Peru - Major development policy issues and recommendations (Vol. 1 of 2) : Main report

Reporl No. 3438-PE PERU: Major Development Policy Issues and. Recommendations (In Two Volumes) F COPY Volume 1: Main Report FILE O April 27, 1981 Latin America & the Caribbean Regional Office FOR OFFICIAL USE ONLY Document of the World Bank 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 were as follows: Currency Unit = Sol (SI.) 1979 1980 US$1 = S/.224.55 S/.289.2 c/.1000 - US$ 4.45 US$ 3.46  FOR OFFICIAL USE ONLY This report is based on the findings of an economic mission, which visited Peru in June/July 1980; it basically reflects the economic situation as of mid-1980. The mission was led by Ulrich Thumm and included the following members: David Franklin and William Wadman (consultants, nutrition and related health aspects), Nathan Koenig (consultant, agriculture), Constantino Lluch (income distribution), Ricardo Martin (tax incidence), and Mirtha Pokorny (summer intern, income distribution). The mission also benefited from the parallel UNIDO industrial sector mission as well as from background papers, provided by Bank staff, on energy, transport, and water. The report was discussed with the Government in November 1980 and March 1981, and comments were incorporated. In the meantime, the Government took vigorous policy action to address many of the issues identified in this report. These recent policy measures are briefly mentioned in the text. A more complete description is presented in paras. xii-xx of the Summary and Conclusions. 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.   TABLE OF CONTENTS (Volume 1) Page No. Summary and Conclusions ................................. i-vii I. Recent Economic Performance ............................. 1 1. Performance Under the Stabilization-Cum- Economic-Recovery Program ....................... 1 2. Present Economic Situation in Perspective .......... 3 2.1 Growth and Employment ......................... 3 2.2 Financial Aspects ............................. 6 2.3 Income Distribution ........................... 10 II. Main Development Issues ............... .. ................ 14 A. Macroeconomic and Financial Issues ....... .. ........ 15 1. Inflation ...................................... 15 2. Pricing, Interest Rate, Exchange Rate, and Trade Policies ............................. 19 3. Public Finance ............... .. ................ 23 B. Sectoral Issues .................................... 27 1. Social Aspects ............... .. ................ 27 1.1 Population and Employment ................. 27 1.2 Poverty, Nutrition, and Related Health Aspects ............................ 32 2. Economic Aspects .............. .. ............... 38 2.1 Economic Infrastructure ................... 38 2.2 Industry ....... ........................... 44 2.3 Agriculture ............................... 48  TABLE OF CONTENTS (Continued) Page No. III. Medium-Term Financial Framework and Longer-Term Development Policies ................................ 55 A. Financial Framework Under Different Scenarios ....... 55 1. Present Situation and Past Experience .... ....... 55 2. Alternative Medium-Term Projections .... ......... 56 3. The "Preferred" Scenario and Its Policy Implications .................................... 58 B. Medium- and Longer-Term Development Policies ........ 63 ANNEXES I. Technical Note on Income Distribution .... ............... 71 II. Inflation, Growth and Distribution, 1970-79 .... ......... 77 III. Incidence of Changes in Government Budget 95 STATISTICAL APPENDIX (Volume 2)  P4g 1 of 2 PBU - 3681C DATA AREA AND Pop0!LATION Total ane 1,285,W aq.b. Dsmity 13.5 par .q. . (total) Agri-alt-ral 305,500 qa.tu 56.6 pa rq.kn. (n-n.) PapoPlatian (mid 1979) 17.3 illion POPULATION CltRACTERISTICS (1978) MUTH (1978) Urban (pent of total) 65.6 Lif- .ap-etay at birth (yearn) 56.0 Crude birth r (pa h...ad) 39r.0 tInfant ertality (pee thanmed) 13.0 (1970) Crude death arat (per thooaad) 12.0 Ate-a ta e-a. eater (ymernt of PoPointion) POP IlcIOr growth ratr (percent) .lana T6.0 Total 2.7 Urbtn 60.0 Utban 4.5 torn) 25.0 PopulatIon ago ot`uctur- (pa-cent) Aeeae to anoata diapa-al (pennant of pop1latitn) n-14 yro. 42.9 Totel 34.0 15-64 yr. 53.4 Urban 51.0 65 + 3.7 lornl Poptlation per phymirian 1,556.0 POOD ANT) NUTRITIOTN (1978) Popylation per torms per-on 74350 POPlantLa per hbopital bad 547.0 Calonit intake as penrent of nequirnmatoa 97.0 ProaLgn (fron per day) 59.0 EtCAT1O7 (1976) of which: animral and poloc 24.0 Ad1lt literary rate (parrent) 72.0 1NCO9 E DlSTRldUTIOS (1972) ACCESS TO OLECTZICITO (pere-t of d-eilign.. 1972) yrrcont of private locoe rerninad by hlgheoc 20 percent of houae6oldn 61.0 Total 32.1 Lo.e.t 20 percent of hoo.eboldo 1.9 Unbar 54,3 L.o-ot 4D percent of hona..holds 7.0 Rgr-l 2.7 GNP PER CAPITA (USS, 1979) 730 (Wotld 1gnk AOlat Mnthodclogy) Anoa.l ame of arocib (ronet. 1973 vrine., 2) NAT1ONAL ACC0UNTS, 1979 UiS nilli-o 2 1969-70 1970-75 1975-79 CDP on -ock-: prlte- 14774.2 IOO.0 3.0 4.6 1.1 Conoceptlct I1264.4 76.2 7.1 5.4 U.5 Gno-- Icopatic Inveo-me.t 2067.8 14.0 0.1 14.5 - 11.3 E.po.ro of c uod n .d NFS 4053.7 27.4 3.9 -6.l 1C.5 Imports of Gcodt awd NFS 2611.7 17.7 8.4 6.4 - 0.0 OUTPUT, LABOR PORCE AND PRODUCTIVT (1970 prices GDP by Sfctor Labor FPor Lbor Prdortinstn Mtdillioc of 1970 S Perreot of Tota1 roth tote Tbo o Paret of Total ireth ae7 Pea of Aerage Genth Rate 1970 1979 1970 1979 1970-79 1970 1979 1970 1979 1970-79 1970 1979 1970 1979 1970-79 kgnlcculnrc 1,574.7 1,556.1 17.3 13.0 0 2,011.9 2,222.4 46.0 40.8 1.1 762.6 691.4 36.1 31.9 _1.1 lodcocry 3,226.3 4,476.5 36.5 37.0 3.7 769.1 1.005.3 19.4 10.5 3.0 4,194.9 6,452.9 '98.6 205.4 0.7 Services 4,084.8 5,760.6 46.2 49.0 3.9 1,407.6 2,212.9 33.6 40.7 5.2 2,902.0 2,612.2 37.4 i20.) - 1.2 Totul.Avenone 8,645.3 11.793.7 100.0 1O0.1 3.2 4,100.6 5,440.6 l00.0 100.0 2.9 2.111.8 2,167.7 .0D.0 100.0 0.3 O2MERNtENT FINANCE Gn.erol Consrro--n Cotr.l G-sroe-nt Bililona of SI. P-r-en of GDP Billioa of S/. Perac.t of GDP 1977 1978 197 1974 1977 1079 1977 1970 1979 1980 1974 1977 1979 1900 Cunre- R-eveno.t 191.0 308.7 631.4 17.7 1b.7 19.0 154.1 263.7 552.2 1,013.4 13.8 13.5 16.6 10.4 Cunnenr EopondInvent 220.7 343.4 542.0 15.7 20.0 16.3 193.1 291.0 448.7 954.0 12.6 16.9 13.5 17. Currnt Acocoont - 37.7 - 34.7 89.4 2.0 - 3.3 2.7 - 39.0 - 27.3 103.5 59.4 1.2 - 3.4 3.1 1. Cepitl geIeno- o - 0.5 1.I - - 0- - - - - - Capital lope-di-nret 43.2 61.5 139.5 4.0 3.0 4.2 40.1 57.7 128.6 266.0 4.1 3.5 3.9 4.t lorrol1 Doficlc - B0.9 - 95.7 - 49.0 2.8 - 7.1 - 1.5 - 79.1 - 85.0 - 25.1 - 206.6 - 2.9 - 6.9 - 0.B - 3.7 Eotnnool Fln-c-iol 34.6 9.5 47.1 2.9 3.0 1,4 34.6 9.4 46.4 59.9 2.9 3.0 1.4 1.1 lrDNEf AND CREDIT L973 1974 1975 1976 1977 1978 1979 1980 (BlUlions of 57. o-ct-oeding no erd of period) Money ooo Qoonl Money q) 98.3 120.0 141.8 166.3 220.5 321.2 615.7 1,177.1 Bank 4nodit cv P.1kc S.ector a/ 27.2 26.9 49.7 101.4 198.9 207.7 212.1 350.2 Bank Credit cc Private Sen,ot of 73.2 84.5 108.2 134.5 173.8 239.3 379.5 701.6 (Perceotagno or iodao oNuererm Horny aod qua--l mneay sa parrot G of CDP 25.0 24.3 22.6 20.0 19.3 17.3 19.6 21.3 Coreomr Pnr" e ldno in lolen (1977 - 100) 37.9 c3.9 54.3 72.4 100.0 157.0 264.7 421.4 dAnnual nhaogea In Cener- Price Indeo 9.5 16.9 23.7 35.5 38.0 57.8 67.7 59.2 Bank Credit tO Poblin Stenor 53.7 - 1.2 84.0 105.0 96.1 44.7 - 26.3 66.1 Saok C-edin to Prioare Sentot 27.7 15.5 28.1 24.3 29.2 37.7 58.6 86.9 a) et c-nent -oh-noa nato of each year.  Sq. 2 of 2 BALANCE OF PAYMENTS (millions of US$) MERC8'ANDISE EXPORTS (millions of US$) 1977 1978 1979 1980 1976-78 1979 1980 Espo-ts of Goods and NFS 2,137.8 2,399.9 4,065.9 4,554.4 Fishmel 182.8 237.0 191.8 Imports of Goods and NFS 2,694.4 2,070.1 2.625.5 3.923.9 Other fish products 35.0 94.5 97.2 Resource Balance - 556.6 329.8 1.440.4 630.5 Cotton 52.3 49.3 71.6 Net Factor Servion boone - 426.4 - 577.7 - 44.9 - 777.9 S.ger 72.3 34.3 13.1 Net transfers 56.8 56.0 122.0 132.9 Coffee 155.2 244.9 141.3 Corrent Aooos-t - 926.2 - 191.9 617.9 _ 14.5 Cspper 342.6 667.5 712.6 Dirnot Foregn Investment, ne 54.1 25.0 71.0 - 64.2 Silver 174.8 389.2 636.3 tNt Psblio M I LT Loan a! 620.0 593.0 853.2 374.0 imo 162.7 171. 212.7 Sisborsemeor 1,026.4 S41.8 1,296.5 1,383 2 Other mimenseI 134 3 229.9 959.1 Ornontizalton - 406.4 - 246.0 - 443.3 804.2 Petrole4a 93.1 605.7 809.8 Nlo Othnr M 4 LT Los-s - 0.1 - 11.2 _ 31.9 64.5 Other 248.1 710.6 783.7 Olsboramennt 74.3 61.11 87.9 180.7 Total 1,675.2 3,474.0 3,863.3 Amortleanloo - 74.4 - 73.0 - 119.7 - 116.2 Short-term Capital - 97.5 - 75.5 100.5 91.2 Other Capitol, net 0 - 260.2 - 31.9 80.2 EXTERN7AL DEBT (aillions of US$ es of Dne.eher 31. 1979) fh.nge Sn Roseroe- (- I- .ncrese) o 349.7 - 92.0 - 1.578.9 - 731.2 Net Re.erons (at the end of the period)o/ -705.0 - 623.0 955.9 1,687.1 Poblic Debt (intl. pnhlioly gseranteed) 5,931.5 Nan-GCar-nte-d Prinate Debt 1,307.8 a/ Adjonted for baleco-of-pay-ntn nopport oo n. and refinancing. lotal Ost.nteding and Di-bureed 7,239.3 RATE OF EXCliANGE (Soles per US$) DEBT SERV1CE RATIO (peroen.t f esp-etm of geed., NFS, 1979) A-ega.e 1977 03.01 Phblin Debt (incl. psblicly sarnn-e-d) 22.6 Overage 1979 156.34 Nom-Gsaranneed Pnin-te Dmbt n.e. Aver.e8 1979 224.55 Total n... Aesna.g 1980 289.2 IBRU/IDA LENDING (nillione of USS as of DOcetr 31, 1979) O.tst.ndig end Dishbnred 234.7 U.ndiabhned 353.1 Osts tnding S inl. sndihsbraed 587.8  SUMMARY AND CONCLUSIONS Present Economic Situation i. Expansionary monetary and fiscal policies pursued during most of the 1970s led to high public sector and balance of payments deficits, par- ticularly during 1975-77, and to increased recourse to foreign financing, mainly from commercial sources on relatively short maturities. The situation was exacerbated by a sharp deterioration of Peru's terms of trade during 1975-78. These developments culminated in the severe economic and financial crisis of 1977-78. ii. In 1978, the Peruvian Government embarked on a stabilization- cum-economic-recovery program, which has been implemented with relative success during 1978-80. The new Government that took office in July 1980 has continued efforts begun under the program and -- more recently -- has adopted a series of far-reaching additional measures at the macro and sectoral levels, which should not only strengthen and complete economic stabilization but also create an appropriate framework within which the recovery process would accelerate (see paras. xii-xx). iii. The implementation of the stabilization-cum-economic-recovery program (1978-80), aided by substantially improved terms of trade and refi- nancing of major parts of the public sector's external debt, resulted in a strong balance of payments performance during 1979 and 1980. The control of the public sector deficit, however, was less successful: after a sharp reduction in 1979 it increased again in 1980, mainly because of the resumption of subsidies, generous wage increases, and substantially increased defense spending. The program was again relatively successful in laying the ground for more efficient resource use through import liberalization, export promo- tion, and a more rational public investment program. iv. In spite of these achievements, the present economic situation remains highly volatile and is characterized by a long list of acute problems: - persistent high inflation, averaging 60 percent during 1980; - high public sector deficit, equivalent to about 6 percent of GDP in 1980; - high un- and underemployment, estimated at 11 and 44 percent respectively of the urban labor force; - stagnating agricultural production, as a result of ill-conceived agricultural policies during the past decade and exacerbated by drought; - deteriorated pattern of income distribution, with increased inci- dence of poverty and malnutrition, particularly in urban areas; - distortions of the whole system of incentives, with deteriorated agricultural terms of trade, high food and petroleum subsidies, and a tax system that is not conducive to employment generation (notably through generous exemptions favoring capital). The need for adjustments is expected to result in substantial adjustment inflation for some time;  - ii - - reduced government expenditures for economic and social purposes (agricultural support services, road maintenance, education, health) because of high outlays for defense and interest payments and some large projects of doubtful economic justification. Even the balance of payments, with high dependence on primary exports, which are subject to strong price fluctuations, and a high debt burden, is less strong than it seems at present. The medium-term prospects critically depend on efficient economic management and particularly on petroleum sector policies. v. To the above list of problems one has to add problems related to the longer-term development of the country. These are: - widespread poverty, mostly concentrated in the rural areas of the southern Sierra, but -- because of the recent decline in real household incomes -- now probably also affecting major segments of the urban population; - rapid population growth and rural-urban migration exacerbating the pressure on the social and economic infrastructure as well as on un- and underemployment; - poor state of health and nutrition with high infant mortality and high incidence of communicable diseases; - water and land resource constraints to agricultural development requiring major investment efforts in rehabilitating existing irrigation systems and opening up new land; - rapidly expanding demand for energy and potable water also requiring urgent large-scale investments calling for thorough planning and careful financial management, including rational pricing policies; - need for better integration of the different regions of the country requiring improvement and expansion of the transport infrastructure. Policy Recommendations vi. These problems call for urgent corrective measures through govern- ment programs and policy changes, some of which will be mutually in conflict. It will be difficult to strike a balance and to accomodate these programs within overall resource availabilities, particularly within the tight public sector resource constraints. It is crucial that these resource constraints (including a sustainable volume of foreign savings in the form of net long- term capital inflows) be taken into account to avoid a repetition in the future of the disequilibria of the mid and late 1970s that required drastic measures, which had strong negative side effects. Stabilization must be conceived as a long-term effort to set a framework of relative financial stability (in terms of sustainable public-finance and balance of payments situation and decelerating inflation), within which the government's longer- term development goals will have to be effectively pursued.  - iii - vii. The concept of "relative financial" stability is defined through a set of macroeconomic projections (see tables 10.1-10.9, Statistical Appendix). These projections, under a large number of assumptions and with important policy implications, delimit the overall resource availabilities and particu- larly those of the public sector over the next five years. This development path of relative financial stability, although by no means the only one possible, will be relatively narrow, and it will require vigorous economic management to steer the economy along these lines. viii. Policy measures that are considered necessary to follow that path (and thus provide a solid basis for medium- and longer-term development policies) are summarized in table 23 and evaluated with regard to their impact on the principal overall socio-economic goals. The key measures are the following: - gradual reduction of public sector deficit through -- tax reform to make better use of the taxation of incomes and goods and services by improving tax administration and reducing exemptions. The tax reform should, at least, be neutral in terms of revenues, preferably have a positive impact and increase the buoyancy of the tax system with regard to GDP growth over its present level of about 1; -- regular price adjustments for publicly supplied goods and services. For some products, there is still need for increases in real terms. Further adjustments would have just to follow the general price movements; -- gradual elimination of food and petroleum subsidies and, in the case of food and possibly kerosene, partial replacement by more specifically targeted interventions in favor of low- income households; -- rigorous scrutiny and tight control of government expenditures, although there is now need for substantial increases in out- lays for social (health, education) and economic purposes (road maintenance, agricultural extension and research) including selective adjustments of government salaries; and -- gradual reduction and restructuring of government personnel; - tight credit policies vis-a-vis the public sector, including the improvement of the public sector's external debt management; - freezing or gradual reduction of Central Bank rediscount ceilings towards the rest of the financial system to have it essentially depend on the mobilization of financial savings. To this extent, reserve requirements could then be gradually relaxed; - regular adjustment of the interest rate structure so that deposit interest rates would reach and maintain a positive level in real terms and thus encourage financial savings;  - iv - elimination of distortions in the system of incentives through -- price decontrol, to be supplemented in the agricultural sector by the introduction of floor prices for non-perishable goods; -- progressive trade liberalization with further reduction of import tariffs according to a pre-announced schedule. Exceptions for infant industries should be granted only on a very selective basis for a small number of industries and with clearly defined time limits; -- regular adjustment of credit interest rates to reach and maintain a positive level in real terms; -- maintenance of a constant real exchange rate; and -- changes in the tax system eliminating payroll taxes, basing tax exemptions for reinvestment on the number of jobs created, and increasing taxation of corporate property so as to reduce the relative cost of labor and increase the relative cost of capital and thus make the tax system more conducive to employment generation. ix. In view of the possible negative short-term impact of many of the recommended policy measures (see table 23) it would be indicated to supplement this policy package by an appropriate incomes policy. Such an incomes policy-- for agriculture basically in terms of pricing policies with gradual adjustments towards longer-term levels of international prices and within the urban economy basically in terms of a gradually increasing labor income share-- should be designed within the overall macroeconomic framework and backed by a social pact between Government, labor unions, and trade associations. X. Given the present state of Peruvian economy and society, medium- and longer-term development policies should aim at improved use of resources, particularly in energy, water, transport, industry, and agriculture as well as at better development of human capital, particularly through improved health care, nutrition, education, and family planning. The key measures are the following: - employment generation as most effective long-term measure to improve income distribution and fight poverty, through revival of economic growth, change of relative factor costs in favor of labor, higher use of labor in public investment projects wherever feasible, and work-oriented adult education to enhance the self-employment potential; - specifically targeted interventions through the health system to improve the nutritional situation of low-income households to be complemented by the expansion of primary health care and family planning;  -v - vigorous energy policy to develop the country's petroleum and hydropower resources. In this context, it is crucial that new foreign risk capital be attracted into petroleum exploration and that rational pricing policies be adopted to contain domestic demand growth and to generate appropriate savings. In the case of power, the costly investment projects need thorough evaluation and optimization, and tariffs will have to be regularly adjusted to allow a reasonable share of self-financing; revival of agricultural development through adequate pricing policy, improved marketing, strengthened support in the form of extension, research, and credit, and more efficient use of water resources through rehabilitation of existing irrigation schemes. In this context, the regular adjustment of water charges is important to provide for better operation and maintenance of the irrigation systems as well as a fair share of self-financing; strengthening and expansion of the industrial sector through general decontrol, continued trade liberalization and export promotion, revision of the whole system of incentives, including the treatment of foreign capital, and decentralization of the management of public enterprises away from the Central Government. xi. The Government's awareness of both short-term problems and longer- term development needs will have to be translated into a balanced package of policy measures, including development efforts to strengthen the country's economic and social infrastructure and its productive capacity. Many of these measures may have an immediate negative impact on public sector finances either through a reduction in revenues or increased expenditures, although most are expected to contribute to improved public sector performance in the longer run. This has to be taken into account when designing the measures and planning the time frame for their implementation. This requires skillful economic management, for which adequate staffing of key positions in the public sector is indispensable, supported by adequate salary policies to attract and retain capable personnel. Latest Developments and Government Actions xii. During the transition period of May-July 1980, the incoming Govern- ment made a thorough assessment of Peru's economic and social situation. An account of the state of the economy and an outline of major policy actions were given in the Prime Minister's first major address in late August. Some of the conclusions were immediately translated into policy action: some key prices such as for petroleum products and power were raised and price controls reduced and relaxed; the devaluation of the sol was no longer pre- announced, and it was accelerated to fully compensate for the differential between domestic and international inflation; and -- perhaps most important during the first few months of the new Government -- import liberalization was greatly advanced in September when import licensing for virtually all but a small number of products was abolished and tariffs were cut from a maximum of 150 percent to 60 percent (lowering the unweighted average by about five percentage points to about 34 percent). Other measures had to await congres- sional action or had to be delayed for political reasons.  - vi - xiii. A major economic policy package was adopted at the end of 1980 and during the first days of 1981. It comprised interest rate adjustments, major price increases for goods and services supplied by the public sector as well as new petroleum legislation. xiv. In November 1980, a law was enacted re-establishing the Central Bank's control over interest rate policy, previously held by the Ministry of Economy and Finance, and eliminating the 17 percent tax on interest payments for bank credits. Armed with this authority, the Central Bank completely revised the interest rate structure in January 1981. Deposit and lending rates were increased by about 20 percentage points to some 50-55 percent. Taking commissions and discounting practices into account, the effective lending rates during the first quarter of 1981 were around 70 percent p.a. and, therefore, highly positive in real terms when compared to expected inflation of some 60 percent for 1981. The Central Bank is closely monitor- ing the financial markets and intends to maintain deposit and lending rates positive in real terms. xv. The increased public sector deficit (equivalent to almost 6 percent of GDP in 1980) was tackled through substantial upward adjustments of food and petroleum prices as well as power and water rates. Major increases -- averaging about 40 percent with some of up to 90 percent -- were implemented in early January 1981; another round of adjustments, although less marked and limited to a smaller number of products, took place in March. These price increases, which are scheduled to be followed by regular smaller adjust- ments, will gradually eliminate all subsidies and help to bring down the public sector deficit from its high 1980 level. Pricing policies for some of the key public enterprises are now specifically targeted: in the case of petroleum to reach approximately international price levels over the next three years, in the case of power and water to reach self-financing ratios of about 30 percent of total investment also within the next three years. xvi. With regard to trade policies, another round of tariff reductions was recently implemented lowering the average tariff by another 3 percentage points. The ultimate goal is a tariff of some 25 percent with very little dispersion by 1984. The plan calls for adjustments according to a schedule that will be negotiated with the different industries. Temporary relief to ease the adjustment process through higher tariff reductions for imported inputs and thus higher effective protection is part of the Government's plan. The export subsidy in form of tax certificates (CERTEX)was revised in February. Rates were reduced to 22, 20, and 15 percent, and the eligibility was greatly rationalized by limiting it to a relatively small number of products defined according to the customs code. These changes will help to limit abuses and substantially reduce the fiscal cost. xvii. Important new policy initiatives with longer-term impact were directed at the agricultural, petroleum, and mining sectors. A new Agricul- tural Promotion Law was enacted in November 1980. This law provides special fiscal incentives to agriculture and agroindustries. It also opens the way for commercial banks and other financial institutions -- in addition to the state-owned agricultural bank, wnich has virtually been the only source of sector financing -- to extend credit to the agricultural sector by eliminat- ing prohibitions on the mortgaging of land. The law also concludes the  - vii - agrarian reform, which was the cause of great uncertainty. The import liberalization process also helps agriculture to the extent that equipment and inputs can be more easily imported at lower prices. In addition, measures are now under preparation to strengthen research, reestablish a national extension service, restructure the Ministry of Agriculture, improve agricultural marketing, and to reorganize and improve agrarian reform enterprises. Particular attention will be given to rehabilitating the sugar industry. xviii. The Government has also given high priority to increasing oil production and exploration. In December 1980, sector legislation was modi- fied by opening secondary recovery, which had been the exclusive preserve of PETROPERU (the State petroleum company), to other domestic and foreign firms in association with PETROPERU. The new law also improves the investment climate by introducing a tax credit scheme that provides additional incentives for investment. The foreign companies currently operating in Peru have reacted favorably to these incentives, and new foreign contractors concluded negotiations with PETROPERU for several blocks in the northern and southern jungle areas. In addition, the sector benefits from the recent change in the export tax legislation phasing out the 17.5 percent tax over a period of two and a half years and replacing it by a 5 percent tax to be credited to income tax payments. xix. The gradual elimination of the export tax also benefits the mining sector. (It is planned that the tax be also eliminated for agricultural exports so that this tax would eventually be fully replaced by income taxation). In addition, the general mining law was changed in several important respects, especially as regards the role of the Government and tax incentives for new investment. MINPECO, the state-owned marketing organization for the mining sector, was dismantled of its monopoly. It retains the right to be marketing agent for wholly state-owned mining companies, while other companies can make their own marketing arrangements. State participation in special mining enterprises was made more flexible by allowing public enterprises other than MINEROPERU and state-owned banks to hold the State's share in equity capital. Finally, tax concessions were put on equal footing for state-related and purely private companies, and investment tax redits were increased to make new ventures financially more attractive. xx. To counteract the negative impact of the recent monetary and fiscal measures on the poorest population strata, the Government has set up two special funds to finance specific food programs, mainly a food stamp program, and employment-intensive investment projects at the local level. The Govern- ment is also committed to gradually improve real incomes of the lower and middle income classes. In this respect, the Government recently initiated a broadly based negotiating process through the tripartite commission (with representatives of the Government, the unions, and the entrepreneurs). While the prime aim of the commission is to establish stability-oriented incomes policies, it may eventually play a more comprehensive role and become the main forum for negotiations of key economic policy measures. xxi. As evident from this brief account, the Government has taken decisive policy measures in many fields. However, a lot remains to be done, particularly in public sector finances and in the social sectors, and it is of crucial impor- tance that the initiated policies be consistently followed in order to provide a stable and financially viable framework for longer-term development efforts.   