977. The slow start-up of these loans (only two of which were "repeater" operations), as well as the slow progress of previous operations has been due, in large part, to the government's weak project execution capacity and a shortage of counter- part funds that worsened as the economic situation deteriorated during this period. As a result, disbursements have averaged only about $25 million per year over the past few years (Annex II contains a summary statement of Bank loans as of February 28, 1978, and notes on the execution of on-going projects). In an effort to improve this situation, the Government and the Bank have agreed on a program to accelerate project execution. The principal measures are: (i) to provide in the 1979 budget an adequate level of counterpart funds for Bank projects; (ii) to restructure the Education and the Lima/Amazon Corridor Projects (see Annex II for further details); and  - 24 - (iii) to set up a mechanism to monitor project execution, including execution of the program loan. This would consist of assigning senior officials from the Ministry of Economy and the National Planning Institute to review progress on the projects and report to the Economic Council of the Cabinet each month. These officials would provide liason between the Bank and Government and assist in closely monitoring progress over the next year. 89. With these actions and since start-up problems facing some of the newer projects have now been largely overcome, the pace of disbursement is expected to increase over the next year. 90. The main objectives of Bank lending to Peru have been to assist in (a) the creation of a physical and social infrastructure capable of sustaining and fostering development; (b) the expansion of productive capacity in crucial sectors; (c) the consolidation of structural and institutional changes, particularly land and education reforms; and (d) the strengthening of agencies to implement and operate projects effectively. In the past, Bank lending has concentrated on infrastructure in the transportation and power sectors. More recently, in the face of mounting economic difficulties, the Bank's emphasis has shifted to more directly productive fields -- mining, agriculture and industry -- to aid Peru in surmounting its balance of payments problems. The proposed loan, and a possible second program loan, if the economic situation warrants it, will directly assist the recovery process. 91. Project preparation has continued so as to maintain a pipeline which can be reactivated when economic conditions permit a resumption of normal project lending. Future lending would support projects that would increase production and exports. The next operation that would be ready for Bank consideration is an irrigation rehabilitation project which would benefit agrarian reform coop- eratives and small farmers growing cotton for export and food crops in the Lower Piura Valley. Apart from this project, those being considered for Bank financing in the near future would require minimal local financing. They include a small rural development project to increase agricultural and live- stock production of agrarian reform settlements in the Sierra and a small project to increase production at PETROPERU's Talara and jungle oil fields. Preparation works have also begun on a sixth agricultural credit project and on a mining operation. 92. Bank support for infrastructure improvement and development will also continue in view of the serious problems that have arisen as a result of past underinvestment. The Water Supply and Power Engineering Loan approved in October 1978 will finance studies for future water supply and hydroelectric projects for the Lima area, and a highway maintenance operation is planned. Finally, Bank lending would be designed to help Peru deal with its difficult social problems. In addition to the agricultural projects mentioned above, a follow-up urban development project is contemplated.  - 25 - 93. Bank loans to Peru constituted about 7 percent of total outstanding debt, including undisbursed, at the end of 1978, and absorbed about 2.8 percent of the country's external debt service in 1978. Assuming increased recourse to long-term bilateral and multilateral aid by Peru, the Bank's share in the country's outstanding public foreign debt by 1985 could reach 12 percent and its share of debt-service would be around 5.3 percent. 94. IFC commitments to date have been US$26.5 million (US$15 million to the Southern Peru Copper Corporation for the Cuajone Copper Mining Project) of which US$14.8 million is held by the Corporation. A summary statement of IFC investments as of February 28, 1979 is presented in Annex II. 95. The other principal aid agencies lending to Peru -- IDB and AID -- are expected to continue giving special attention to agriculture with IDB emphasizing agricultural credit and AID stressing rural development. Total loan commitments as of June 30, 1978 by the principal agencies are summarized in the following table: IBRD IDB AID TOTAL