I. RECENT ECONOMIC PERFORMANCE 1. Performance Under the Stabilization-Cum-Economic-Recovery Program 1. Throughout most of the 1970s, government policies in Peru were not conducive to the mobilization of savings and the efficient use of resources. The results were high public sector deficits (averaging 6.5 percent of GDP during 1970-78 and peaking at 9.3 percent in 1975), increas- ing savings-investment gaps (averaging 5.9 percent of GNP during 1972-78 and peaking at 15 percent in 1975), and little response of production to investment. Inadequate national savings were compensated by increased exter- nal borrowing, which resulted in a total external debt equivalent to 56.8 percent of GDP in 1978 and public debt service equivalent to 31.2 percent of the country's exports of goods and non-factor services. When in addition anchovies, one of the major exports, virtually disappeared and the country's terms of trade were adversely affected after 1974/75, the external financial situation got more and more out of control. Beginning in 1975, successive economic teams made several efforts to cope with the mounting crisis. This, however, was not done consistently over an extended period of time and was, therefore without lasting success. By mid-1978, the economic crisis had reached grave proportions with a drop in real GDP, inflation approaching 100 percent, and the decline of the banking system's net international reserves to a negative level of about US$1,200 million. 2. By mid-1978, the Government embarked on a stabilization-cum- economic-recovery program that aimed at strengthening public finances, stimulating exports, stemming the loss of international reserves, and promoting more efficient use of private and public sector resources. The program was supported by an IMF stand-by arrangement, a program loan from the World Bank, and was also greatly helped by rescheduling and refinancing of large portions of the external debt. The relatively successful implementation of this program together with increased petroleum exports and a substantial improvement of the country's terms of trade helped to turn the financial situation around and to begin the process of economic recovery as reflected by the financial and economic indicators summarized in table 1.  Table 1: SELECTED FINANCIAL AND ECONOMIC INDICATORS, 1977-80 1977 1978 1979 1980 prel. Net international reserves of the banking system (US$ million) -1,100.9 -1,025.0 553.9 1,285.1 Gross international reserves of the banking system (US$ million) 457.4 592.4 1,858.2 2,556.4 (Equivalent to .. months of imports of goods and non-factor services) (2.0) (3.4) (8.5) (7.8) Medium- and long-term external debt (in % of GDP) 44.4 56.8 49.0 40.5 of which: public debt 34.5 45.6 40.1 33.4 Public debt-service ratio (in % of exports of foods and non-factor services) 30.6 31.2 22.6 a/ 31.3 a/ Overall public sector deficit (in % of GDP) 9.2 5.7 1.7 5.9 Domestic credit expansion to the public sector (in % of GDP) 3.1 3.8 0.7 2.5 Savings-Investment gap (GNS - GDI in % of GNP) -7.5 -2.0 3.8 1.6 GDP growth (%) - Overall 0.0 -0.7 3.4 3.1 - Per capita -2.6 -3.3 0.7 0.4 Inflation Lima CPI (annual percentage change) 38.0 57.8 67.7 59.2 GDP deflator (annual percentage change) 37.7 63.3 73.1 57.9 a/ Including refinancing. Source: Central Bank; ONE; Bank staff estimates. 3. While the Economic Recovery Program (ERP), by its nature, has been medium to long-term oriented, particularly with respect to the opening up of the economy and the rationalization of the public investment program, the thrust of the Government's economic policies over the past two years was mostly short-term oriented to improve public finances and to overcome the balance of payments crisis. Besides the problem of the efficiency of resource use, which has been tackled through import liberalization, export promotion, and a more rational public investment program, the longer-term development issues, particularly in the social sectors, have not been effectively addressed during the past two years. Even the resource mobilization problem was addressed  - 3 - only with regard to the immediate problems of the public sector and the finan- cial system through tax increases, measures to improve tax administration, price adjustments, and raising interest rates. 4. In spite of the generally successful implementation of the ERP, many problems persist: high inflation; substantial distortions of the whole system of incentives (prices, interest rates, tax incentives) with a high potential for further adjustment inflation; widespread un- and underemployment; low quality and effectiveness of public expenditures vis-a-vis the country's needs, particularly in the social sectors; sluggish agricultural development; weakness and rigidity of public administration; and problems that have been clearly beyond the ERP's scope such as rapid population growth and marked interregional and interpersonal inequalities of the distribution of income and wealth. Some of the problems have become even more severe as a result of the recent recession and stabilization efforts that resulted in higher unemployment and substantial cuts of public expendi- tures, particularly salaries and outlays for socially oriented programs such as education and health. The following sections present a broader and more complete picture of economic performance during the last few years. 2. Present Economic Situation in Perspective 2.1 Growth and Employment 5. GDP growth averaged 3.4 percent per year in real terms during 1970-79; it was higher during 1970-75, averaging 4.8 percent, but dropped to a mere 1.1 percent during 1975-79 because of the severe economic and financial crisis. The most dynamic sectors were mining, power, transport, banking, and government with a combined contribution to GDP growth of about 52 percent during 1970-79, compared to a share of 34 percent of GDP in 1970. Agriculture virtually stagnated, and manufacturing and construction grew only during the first half of the 1970s (see table 2). On the demand side, the growth of consumption of domestically produced goods and services was the most stable element, persistently absorbing about 86 percent of GDP growth. Durin., the first half of the 1970s, investment growth was particularly high contribut- ing about 38 percent to GDP growth, while exports dropped and slowed down growth. During the second half of the 1970s, however, exports substantially contributed to the growth of GDP. During 1977-79, they were the only dynamic element of final demand (see table 3).  Table 2: GDP GROWTH BY SECTORS, 1970-79 (Percentages based on constant 1973 prices) Average annual growth 1/ GDP Shares Contribution to GDP growth 1970-79 1970-75 1975-79 1970 1970-79 1970-75 1975-79 Agriculture 0.6 0.7 0.3 14.8 2.7 2.0 5.2 Fishing -4.4 -17.1 8.5 2.2 -2.7 -4.9 5.2 Mining 4.8 1.2 12.6 7.1 12.3 0.3 54.3 Manufacturing 3.2 5.7 -0.8 25.0 23.4 30.3 -0.7 Construction 3.2 11.0 -6.3 3.0 2.9 7.2 -12.1 Government 4.8 5.7 2.4 9.7 13.1 12.0 17.6 Others 4.1 6.3 0.8 38.2 48.1 53.1 30.5 Power 10.0 9.8 9.8 0.6 2.5 1.4 6.3 Commerce 3.5 7.9 -2.2 12.8 14.2 23.7 -18.9 Transport 6.3 8.7 2.1 5.0 10.0 9.6 11.0 Fin. Inst. 4.0 5.0 2.6 11.2 13.8 11.7 21.1 Services 3.4 4.1 1.7 7.2 6.9 6.2 9.3 Others 2.0 1.8 2.2 1.4 0.7 0.5 1.7 Total GDP 3.4 4.8 1.1 100.0 100.0 100.0 100.0 1/ Trend rates based on least square estimate. Source: ONE; Bank staff estimates.  - 5 - Table 3: GDP GROWTH BY DEMANDS COMPONENTS, a/ 1970-79 (Constant 1973 prices, percentages) GDP Shares Contributions to GDP growth 1970 1975 1977 1979 1970-79 1970-75 1975-77 1977-79 Consumption 72.8 75.5 80.3 76.0 86.4 86.4 86.3 -80.6 Investment 6.3 12.7 6.8 6.6 7.4 38.3 -122.6 -0.4 Exports 20.8 11.7 12.9 17.4 6.2 -24.7 136.3 181.0 GDP 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 a/ All demand components net of direct and indirect imports. Source: ONE; Bank staff estimates. 6. The mediocre growth performance translated directly into inadequate employment generation and insufficient absorption of the rapidly growing labor force. During 1970-79, total employment grew by 2.7 percent a year while the labor force grew by 3.0 percent. Open unemployment, therefore, increased from 4.7 percent in 1970 to 7.1 percent in 1979. While employment in agriculture has been relatively stable and unemployment relatively low, open unemployment basically is a non-agricultural or urban phenomenon. During 1970-79, non- agricultural employment increased by 4.1 percent a year, the non-agricultural labor force by 4.5 percent, fueled by rapid natural growth and by rural-urban migration. As a result, open unemployment in the non-agricultural sectors increased from 8.3 percent in 1970 to 11.2 percent in 1979 (see table 4). Open unemployment in a system without unemployment insurance is mostly short lived because people cannot afford to remain totally unemployed for prolonged periods and have to look for some alternative source of income and employment. Inadequate employment generation of the economy is mainly reflected by high underemployment in terms of low number of working hours and low income. 1/ Low-productivity employment is concentrated in the agricultural sector. It increased, however, steeply in the non-agricultural sectors during recent years as a result of the economic crisis and low economic growth. 1/ The Ministry of Labor classifies a person as underemployed if weekly working hours are less than 35 and/or the income is less than the 1967 minimum wage adjusted for inflation.  - 6 - Table 4: UN- AND UNDEREMPLOYMENT, 1970-79 (Percent of Labor Force) 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 Unemployment 4.7 4.4 4.2 4.2 4.0 4.9 5.2 5.8 6.5 7.1 Agricultural labor force 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 Non-agricultural labor force 8.3 7.7 7.3 7.1 6.6 8.1 8.4 9.4 10.4 11.2 Underemployment 1/ 45.9 44.4 44.2 41.3 41.8 42.4 44.3 48.1 52.0 51.4 Agricultural labor force 64.3 63.6 67.0 65.4 65.4 68.2 68.8 62.1 65.4 63.5 Non-agricultural labor force 30.9 29.0 26.6 23.3 25.0 24.8 32.7 39.2 43.7 44.1 1/ For definition, see footnote on preceding page. Source: Ministry of Labor. 2.2 Financial Aspects Public Sector 7. During most of the 1970s, the Government pursued expansionary expenditure policies, which were not matched by corresponding efforts to raise revenues. Moreover, inadequate pricing policies (including subsidies for food and petroleum imports) and inefficient management did not allow public enterprises to generate sufficient cash to make reasonable contributions to the financing of the investment program. The results were steeply increas- ing public sector deficits (see table 5) requiring excessive recourse to internal and external financing. The excessive public sector demand spilled over into the balance of payments with rising difficulties from increasing current account deficits and excessive debt service. Moreover, the structure of government expenditures did not really respond to the country's needs: expenditures for social and economic services, yielding place to interest payments and defense outlays, lagged substantially behind the general trend of current government expenditures and reached extremely low levels at which standards of service greatly suffered (see table 6); in addition, investment expenditures were heavily concentrated in large-scale projects, some of which are of doubtful economic justification such as the Majes irrigation scheme, with extremely long gestation periods and limited employment creation.  Table 5: PUBLIC SECTOR OPERATIONS IN RELATION TO GDP, 1971-80 (Percentages) 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 Central Government Current revenue 14.0 13.9 13.6 13.8 14.0 13.4 13.5 14.2 16.6 18.4 Current expen- diture 12.5 12.9 13.4 12.6 14.4 14.8 16.9 15.7 13.5 17.3 Current account 1.5 1.0 0.2 1.2 -0.4 -1.4 -3.4 -1.5 3.1 1.1 Capital revenue - - - - - - - - - - Investment expenditures 4.2 4.3 3.9 4.1 4.5 4.5 3.5 3.1 3.9 4.8 Overall deficit -2.7 -3.3 -3.7 -2.9 -4.9 -5.9 -6.9 -4.6 -0.8 -3.7 Total Public Sector Current account 2.7 2.5 0.9 2.0 -0.9 0.0 -3.1 -0.5 3.8 0.9 Capital revenue ... ... ... 0.6 0.0 0.0 - 0.0 0.0 0.0 Investment expenditures 4.9 5.3 5.9 8.3 8.4 8.3 6.1 5.2 5.6 6.8 Overall deficit -2.2 -2.8 -5.0 -5.7 -9.3 -8.3 -9.2 -5.7 -1.7 -5.9 Source: Central Bank; IMF.  -8- Table 6: STRUCTURE OF CENTRAL GOVERNMENT CURRENT EXPENDITURE, 1972-78 (Percentages) 1972 1973 1974 1975 1976 1977 1978 General services 43.6 42.9 43.6 44.5 46.8 54.0 45.2 of which: defense (22.4) (24.1) (25.1) (28.1) (31.4) (40.0) (32.0) Social services 36.3 35.8 34.7 35.5 34.0 25.4 22.7 of which: education (27.9) (28.3) (26.9) (24.5) (22.9) (18.1) (16.1) health (7.1) (6.3) (6.6) (5.4) (6.2) (4.7) (6.0) Economic services 7.6 8.0 7.1 7.9 7.0 4.5 6.1 of which: agriculture (3.6) (3.8) (2.6) (2.7) (1.8) (1.4) (3.4) transport (2.6) (2.2) (2.2) (2.0) (2.0) (1.5) (1.5) Other a/ 12.5 13.3 14.6 12.1 12.2 16.1 26.0 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Total as % of GDP 12.9 13.4 12.6 14.4 14.8 16.9 15.7 a/ Mostly interest payments. Source: Central Bank. Money and Credit 8. Expansionary fiscal policies were supported by rapid credit expansion and a rapid increase in overall liquidity. Credit to the public sector expanded particularly fast crowding out the private sector. Low interest rates, which have been negative in real terms for many years, additionally fueled this process of monetary expansion resulting in inadequate mobilization of financial savings, accelerating inflation, and increasing balance of payments deficits (see table 7). Until 1978, the financing of the public sector deficit was a major source of inflation. During 1979 and part of 1980, the monetization of the large increase in international reserves played a major role. Substantial devaluations, validated through credit expansion and an acceleration of the velocity of circulation also contributed to the acceleration of inflation.  Table 7: MONEY AND CREDIT EXPANSION, 1972-80 (Annual percentage changes for money, credit and prices) 1972-73 1973-74 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 Money and quasi-money 20.1 22.1 18.1 17.3 32.6 45.7 98.4 78.1 Credit 31.8 10.9 41.8 49.4 57.9 41.4 16.0 62.0 Public sector 53.7 -1.2 84.8 104.0 96.1 44.7 -22.3 57.3 Private sector 27.7 15.5 28.1 24.3 29.2 37.7 61.9 77.5 Consumer prices 9.5 16.9 23.7 33.5 38.0 57.8 67.7 59.2 (Lima CPI) Velocity of circulation 1/ 7.6 8.0 8.5 10.0 10.9 10.3 9.5 n.a. Interest rates (Commercial banks, Lima) Credit 12.0 12.0 12.0 12.0-15.5 15.5-17.5 17.5-31.5 31.5-32.5 31.5-32.5 Savings deposits 5.0 5.0 5.0 5.0-9.0 9.0-11.5 11.5-29.0 29.0-30.5 29.0-30.5 1/ Based on Gross Output and M3 Source: Central Bank; IMF; ONE Balance of Payments 9. Excess demand as measured by substantial savings-investment gaps (that peaked at 15 percent of GNP in 1975) resulted in high deficits of the current account of the balance of payments and -- after the sources of external financing were gradually drying out and gross capital inflows were almost completely absorbed by debt service -- in substantial losses of inter- national reserves. At the height of the financial crisis in 1977/78, net international reserves reached a negative level of about US$1,100 million and gross reserves amounted only to about US$450 million, equivalent to 2.0 months of imports of goods and non-factor services (see table 8). During 1979, the balance of payments improved substantially as a result of forceful demand management, increased petroleum exports, successful promotion of non-traditional exports, an improvement of the country's terms of trade, and debt rescheduling and refinancing. This process continued in 1980, although vigorous import liberalization resulted in a sharp increase of imports (56 percent over 1979) and in a minor current account deficit.  - 10 - Table 8: BALANCE OF PAYMENTS AND INTERNATIONAL RESERVES, 1971-80 (% of GDP) 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 Current account 0.4 -0.4 -1.9 -6.3 -10.0 -8.2 -6.8 1.6 4.2 -0.1 Net long-term capital -0.4 1.7 4.2 7.3 7.6 7.1 4.9 5.1 6.0 3.0 Change in reserves 1.0 -0.6 0.1 -2.2 3.4 3.6 2.6 -0.7 -10.7 -3.8 (increase - ) Reserve level, net 331.8 397.3 410.6 692.5 115.8 -751.7 -1100.9 -1025.0 553.9 1285.1 (Us$ million) Reserve level, gross 5.1 5.7 4.9 4.7 1.9 1.7 2.0 3.4 8.5 7.8 (months of imports equivalent) Source: Central Bank; IMF. 2.3 Income Distribution 1/ 10. Reflecting the stabilization efforts and subsequent changes in production, employment, and relative prices, income distribution has undergone marked changes during recent years. Functional income distribution, in general terms, is characterized by a drop of the share of wages and salaries and contractual capital incomes (rent, interest), relative constance of the share of income from self-employment, and an increase in the share of gross profits (see table 9). White-collar workers (salary earners) suffered a larger drop of their share in national income than blue-collar workers (wage earners). This larger drop, particularly during 1978 and 1979, was partly due to restrictions imposed on the salaries of government employees. The average remuneration of dependent workers declined by 14.2 percent in real terms during 1970-79, the real wage of a blue-collar worker in the Lima area by 10.6 percent during the same period, and that of a white-collar worker by 36.4 percent 2/. By comparison, the real average salary of a government employee dropped by an estimated 29.3 percent. Within the group of self- employed, those working outside agriculture expanded their share somewhat, while farmers suffered a substantial drop of their share in domestic income, particularly during 1978 and 1979 as a result of domestic policies and the 1/ For the method followed to estimate the different aspects of income distribution, see Technical Note on Income Distribution, Annex I. 2/ According to more recent data for the Lima metropolitan area, real wages and salaries started to increase during the forth quarter of 1979 and throughout 1980.  - 11 - drastic deterioration of agricultural terms of trade. Continued rapid rural- urban migration helped the remaining self-employed farmers to maintain a higher share of domestic income; the demographically adjusted share followed a U-shape development, recovering towards the end of the 1970s after gradual decline during 1970-73 (see table 2.9, Statistical Appendix). 11. Although the changing shares of different income sources are related to sectoral developments, especially in agriculture and mining, the general picture remains essentially the same -- drop of wages and salaries, increase in self-employed incomes and gross profits -- for the non-agricultural and non-mining activities together (see table 2.10, Statistical Appendix). The elimination of the net outflow of factor service incomes abroad, which increased rapidly during the past two years, does not fundamentally change the picture either. Factor income shares in national income closely followed the lines of shares in domestic income (see table 2.11, Statistical Appendix). Table 9: FUNCTIONAL INCOME DISTRIBUTION AND REAL INCOMES, 1970, 1975, 1977-79 1970 1975 1977 1978 1979 Percentage Shares in Domestic Income Wages and salaries 40.5 42.1 41.5 38.0 34.5 Wages 19.1 21.7 22.0 20.6 19.1 Salaries 21.4 20.4 19.5 17.4 15.4 Self-employed 23.8 21.8 21.6 21.8 21.7 Agriculture 10.4 8.1 7.4 6.3 5.8 Other 13.4 13.7 14.2 15.5 15.9 Contracted capital income 5.3 4.2 2.7 2.5 2.5 (rent, net interest) Gross profits 30.4 31.9 33.2 36.7 40.3 Domestic income 100.0 100.0 100.0 100.0 100.0 Real Incomes, Index 1970 = 100 Wages and salaries 100 116.2 107.8 92.7 85.8 Wage, Lima Metropolitan Area 100 114.8 99.2 89.4 89.4 Salary, Lima Metr. Area 100 108.4 81.1 69.7 63.6 Source: Table 2.9, Statistical Appendix; Ministry of Labor; ONE.  - 12 - 12. The changes in the functional income distribution had different effects on the household incomes of different income groups. During 1971/ 72-79, the interpersonal distribution deteriorated: real household incomes of the lowest income group dropped by almost 18 percent, those of middle income groups by 10 to 17 percent, while those of the top income group increased by over 10 percent. During 1975-79 -- years of difficult adjustments and economic crisis -- the higher middle income groups (groups III and IV, essentially blue and white collar workers) suffered the highest drops (see table 2.12, Statistical Appendix and Annex I). 13. The picture is regionally highly differentiated. Rural areas and the Sierra region fared relatively better than urban areas and the Costa region. The drop in real household income after 1977 was less pronounced in rural areas than in urban areas, because the decline in real incomes of dependent workers (wages and salaries) mostly affected urban jobs (see table 2.13, Statistical Appendix). Tentative estimates show that the groups worst affected by the 1975-79 adjustments were the middle and lower middle income groups in urban areas, typically blue and white collar workers and some of the self- employed engaged in subcontracting activities in the informal sector. Rapid rural-urban migration helped to improve real family incomes in rural areas, while, at the same time, they contributed to exarcerbate the situation in urban areas. The ratio of rural to urban household income went down slightly from 1 to 4.2 in 1971/72 to 1 to 3.6 in 1979. 14. While the real per-capita product, at the national level, evolved only slightly during 1970-75, it dropped considerably during 1975-79. This development, however, was unevenly shared amongst the different regions of the country. The Lima area experienced a fairly stable increase in real per-capita income up to 1975, but suffered the strongest decline thereafter. The other regions followed an S-pattern with declining income during 1970-73, followed by increases during 1973-75 and sharp declines thereafter. In general, the Sierra -- depending more on agriculture than the rest of the economy -- showed less fluctuations of the real per-capita income than the other regions. This, to some extent, is also the result of substantial out-migration. The Selva, in turn, with heavy in-migration, was more subject to fluctuations in real per-capita income than the rest of the country (see tables 2.14 and 2.15, Statistical Appendix). As was to be expected, the adjustment process during the past few years imposed the heaviest burden on the more advanced Lima area and Costa region where most of the country's modern sector activities are located. 15. The broad picture of functional income distribution in the urban economy (non-agricultural, non-mining GDP) throughout the 1970s is charac- terized by relative constancy of the share of income from self-employment, a rise of the wage and salary share during the early 1970s, followed by relative constancy during the mid-1970s, and a sharp decline thereafter. The capital share followed the inverse pattern of the wage share, except for a marked jump in 1974. While this jump is associated with a substantial increase in output at the time when absolute protection through the National Register of Manufac- tures took effect, the remaining changes are associated with changes in the internal terms of trade between agriculture and the urban economy (that  - 13 - roughly followed a pattern of increase during the early 1970s, relative constancy during the mid-1970s, and sharp decline after 1977) and accelerated inflation. 1/ 16. The changes in the internal terms of trade can be traced to two sets of forces operating at different times. During the early 1970s, the internal terms of trade followed the worldwide upward trend of agricultural commodity prices relative to manufactured products. Later on, particularly since 1977, they changed through the differential impact of domestic infla- tion on agricultural and urban prices. This differential impact was brought about particularly through the effects of massive currency devaluations, which increased relative unit cost in the urban sector (because of the rela- tively higher content of traded goods, particularly traded inputs). The devaluations resulted partly in reductions of urban output and partly in higher inflation. Urban profits (in terms of urban output) remained stable, while labor incomes had to bear the full burden of adjustment and the substan- tial increase in net indirect taxation. This process was probably corroborated through expectations and strategies by capital income earners to maintain their incomes in dollar terms, which were accomodated through substantial credit expansion. 17. The observed shifts in income distribution were exacerbated through fiscal measures during the past four years (revenues, expenditures, and price adjustments), whose incidence -- generally speaking -- tended to be regressive. 2/ The tax system placed the highest burden on middle and lower- middle income households for some time. The regressivity became even more marked during recent years, particularly because of the relative increase in the taxation of goods and services and the payroll taxes and the reduction in the taxation of personal income. While the average tax rate for all households declined slightly during 1975-77, it increased for the lowest three income groups. During 1977-79, the overall tax burden increased, most markedly, however, for middle income households (see table 10). 1/ For a broader discussion of possible explanations of the observed changes in income distribution, see Annex II "Inflation, Growth and Distribution, 1970-79". 2/ For a more detailed assessment of the incidence of changes in government revenues and expenditures, see Annex III "Incidence of Changes in Government Budgets, 1975-79".  - 14 - Table 10: AGGREGATE TAX RATES BY HOUSEHOLDS, 1975-79 (percentages) Household Income Groups 1/ Average I II III IV V (Low) (----- Middle ------) (High) 1975 9.73 13.30 14.38 12.95 13.31 13.30 1976 9.36 13.04 14.27 12.61 12.29 12.65 1977 10.32 13.70 14.74 12.57 11.33 12.18 1978 11.03 15.85 17.77 14.96 12.93 14.18 1979 12.34 17.84 20.06 16.49 14.57 15.86 1/ Definition of income groups according to table 2.12, Statistical Appendix. Source: Bank staff estimates (For details see Annex 3: Changes in tax incidence, 1975-79). 18. With regard to the incidence of expenditures, the picture is some- what less clear, since most of the expenditures are incurred for non-attributable general purposes like general services, defense, and interest payments (which together during 1975-78 accounted for two-thirds of government current expendi- tures). The sharp decline in the share of expenditures for social purposes after 1976, however, tended to be highly regressive, since lower income house- holds depend on these public services to a larger extent than higher income households. The elimination of financial subsidies to PETROPERU after 1976 may have had some progressive impact, since it mostly affected gasoline, which to a large extent is consumed by middle and higher income households, while diesel and kerosene were affected to a lesser degree. The maintenance of food subsidies and their sharp increase in 1980 may also have had some progressive impact, although the picture with regard to wheat is ambiguous to the extent that higher income households may consume relatively more wheat products and that wheat subsidies have a negative impact on producer prices for other grains. II. MAIN DEVELOPMENT ISSUES 19. During the past three years, the Government had to concentrate efforts on the solution of short-term problems to overcome the financial and economic crisis and keep the economy afloat. At the same time, it initiated a process to make better use of the country's resources by opening up the economy (through the liberalization of imports and promotion of non-traditional exports) and rationalizing public investment (through reallocation of funds to  - 15 - high-priority projects and postponement or elimination of low-priority projects). The development of human resources and -- to some extent -- that of the country's natural resources and physical infrastructure were, however, neglected: current government expenditures for social (education, health) and economic services (agriculture, transport) dropped in real terms to reach a point where services are grossly inadequate as reflected by virtual non-existence of agri- cultural extension, badly maintained roads, or inadequate operation of hospitals; public investment continued to be heavily concentrated in large-scale projects, generally with low rates of return and, therefore, inadequate contribution to economic growth and employment; population growth was left unchecked, urbani- zation unstructured; and the distortions of the incentives structure (prices, interest rates, tax exemptions, labor market regulations) remained so as to favor the use of (relatively scarce) capital and to discourage the use of (relatively abundant) labor. At the same time, while the acute balance of payments crisis was overcome, the public sector deficit increased again in 1980 after having been reduced in 1979, and inflation with its strong distor- tionary effects has continued at a high level. Moreover, its temporary repression through price controls and its negative impact on the internal terms of trade between agriculture and the urban economy and thus on income distribution created a highly volatile situation with the need for major adjustments. In many fields, the situation is critical, as reflected by social unrest during recent years, and requires urgent corrective action. This section of the memorandum concentrates on those issues that the World Bank perceives as the most critical ones. 1/ A. Macroeconomic and Financial Issues 1. Inflation 20. As in many other countries, high inflation in Peru basically is a phenomenon of the 1970s. Prior to 1973, annual price changes hovered around 6 to 7 percent, with the exception of the relatively inflationary 1963-68 period when annual price increases averaged 12.3 percent. Between 1973 and 1979, there was an almost continuous acceleration of inflation. First signs of decelerating inflation were to be observed during the first half of 1980, although this -- to some extent -- was the result of price controls (see table 11). With the exception of 1973-75, when accelerating international inflation certainly contributed to the acceleration of infla- tion in Peru, inflation during the 1970s was mostly homemade: as a result of rapid credit expansion, mainly to the public sector, averaging 32 percent per year during 1972-78, total liquidity (money + quasi-money) increased by 26 percent per year, fueling domestic demand, spilling over into the balance of payments, and eventually calling for the strong devaluations of 1976-78. Starting in mid-1978, overall credit expansion was contained. However, liquidity increased even faster, mostly because of the monetization of the high balance of payments surplus (see table 7). 1/ In this context, we should mention again that this report basically reflects the situation of mid-1980. The short-term problems addressed in the report prevailed for most of 1980. In the meantime, however, the Government implemented a package of important policy measures including price and interest rate adjustments that will contribute to the solution of some of the most pressing financial problems (see Summary, paras. xii-xx).  - 16 - Table 11: ANNUAL PRICE CHANGES, 1973-80 (PERCENTAGES) Import Price Index Lima Consumer Price Index Import Price Index in US$ as Measured Average Annual Quarterly in Soles 2/ in US$ 3/ by World Bank Index Changes Changes 1/ of International Inflation I 4.0 1973 II 9.5 8.6 14.1 15.8 20.3 III 12.0 IV 13.3 I 15.5 1974 II 16.9 17.0 35.9 43.1 24.6 III 17.2 IV 17.7 I 21.3 1975 II 23.6 21.2 36.0 24.3 15.3 III 26.0 IV 25.6 I 27.7 1976 II 33.5 24.6 34.2 -2.3 -1.1 III 36.8 IV 43.1 I 39.8 1977 II 38.0 45.6 52.5 7.8 8.7 III 36.1 IV 32.6 I 40.8 1978 II 57.8 53.4 105.1 6.5 15.3 III 61.3 IV 72.1 I 72.6 1979 II 67.7 68.1 59.7 11.8 13.2 III 61.9 IV 66.0 I 61.7 1980 II 59.2 56.8 44.7 12.8 12.5 III 58.0 IV 58.8 1/ With respect to corresponding quarter of the previous year. 2/ According to National Accounts. 3! Converted at average exchange rate, adjusted for changes in actual import taxes. Source: ONE, World Bank  - 17 - 21. Inflation has caused major distortions in the economy: marked changes in relative prices of different goods and services and erosion of real wages and salaries had a strong negative impact on income distribution (see paras. 14-16); diversion of human and capital resources towards infor- mation gathering and arbitrage to take advantage of lags that occur in the process of general price increases; financial repression through negative interest rates for deposits resulted in inadequate mobilization of financial savings; and negative interest rates for credit was not conducive to the best use of scarce resources. Available data do not provide clear evidence of the impact of negative real interest rates on financial savings captured by the domestic financial system. The share of the increase in quasi-money (= proxy for financial savings) in gross national savings was subject to strong fluctua- tions. During the past few years, however, the only dynamic element were dollar denominated deposits, while the share of domestic currency denominated instruments stagnated or even slightly declined (see table 12). Inflation as well as the interest rate and foreign exchange policies prevented the financial system from playing an increasingly important role of financial intermediation, as one would expect in the process of economic development. To bypass legal restrictions with regard to interest rates and reserve requirements, financial institutions may even have increasingly promoted direct transactions between savers and investors on a commission basis. Table 12: GROSS NATIONAL SAVINGS -L/AND QUASI-MONEY, -/1972-79 Billions of soles Percentages Gross nat. Quasi-money Quasi-money Quasi-money (2) (3) (4) savings fin. system fin. system bank. system (1) (1) (1) w/o foreign w/o for. curr. curr. depos. deposits (1) (2) (3) (4) 1972 41.9 7.3 7.3 4.5 17.4 17.4 10.7 1973 50.5 8.8 8.8 5.8 17.4 17.4 11.5 1974 58.0 8.8 8.5 4.8 15.2 14.7 8.3 1975 52.5 12.5 12.8 6.6 23.8 24.4 12.6 1976 81.1 11.9 11.7 5.4 14.7 14.4 6.7 1977 92.8 19.0 17.2 12.9 20.5 18.5 13.9 1978 248.3 67.0 29.9 18.9 27.0 12.0 7.6 1979 646.3 218.5 109.9 79.5 33.8 17.0 12.3 1980 866.1 n.a. n.a. 137.2 n.a. n.a. 15.8 1/ Including net private transfers from abroad 2/ Annual increase in stock Source: Central Bank; IMF 22. Although fiscal and monetary policies pursued under the stabiliza- tion-cum-economic-recovery program since mid-1978 were relatively restrictive as reflected by decreasing public sector deficits and reduced overall credit  - 18 - expansion, they failed to check inflation effectively, mostly because of high balance of payments surpluses since early 1979, which contributed to the substantial expansion of liquidity. Accelerated import liberalization through removal of the remaining non-tariff barriers, streamlining of administrative procedures, and tariff reductions is critical to reduce inflation and encourage higher efficiency of resource use. The liberalization measures taken by the Government in August/September 1980 and April 1981 should, in time, reap the expected results. Since domestic demand exceeds domestic supply, the gap could be filled either through price increases (which was the case until recently) or through increased supply from imports with a dampening effect on prices. Moreover, the structure of domestic supply, after years of resource misallocation, is not in line with the structure of demand so that increased imports would also have to fill this "structural gap". The dampening effect on domestic inflation from increased imports may, however, be neutralized by oligopolistic pricing policies in a highly concentrated commercial and indus- trial sector. Therefore, specific action to foster competition should be taken, e.g. in the form of "importaciones de choque", through public and private organizations of articles whose prices increase substantially faster than average and through the systematic spread of price information for important consumer articles. 23. In addition, the Central Bank should continue to pursue its re- strictive monetary policies, in particular the retention of export earnings and the open market operations to absorb liquidity. These measures should, however, be complemented by adjustments of the interest rate and exchange rate policies (see paras. 27 and 28). 24. The present inflation also shows strong "cost push" signs in the form of increased wages and mark-ups, fueled by still higher inflationary expectations. A restrictive incomes policy, in line with the expected growth of resource availabilities and backed by a "social pact" between the Govern- ment, entrepreneurs, and unions, could be an additional effective instrument to fight inflation and, at the same time, to promote employment. While this task is politically extremely difficult, it has high potential in a conflict-prone situation like the Peruvian. The recent establishment of the "Comision Tripartita" under the leadership of the Ministry of Labor is a good start. The approach of a concerted incomes policy had success for some time in the United Kingdom and Germany, also under politically and socially difficult circumstances. Such a policy would in the short term have to address particularly the entrepreneurs whose share in national income has substantially increased over the past few years--mostly because of price movements leading to increased profit margins, while output shrank or stagnated. The need for some "re-alignment", however, does not mean that the status quo ante (say the 1975 situation) should be re-established. The international competitiveness of Peruvian wages and salaries (including the relatively high social benefits) obviously is a major concern. The present level of total hourly labor costs (including all fringe benefits) for an unskilled worker earning the Lima minimum wage, which is roughly US$1, is about in line with the economy-wide average labor productivity and with wage levels in the Caribbean region (with the exception of Haiti, where it is only about US$0.3) and somewhat lower than in Mexico. In other countries, the minimum wage is lower than the economy wide average labor productivity, usually around 60 to 70 percent. The higher ratio for Peru of almost 100 percent could already  - 19 - indicate that the present minimum wage level 1/ might strain the country's potential. In any event, the question of the adequacy of the wage level, irrespective of the actual or assumed cost of living, deserves careful study. In the medium term, wage increases should be about in line with increases in labor productivity to avoid inflationary pressure from increasing unit labor costs. This medium-term orientation, which could be the guiding principle of the proposed negotiated incomes policy, irrespective of the short-term need for some re-alignment in income shares, would contribute to dampen labor cost and provide more equitable growth through higher employment generation. 2. Pricing, Interest Rate, Exchange Rate, and Trade Policies 25. Prices, interest rates, and the effective exchange rate (includ- ing tariffs and export subsidies) are key signals for the allocation of resources. They have been subject to government control and regulation in Peru for many years resulting in serious distortions with negative impact on the efficiency of resource use. At the end of July 1980, prices for about 40 different categories of goods and services were subject to direct government control through state-owned enterprises and prices for about another 80 goods and services, to a large extent supplied by private enterprises, were subject to government regulation. Although price controls seemingly contain price increases, they favor oligopolistic practices through concerted action to request periodic price increases. This applies particularly in markets with high effective protection, which is the case for most industrial products-- even after the recent tariff cuts. Similarly, interest rates are regulated. Until recently, negative real deposit rates around -20 percent (see table 7) have resulted in inadequate mobilization of financial savings; negative real credit rates, also around -20 percent (see table 7) although somewhat attenuated through additional charges, have resulted in inefficient resource use. Moreover, the regulation, by preventing financial markets from reaching equilibrium, may have resulted in an excessive spread and, thus, excessive profits of the banking system. Finally, the exchange rate is managed by the Central Bank, and the "pace of the crawl" was at times determined by the targeted rather than by the actual domestic inflation rate as compared to international inflation. Begin- ning in the second quarter of 1979, this resulted in a gradual appreciation of the sol in real terms. During the third quarter of 1980, the sol may have been overvalued by about 15 percent with regard to the assumed purchasing power parity based on an estimate for 1978 by Williamson (see table 13). 2/ If one assumes that the free exchange rate of 1959 roughly reflected purchasing power parity, the actual nominal exchange rate of the sol in 1980 would have been overvalued by about 25 percent with respect to the US dollar. 1/ Although the minimum wage in many other parts of the country is lower than in Lima, the Lima minimum wage may be most representative with regard to the international competitiveness of the industrial sector. 2/ During 1978 and 1979, the change in the nominal exchange rate was very close to that of the effective exchange rate, which takes changes in export and import taxes as well as export subsidies into account. The standard conversion factor changed from 0.9716 in 1978 to 0.9894 in 1979 or by 1.8 percent. The change from 1979 to 1980 must be similar or possibly somewhat lower so that the overvaluation argument based on nominal exchange rates basically holds.  - 20 - Table 13: ACTUAL EXCHANGE RATE AND PURCHASING POWER PARITY OF THE SOL, 1978-80 Actual ex- Domestic U.S. in- Inflation Purchasing Deviation change rate Inflation flation 2/ differential power parity 3/ (5)-(1)(%) SI. per $ (%) 1/ (%) (%) SI. per $ (1) (1) (2) (3) (4) (5) (6) I 130.30 - - - 132.7 1.8 1978 II 141.86 16.9 3.0 13.5 150.6 6.2 III 166.75 16.7 1.6 14.9 173.0 3.7 IV 187.43 11.4 2.2 9.0 188.6 0.6 I 203.37 13.7 3.6 9.7 206.9 1.7 1979 II 218.60 13.9 3.5 10.0 227.7 4.1 III 232.22 12.3 3.2 8.8 247.8 6.7 IV 244.01 14.2 3.5 10.3 273.4 12.1 I 257.29 10.7 4.5 5.9 289.7 12.6 1980 II 276.73 11.2 2.0 9.0 315.8 14.1 III 297.39 13.1 3.1 9.7 346.4 16.5 1/ Quarterly changes of the LIMA CPI 2/ Quarterly changes of the U.S. WPI 3/ 1978 I estimate of the purchasing power parity based on Denise Williamson: Exchange rate policies in Peru, 1971-1979, paper prepared for the con- ference on "The Crawling Peg: Past Performance and Future Prospects", Rio de Janeiro, October 1979; 1977 II - 1980 II projected on the basis of differential between domestic and U.S. inflation. Source: IMF; Bank staff estimates 26. Considering the distortions resulting from widespread government interventions, which in many state-owned enterprises reached a degree that left management virtually without any meaningful authority and financial responsibility, the Government should pursue a vigorous policy of decontrol, decentralization, and devolution of economic decision making to the company level. Price controls and regulations should be progressively dismantled and price formation left to the market subject to appropriate anti-monopoly and anti-dumping safeguards. This will, however, result in an additional infla- tionary push of short-term adjustments. To moderate the impact, adjustments could be negotiated within the framework of the proposed incomes policy (see para. 24). In case of oligopolistic market structures, additional imports should have a positive impact and, in addition, the state could intensify competition through state enterprises without imposing direct controls. Public enterprises would, however, have to follow pricing policies that allow them to be financially viable. This principle should be gradually extended to  - 21 - all public enterprises including public utilities. Assuming normal capacity utilization and efficient operation, prices should be set at a level to generate an internal cash flow sufficient to meet a reasonable portion of the financial requirements of expansion in line with demand growth. Low-income classes could be helped through cross-subsidization or direct consumer sub- sidies rather than through control of producer prices. Substantial progress towards price decontrol has been made recently by lifting price supervision and by adjusting prices that are still subject to state intervention. 27. Although decelerating inflation would in time result in positive real interest rates, there is a need for regular adjustments in line with the prevailing interest rate structure abroad. The Central Bank's recent revision of the interest rate structure takes this into account. Higher deposit rates are likely to result in a higher capture of savings in the financial system and, possibly, in a reduced spread between deposit and effective credit rates, particularly if the adjustment were supplemented by freeing the access to the market (including foreign banks) and, thus, increasing competition. However, given the pegged (although crawling) exchange rate higher deposit rates may trigger additional capital inflows, which would be inflationary. To protect the external flank the speed of devaluation would have to be accelerated to fully compensate the differential between domestic and international inflation and to make up lost ground (see table 12). In addition, if necessary, an interest equalization tax could be introduced for non-resident capital owners. 28. As long as domestic inflation is substantially higher than inter- national inflation, regular adjustments of the exchange rate are crucial to maintain international competitiveness. The appreciation of the exchange rate in real terms observed during 1979-80 is an inadequate instrument to fight inflation. The slow-down of the exchange rate depreciation should be rather the result of successful anti-inflationary policies. The exchange rate policy should be defined with a view to the medium-term requirements of domes- tic development, mainly economic growth and employment generation. An over- valued exchange rate translates directly into relatively high international prices for domestic products and labor with damaging effects on the domestic economy through declining exports and increased competitiveness of imports. 29. The exchange rate has to be seen in the context of foreign trade policies, together with import tariffs and the whole system of export sub- sidies. The present system of highly differentiated tariffs and export subsidies is equivalent to a system of multiple exchange rates. Any changes of the different policy instruments have to be closely coordinated and harmonized to eliminate distortions in the overall structure of incentives. The present tariff structure, even after the recent changes, provides rela- tively high effective protection for the manufacturing sector. At the same time, CERTEX and subsidized export financing provide strong export incentives. The present CERTEX system, however, based on gross value of production rather than value added, discriminates against products with high manufactured  - 22 - content. 1/ Although the CERTEX, combined with more realistic exchange rates, certainly helped to boost non-traditional exports during the last few years, it has also to be recognized that the strong export drive was partly a response to the depressed domestic market. If the real exchange rate continued to appreciate and the other instruments were not changed, a re-orientation towards the highly protected domestic market would have to be expected, particularly for products with high manufactured content, which from a growth and employment point of view are the most desirable ones. 30. To re-orient the industrial sector and to make better use of the country's resource endowment, the level and structure of tariffs and export subsidies would have to be revised. Lower tariffs and lower export sub- sidies, combined with the pursuit of a rational exchange rate policy, would provide the same results in terms of export promotion with less distortionary effect on domestic prices and, probably, at a lower fiscal cost. The CERTEX should be based on value added (or some operational proxy that is easier to calculate and monitor) to eliminate discrimination against products with high manufactured content. Also tariffs should be less differentiated to provide a more uniform level of protection, which, in time, would bring about the desirable shift in the structure of manufacturing production towards more labor-intensive products and higher degrees of processing. The recently adopted changes of the tariff system are important steps in the right direction. While trade liberalization as now pursued by the Government has its great merits and will contribute to the containment of inflation and -- in the medium run -- to more efficient resource use, there are obvious risks involved in terms of reduced economic growth and employment, particularly if tariffs are cut too fast. To cushion the impact of increased foreign competition, a gradual approach could be advocated according to a negotiated and pre- announced schedule of further tariff reductions, which allows entrepreneurs time to adjust. Exceptions for infant industries should, however, be granted only on a very selective basis for a small number of industries and within clearly defined time limits. 31. The new Government's trade, exchange, and interest rate policies are in line with the thoughts expressed in this report. Non-tariff barriers against imports were removed and tariffs reduced by an average of 8 percentage points (with the maximum rate set at 60 instead of 150 percent). Further tariff reductions are being considered with the ultimate goal of a rate of some 25 percent with very little dispersion. The devaluation of the sol was also accelerated in line with higher domestic inflation during the second half of 1980 and the first three months of 1981. Moreover, the CERTEX system 1/ The manufactured content is defined as total domestic value added by manufacturing, either directly in the exporting sector or indirectly through inputs from other manufacturing subsectors. Since CERTEX is based on gross value of production, products with low value added, mainly resource-based products, receive a relatively higher subsidy per unit of value added than products with high manufactured content. In the case of products that have a high content of domestic manufactured inputs, the CERTEX may not even compensate for the relatively high price of these inputs.  - 23 - underwent a thorough revision: rates were lowered, and the list of eligible products was reduced and specifically defined according to the customs code rather than broad categories, which were subject to widely varying interpre- tations. Finally, the Central Bank -- armed with new authority -- undertook a thorough revision of the interest rate structure and made substantial upward adjustments of both deposit and lending rates. More action is, however, still desirable. It would be particularly important to make additional efforts towards the gradual removal of administrative controls of prices and interest rates. This obviously presupposes a strengthening of competitive forces, particularly by facilitating market access. 3. Public Finance 32. Although public sector finances improved substantially during 1979 and the first half of 1980 as reflected by a reduction in the overall deficit (see para. 7), serious structural problems remain to be solved. The financial deterioration that took place during the second half of 1980 exacerbated the situation. Improvements were previously achieved through cuts in real expenditures, mainly for social and economic services (education, health, agriculture, transport) and salaries, and through a substantial increase in revenues. On balance, both groups of measures tended to be regressive, and expenditures in some fields as well as salaries reached levels that are grossly inadequate. For example, per-capita expenditures for education and health were about $33 and $10 respectively in 1978 as compared to $75 and $26 in Panama or $69 and $12 in Costa Rica--two countries with relatively advanced social services; 1/ outlays for highway maintenance were $500 per km in 1979 as compared to $1,100 that would be considered adequate. There is an urgent need to step up expenditures in these fields and for institutional strengthening, particularly through more adequate salaries to attract and retain capable staff. The recent salary increases for government employees and the announced policy of quarterly salary adjustments in line with the increasing cost of living may be adequate for a period of overall adjustment. However, a more selective salary policy with substantial increases at the managerial level (in line with improved productivity through additional work efforts and training) would be required with a longer term view to strengthen the public administration. 33. To keep the public sector deficit manageable increased expenditures in high priority fields should be matched by (i) cuts of expenditures of lower priority; (ii) a trade-off between recurrent and capital expenditures; (iii) increased revenues from taxes and/or earnings of public enterprises or (iv) a combination of all these offsetting measures. The tax burden of about 19 percent of GDP in 1980 is relatively high for a country of Peru's level of development. Thus, the scope for additional resource mobilization through increased taxes is fairly limited, and the other possible avenues have to be oxplored with priority. 34. With regard to cuts in low priority expenditures, subsidies and defense spending are the obvious candidates. Subsidies had been sharply reduced during 1979, but the reduction of wheat prices in early 1980 as 1/ See BID - Progreso Economico y Social en America Latina, Informe 1979.  - 24 - well as the postponement of upward price adjustments for other foodstuffs such as rice and sugar and for petroleum products resulted in the resurgence of massive subsidies amounting to S/.80 billion for foodstuffs and to S/.240 billion for petrolem products. It is only the sugar subsidy that comes directly out of the Treasury, while the other subsidies are revenues foregone by public enterprises, ENCI, ECASA and PETROPERU. The immediate financial burden is again somewhat lower than the economic subsidy because of medium-term financing of most of the food imports. The subsidization of gasoline tends to be regressive, that of diesel may be neutral, while that of kerosene and foodstuffs may be slightly progressive. While it is desirable to eliminate all subsidies to improve the fiscal situation and the efficiency of resource use, a gradual approach may be required to smoothen the social impact. Subsidies could be progressively eliminated over a period of say 12 to 18 months. 1/ At the same time, some compensatory measures could be taken to counter the negative impact on the lowest income strata. In the case of petroleum products, the cross-subsidization of kerosene for household use could be continued, compensated by correspondingly higher increases in the price for gasoline, diesel, and kerosene for industrial use (see para. 74). Obviously, this presupposes effective means of preventing the use of lower priced household kerosene for industrial purposes. In the case of foodstuffs, the relatively inefficient approach of general subsidies should be replaced by specifically targeted measures (see paras. 67-69). This approach could also be explored for the subsidization of kerosene as a possibly more efficient alternative to general cross-subsidization, particularly since the proposed food aid measures would already provide for a delivery system. 35. The freezing of defense expenditures in real terms or only minimum increases of say 3 percent per year, although politically extremely sensitive, would in time release an important amount of resources, which could be allocated to high priority areas of social and economic development. Decelerating real growth of defense outlays to 3 percent as compared to some 10 to 11 per- cent during 1969-80 would release about S/.400 billion at constant 1980 prices over the next five years. Similarly, the reduction and gradual shift of the public debt towards more favorable sources would gradually lower the interest burden and also release resources for other purposes. 36. Employment and salaries are other important aspects of the structure of government expenditures. The number of government employees increased rapidly (by 4.1 percent per year) during 1970-78; during 1971/72 - 75-76 the annual increase was even 6 percent per year. As government control of the economy expanded, new agencies were created and some of the existing institu- tions (like planning, labor, energy and mines, and multisectoral programs) grew very fast (see tables 5.9 and 5.10, Statistical Appendix). Even after the 1978/79 mergers of some government agencies and the reduction of staff, the number of government employees (excluding education, justice, and defense) still seems to be high at about 9,800 employees per 1 million of population as compared to about 7,700 in Ecuador, which could hardly be considered as a 1/ For fiscal reasons, the Government chose a more radical approach with regard to food subsidies. This makes the need for specifically tar- geted compensatory measures even more urgent. Compensatory measures, mainly in the form of food-stamps, were expected to become effective in March 1981.  - 25 - model in this respect. The salary scale, which has remained basically un- changed throughout the 1970s, is outdated. To fight the gradual erosion of real salaries, staff have been promoted to higher grades. By now, some administrations seem to be top-heavy without having the qualified staff that the grade structure might suggest (see tables 5.8-5.10, Statistical Appendix). Future salary increases would have to be structured carefully and parallelled by restructuring the salary scale and employment. The practice of across-the-board salary increases by an absolute amount should be given up and be replaced by a more differentiated approach that would be conducive to attract and retain qualified people in key managerial positions. The gradual reduction and restructuring of government personnel could be achieved through: (i) freezing the total number of employees, allowing only rare exceptions of hiring, preferably through special contracts that could be terminated after completion of the particular task; (ii) gradual reduction through attrition at a rate of some 3 percent per year (as suggested by the present age structure of government employees); and (iii) re-assignment of existing employees to the newly created departmental administrations. 37. The presumption that capital expenditures are conducive to accele- rated growth and development while recurrent expenditures are not, needs revision, particularly in the light of recent experience in Peru, where many large-scale projects have been poorly planned and designed and resulted in low or negative returns. Cuts in the outlays for a project like Majes would certainly not lower the pace of growth, while increased expenditures for education, health, agricultural research and extension as well as road maintenance would most likely make a significant contribution to development. In any event, efforts to improve the quality of public investment, started under the Economic Recovery Program, should be strengthened. Investment priorities should be established and projects submitted to rigorous economic evaluation before the Government embarks on the commitment of large amounts of funds over several years. Project evaluation essentially is a planning task, for which the Instituto Nacional de Planificacion after the integration of Cooperacion Popular may not be well equipped. It would be highly desirable to have a small staff of highly qualified planners with sufficient authority perform this task to ensure that only projects are undertaken which are technically sound and economically justified. The staff should have sufficient funds available to contract consultants for most of the project appraisals. The preparation of a Consultative Group meeting might provide an opportunity for putting these principles into practice. 38. Tax measures taken during the last few years were basically designed with a view to their revenue generation potential and relative ease of administration. Allocative and distributive considerations were of minor concern. Although tax revenue increases during the last two years were high, the tax system is still not very elastic, 1/ has a narrow basis in terms of contributors, relies heavily on the taxation of foreign trade with distor- tionary effects on resource allocation, and has an overall tendency to be 1/ Tax projections over the next five years, based on the presently existing system, point to an elasticity of 1 with regard to GDP growth.  - 26 - regressive, i.e. to place a relatively heavier burden on low income strata than on high income strata. The recently announced reform measures would be steps in the right direction. With only about 115,000 persons or 2 percent of the economically active population actually paying personal income tax, of which almost 80 percent are concentrated in Lima 1/, the present tax system certainly does not make adequate use of a source that is among the most important in more developed countries, but also of higher importance in other Latin American countries. In 1979, personal income tax and payroll tax revenues together were only slightly over 1 percent of personal income; total income tax revenues were less than 5 percent of national income. There is large scope to broaden the income tax base and to make better use of this source of taxation, particularly through reduction and simplification of exemptions. This also largely applies to the corporate income tax, which is mainly paid by mining and petroleum firms while most other enterprises manage to reduce their tax liabilities to very low levels by taking advan- tage of generous (and highly differentiated and thus complicated) tax exemptions. 39. With respect to overall tax revenues, more effective use could also be made of the existing taxes on goods and services. The wide varia- tions in the effective tax burden by sectors, besides reflecting the varia- tion of tax rates and the large number of legal exemptions, suggests that there is considerable evasion through overdeclaration of inputs and under- declaration of sales. Moreover, deductions for inputs are made irrespective of whether tax was actually paid by the supplier of these inputs. 40. To correct the distortions in the present incentives structure, it would be desirable to eliminate gradually all payroll taxes that dis- courage employment as well as export taxes that constitute a considerable burden on the mining sector irrespective of its actual profitability. All these measures, however, together with the reduction in import tariffs that already took effect, will result in a substantial reduction in tax revenues. They should be compensated by other tax measures like the increase in income taxes and taxes on goods and services. With a view to future financial requirements, all tax measures should be designed in a way to be, at least, neutral in terms of overall revenues while changing the relative tax burden on different income groups and factors of production to make the system more equitable and responsive to the country's development needs. 41. In addition to the proposed measures, further (if marginal) improve- ments could be achieved through a restructured betterment tax and fees for certain government services that so far have been delivered free of charge. Restructuring of the betterment tax to reflect the increased land value derived from public works like road improvements or water supply requires the establishment of a reliable cadastre and the adoption of sound principles of land evaluation -- a cost that may well be justified in view of the fiscal benefits and greater equity. While revenues from a restructured betterment tax would be marginal, they would help to contain transfer payments from the Central Government to the local and regional level. At the same time, higher 1/ See C. Amat y Leon et al: El Impuesto a la Renta de Personas Naturales en el Peru (1980), manuscript.  - 27 - betterment tax revenues would make the tax system more equitable by having the beneficiaries of certain projects directly contribute to their financing. Similarly, the proposed cost-sharing scheme for the agricultural extension service (see para. 108) would be a step in the same direction. B. Sectoral Issues 1. Social Aspects 1.1 Population and Employment Population 42. Total population is estimated at 17.3 million people in 1979, with about two-thirds living in urban areas. 1/ In line with increas- ing birth and decreasing death rates, population growth accelerated during the last 100 years to peak at around 3 percent per year in the early seven- ties. Since the mid-seventies as a result of general social and economic development, crude birth rates have been declining faster 2/ than crude death rates 3/, and the rate of population increase dropped to about 2.7 percent a year by 1978. It is expected to drop further and average about 2.5 percent a year throughout the remainder of the century. By the year 2,000, total population is expected to reach about 29 million. 43. Based on a projection of present trends, the net reproduction rate 4/ is expected to decline from 2.2 in 1978 to 1.0 only by the year 2025. If present trends continue, stationary population would not be reached before the year 2090; it would then amount to 57 million people. The population dynamics reflected by these figures and the resulting structure with a high child dependency ratio 5/ of over 80 constitute a heavy burden on social and economic development that will make the provision of food, basic services such as education, health, and housing, as well as employment creation difficult. 1/ Population centers with more than 2,000 inhabitants and all provincial capitals irrespective of size. 2/ The crude birth rate (= number of live births per year per 1,000 persons of mid-year population) declined from 43 in 1970 to 39 in 1978. 3/ The crude death rate (= number of deaths per year per 1,000 persons of mid-year population) declined from 15 in 1970 to 12 in 1978. '/! Net reproduction rate = number of daughters that a newborn girl will bear during her lifetime, assuming fixed age-specific fertility and mortality rates. 5/ Child dependency ratio = ratio of child population (0-14) to the remainder of the population times 100.  - 28 - 44. Population growth has been accompanied by rapid urbanization. During 1961-72, urban population grew at some 5.6 percent per year, while growth of rural population dropped to 0.7 percent. 1/ With urban dwellers now accounting for about 66 percent of total population, urban population growth slowed to about 4.5 percent in 1978. The urban system is marked by an overwhelming primacy of the Lima-Callao metropolitan area resulting from strong administrative centralization, cultural domination, and a concen- tration of economic activities. While during recent years urban population growth has been fastest in medium-size towns, Lima-Callao still accounts for some 40 percent of urban population and 25 percent of total population; problems there with respect to housing, water, public transportation, health and other public services are overwhelming. 45. Although with the relative decline of the reservoir of potential rural migrants urban population growth is expected to slow down further to some 3.5 percent during the remainder of the century, population growth and the process of urbanization are still areas of concern. Given the existing resource limitations, efforts need to be made to reduce population growth beyond what could be expected as the "automatic" decline through continued urbanization. A population program could be launched within the framework of the Government's new health strategy, which concentrates on the expansion of the primary health care delivery system, particularly in rural and mar- ginal urban areas. Lower population growth would reduce pressure on the socio-economic system: in the short run, on nutrition and health delivery; in the medium run, on education and physical infrastructure; and in the long run, on employment. Efforts should also be undertaken to slow down rural-urban migration through the provision of more productive employment and improved public services in rural areas and to direct the still continuing migration more towards the less congested medium-size towns. Table 14 points to the orders of magnitude and potential maneuvering space involved. Without action, total population is expected to increase to 29 million people by the year 2000. Depending on policies and people's response, urban population could increase to anywhere between 18.8 and 23.2 million -- a maneuvering space of up to 4.4 million overall and possibly of up to 1.7 million for Metropolitan Lima that is worth exploring. Actions aiming at lower and better balanced urban growth by strengthening the periphery potentially have high social rates of return. 1/ Similarly, population growth in the Sierra, strongly affected by heavy outmigration, is very low (around 1 percent p.a.).  - 29 - Table 14: PROJECTED POPULATION GROWTH, 1980-2000 (million people) 2000 a 1980 I II III Total population 17.7 29.0 b/ 29.0 b/ 29.0 b/ Urban population 11.9 23.2 21.8 18.8 Rural population 5.8 5.8 7.2 10.2 a/ I = Continuation of present trends, assuming "saturation level" for urban population of 80% by 2000; II = Realistic variant with pronounced regional development policy, assuming "saturation level" for urban population of 75% by 2000; III = Theoretical variant without future rural-urban migration. b/ For simplification, the overall population growth was kept constant irrespective of the different assumptions on rural-urban migration. Source: Bank staff estimates. Employment 46. With some 11 percent of the urban labor force openly unemployed and some 44 percent underemployed (see table 4), the employment situation in 1979 was grave. 1/ This was partly a result of the recent economic crisis. However, even with recovery to normal levels of economic growth, the employment problem will remain acute because of the rapid growth of the labor force, particularly in urban areas. In spite of gradually declining participation rates in line with improved education and continuing urbanization, the labor force is expected to grow at over 3 percent a year throughout the remainder of the century. To absorb the projected increase in the labor force, even without reducing current un- and underemployment, about 195,000 new jobs per year are needed on average during the next five years compared to an annual rate of about 120,000 during 1975-79 and 115,000 during 1970-75--a formidable challenge to the Peruvian economy. If all new urban job seekers, roughly 150,000 persons a year, had to be absorbed in the modern industrial sector at the presently prevailing capital-labor ratio (see para. 47), the necessary annual investment would be on the order of S/. 1,100 billion at 1980 prices, equivalent to almost 20 percent of GDP -- an amount that is clearly out of reach. These deliberations put the Government's general employment goal of creating 1 million jobs during the next two years into context. If one aims at the creation of permanent jobs, the goal clearly would have to be redefined in less ambitious and more realistic terms to become achievable within the country's present resource contraints. 1/ The figures are based on the surveys that the Ministry of Labor has been conducting for 10 years and that, judging from the methodology and orientation of the questionnaires, are of reasonable quality.  - 30 - 47. Inadequate employment generation and rising un- and underemployment can be traced to sluggish economic growth and the capital intensive growth pattern induced by distorted factor cost relationships and the institutional setting of the labor market. Negative real interest rates, a grossly overvalued exchange rate up to 1978, tariff exemptions for imported capital goods, income tax exemptions for re-investment, high protection for product lines with usually high capital intensity, unionization and generous social legislation, as well as public investment almost exclusively channeled towards large-scale projects contributed to shaping a highly capital intensive growth pattern with an economy-wide average of US$22,000 of investment (at constant 1980 prices) per newly created job during 1970-79 and an average of US$36,500 for the formal manufacturing sector and probably as little as US$1,650 for the informal manufacturing sector during 1972-76. Recent changes such as an increase in the payroll tax, financing of the newly created housing fund (FONAVI) through an additional payroll tax as well as regulations such as the "estabilidad laboral" tend to discourage employment in the modern sector even more. They encourage the substitution of capital for labor, overtime of the alreadv employed, and subcontracting with the informal sector that is not subject to these taxes and labor market regulations; they discourage better use of existing production capacities through multiple shift operations. 48. The employment effect of public investment, during both construc- tion and operation, is also low. Investment is heavily concentrated in large-scale projects that tend to use capital-intensive construction tech- niques and to require high investment per unit of output. Gross output per worker in the construction sector in general is three times higher than in small-scale labor-intensive public works projects of the type that the Government recently financed in the Sierra region; i.e. three times more jobs are created per unit of expenditure in these small-scale projects than in construction in general. The ratio is probably much higher with regard to large-scale public investment projects, since the average figure for the construction sector as a whole is heavily influenced by relatively labor-intensive house construction. Similarly, the permanent employment effect per unit of investment is much higher in small-scale irrigation rehabil- itation projects and colonization projects in the Selva region than in larger- scale irrigation projects. Based on the cost per ha, which is a proxy for the investment per job created or upgraded 1/, a relation of 24 to 6 to 1 was calculated for these different types of agricultural projects. These rough calculations show that by concentrating on large-scale projects employment creation through public investment is kept much below its potential -- not to mention the low economic return of some of these large-scale projects. Although the direct employment effect of public investment projects is not the most important criterion, it is important enough to be taken explicitly into account. 1/ The relation would probably change slightly in favor of the large-scale projects if proper account were made of the relative number of newly created vs. upgraded jobs. In general, it is to be expected that the portion of newly created jobs in large-scale projects (opening up additional areas) and in colonization projects is higher than in small-scale rehabilitation projects.  - 31 - 49. Sustainable employment creation would have to come primarily from accelerated economic growth. The employment generation effect, however, could be enhanced through a significant reduction in the relative price of labor vis-a-vis capital. The cost of labor could be reduced by abolishing the different payroll taxes. To compensate the negative fiscal impact and to provide for the desirable increase in the cost of capital, the tax on corporate property (patrimonio empresarial) could be increased, particularly through a more realistic evaluation of assets and systematic adjustments in line with inflation. In addition, the recent upward adjustments of the interest rate structure and the accelerated devaluation of the exchange rate in line with the differential between domestic and international prices also increase the relative cost of capital and encourage its more efficient use. Moreover, tax incentives should be geared to the use of labor, not capital. Tax exemptions should be granted on the basis of the number of jobs created, not the volume of investment. In this sense, the proposed introduction of accelerated depreciation could be counterproductive; it would further stimulate investment in fixed capital while the existing structure of incentives already contributed to the build-up of substantial excess capacity in relatively capital-intensive production lines. The calculation of tax exemptions could be based on a "normal amount" of investment per job (say US$10,000) and the number of jobs actually created. Assuming that e.g. 50 percent of investment (new or re- investment) were income tax deductible and the number of new jobs created were 100, a maximum of US$500,000 could be claimed, irrespective of the actual investment cost. An alternative to this approach would be the introduction of a negative payroll tax that would subsidize the cost of labor in line with actual employment. 50. Another major obstacle to more employment generation is the "estabilidad laboral"--a rigid system of job security regulations, now part of the Constitution--which makes labor virtually a fixed cost and prevents the flexibility of adjustment to changes in demand. One way towards more flexibil- ity would be to allow fixed-term appointments, particularly in export-oriented industries. To make the measure more palatable, branch-specific maximum limits of fixed-term appointments (e.g. 50 percent of the work force) could be negotiated. The "estabilidad laboral" also has a negative impact on labor productivity and, thus, on the cost per unit of output. The allowance of maximum annual dismissal rates of 1-2 percent may be an effective means to increase productivity. 51. Since the choice of technology for a given line of production is limited, a change in relative factor costs would lead investment towards more labor-intensive product lines like garments, footwear, sporting arti- cles, and toys. The continued promotion of manufactured exports and the establishment of free zones for export-oriented assembly industries would greatly enhance this shift in the production structure. 52. The employment generation potential of the industrial sector, however, is probably not sufficient to absorb rapid labor force growth and to reduce high un- and underemployment. Thus, a large share of the labor force will still depend on employment provided by the urban informal sector, mostly in the form of self-employment. To enhance the self-employment poten- tial, low-cost work-oriented adult education could play an important role.  - 32 - 53. Government expenditures could also have an important impact on job creation, with a shift in public investment towards smaller-scale, more labor-intensive projects. This is not to advocate massive public works programs, which, given the discrepancy between the structure of demand of low income households derived from these programs and the structure of supply inherent in presently installed capacities and rigidities within the agricultural sector, could be highly inflationary in spite of excess capacity in the industrial sector. But a gradual shift towards smaller projects with a more immediate impact on production and more labor-intensive construction techniques would multiply the employment effect of investment. This shift could be complemented by the revision of design standards and procurement regulations to encourage more labor-intensive construction techniques. The recent establishment of a special employment fund could be a suitable means for the financing of labor-intensive investment projects. 1.2 Poverty, Nutrition, and Related Health Aspects Poverty 54. Based on data from the national household survey (ENCA), it was estimated that in 1971/72 up to 31 percent of total population lived under conditions of absolute poverty, i.e. earning incomes that did not permit to consume what is considered an adequate volume of food and non-food items. Regionally, the incidence of poverty varied widely between a low 14 percent of the population in Lima and a high 52 percent in the Southern Sierra region. In general terms, poverty was mostly concentrated in the Sierra with almost 42 percent of the population living in these conditions as compared to about 27 percent in the Costa and 34 percent in the Selva region. 1/ The devel- opment of real household incomes and their distribution by income groups and regions suggest that the present situation is worse: with the overall drop in real household incomes, particularly of the middle and lower income households, many people may have slipped below the poverty line; the deter- ioration was relatively more pronounced in urban areas and in the Costa region than in rural areas and the Sierra region (see tables 2.12-2.14, Statistical Appendix). These developments inevitably had a negative impact on the nutrition and health situation of the population. Nutrition 55. Little information exists on the present nutritional situation in Peru. The only nationwide assessment is based on the 1971/72 household survey. Applying the weight-for-age criterion, Amat et al. 2/ estimated that 44 percent of pre-school age children were malnourished, i.e. had weights below the corresponding standard for their age. Even taking into considera- tion that the weight-for-age standards used by Amat were not based on the 1/ See V. Thomas: The measurement of spatial differences in poverty: the case of Peru, World Bank Staff Working Paper No. 273, January 1978. 2/ See C. Amat y Leon et al.: Analisis de la Situacion Alimentaria en el Peru, Ministerio de Economia y Finanzas, Lima, 1977; also table 1.7, Statistical Appendix.  - 33 - Peruvian population and that, in general, the weight-for-age criterion as compared to the more adequate weight-for-height criterion may mis-classify up to one half of those in the category of first degree malnutrition, the data suggests that the nutritional situation in 1971/72 was bad with at least 30 to 40 percent of pre-school age children suffering from varying degrees of malnourishment (see table 1.7, Statistical Appendix). 56. On the other hand, Reutlinger and Alderman 1/ estimated that during the 1960s, aggregate per-capita calorie availability in Peru averaged approxi- mately 96 percent of requirements based on the FAO standard of 2,350 cal. per capita per day. For the early 1970s, their estimate is 98 percent of that requirement, which is about in line with recent availability data of the Ministry of Agriculture. For 1973, however, Reutlinger and Alderman estimate that more than half of the population had diets whose calorie content was below the FAO standard and that approximately 40 percent had diets below 90 percent of the FAO standard. 57. Since real household incomes decreased and the size distribution of income became more unequal during recent years, it is likely that food consumption by low and middle income persons further declined. It is important to assess the probable changes in calorie consumption which may have resulted from income and price changes in the last decade. 58. Estimates based on per-capita calorie consumption according to Amat et al., on calorie income elasticities according to Reutlinger et al., 2/ and on the development of real household income suggest that the average calorie intake of low and middle income people may have dropped by 4 to 6 percent (depending on the region) between 1971/72 and 1979 (see table 15). Changes in relative prices, which resulted in, at least, a five percent increase in the real average cost per calorie for a low income household in Lima, exacerbated the situation. Combined income and price effects could have led to as much as a ten percent reduction in per capita calorie intake for low income urban households over the past decade. The combined impact of price changes, food import policies, land reform, and agricultural policies in general on the food consumption of the rural poor is not clear. Since by any criterion conditions at the beginning of the reference period were sub-standard for the rural poor it is likely that nutritional conditions have worsened for poor persons throughout Peru. 1/ S. Reutlinger, H. Alderman: The Prevalence of Calorie Deficient Diets in Developing Countries, World Bank Staff Working Paper No. 374, March 1980. 2/ The calorie income elasticity according to Reutlinger et al. is 0.3. M. Ferroni also arrives at arc elasticities of 0.3 based on ENCA. See M. Ferroni: The Urban Bias of Peruvian Food Policy, Ph.D. Dissertation, Cornell University, Ithaca, N.Y., 1980.  - 34 - Table 15: PER-CAPITA CALORIE CONSUMPTION OF LOW AND MIDDLE INCOME HOUSEHOLDS, 1971/72 and 1979 1971/1972 1979 Low Middle Low Middle Lima 1813 2090 1714 2003 Coastal Cities 2244 2440 2121 2338 Sierra Cities 2364 2235 Selva Cities 1989 1880 Coastal Towns 2132 2360 2016 2261 Sierra Towns 1985 2287 1877 2191 Selva Towns 1793 . 1695 Rural Coast 2012 2139 1902 2050 Rural Sierra 2085 1971 Rural Selva 2624 2481 implausible data. Source: See table 1.8, Statistical Appendix. 59. While rural food crop producers are partially able to isolate themselves from market and policy induced deterioration of food quantity and quality, urban consumers must adjust to lower incomes and higher food prices by consuming less or changing consumption patterns or both. Grados and Miranda 1/ repeated the ENCA procedures for a small sample of Lima households in 1978. They found that total food consumption of low-income households in Lima decreased by about 7 percent as compared to 1971/72 and that these low income households were consuming 6 percent more potatoes, 18 percent less bread, 19 percent more rice, 36 percent less milk, 23 percent more sugar, 7 percent more noodles, 8 percent more fish, 8 percent less beef, and almost 90 percent more chicken. From these data it cannot be concluded that nutrient densities in the diet have changed, but it is likely that protein densities and therefore total protein intakes have decreased. It is reasonable to conclude that the diet quality and perhaps even quantity of the higher income strata in Lima has improved over the last decade, while both quality and quantity have deteriorated for low and middle income households throughout the country. 60. Food subsidies, although an instrument of low cost effectiveness, may have provided some relief for low income households. We estimate that the retail price of cereals by mid-1980 would have been somewhere between 13 to 18 percent higher in the absence of the subsidies. Cereals contribute approximately 40 percent of calories and approximately 35 percent of proteins in urban diets. Based on 1965 estimates of price elasticities for cereals, it can be assumed that average per-capita calorie consumption would have been an 1/ R. Grados, J. Miranda: La Pobreza en Lima Metropolitana, Apuntes (1980).  - 35 - additional 2 percent lower in the absence of subsidies on wheat and rice. Perhaps, the combined effect of all subsidies was to maintain calorie intakes 5 percent higher than they would otherwise have been. Hence the concern about alternative interventions to replace the subsidy program (see paras. 66-68). 61. A recent study by Bodenstedt et al. 1/ found that the average calorie intake was 96 percent of the FAO requirement for the area around Lima, 92 percent for the central Sierra and 72 percent for the northern Sierra. This probably accurately reflects the present food consumption situation in Peru. Food consumption changes, which occurred in the last decade, suggest an appreciable but not massive deterioration of the nutritional situation. If conditions in 1971/72 had been as bad as reported by Amat et al., 2/ Peru would now have a serious nutritional problem -- a view that, although shared by many knowledgeable people, is difficult to corroborate with data on anthro- pometry or health factors. We tend to believe that the present nutritional situation, although bad and most likely worse in terms of both quantity and particularly quality than in 1971/72, does not show alarming signs of widespread severe malnourishment. Families were generally able, through effective substitution mechanisms, to maintain a certain minimum calorie intake in spite of reduced real incomes. Health Related Indicators 62. During the 1960s and 1970s, general mortality declined from 17.8 deaths per 1000 inhabitants in 1962 to 11.9 in 1977; infant mortality declined from 160 to 107 deaths per thousand live births in the same period. These global figures, however, disguise wide interregional disparities in mortality. In 1970, for example, the national infant mortality rate was approximately 155 per thousand live births, while in the Cuzco province of Acomayo it reached 300 and in Lima it was 82. Overall, the downward trend in general and infant mortality rates is encouraging, yet Peruvian mortality rates are among the highest in Latin America (see table 1.9, Statistical Appendix). 63. Morbidity data for the late 1960s and early 1970s show various trends depending on the kind of illness. Infectious diseases continue to have a high incidence. Most diseases that are transmitted through inadequate sanitation (dysentery, helminthiasis, malaria, etc.) have noticeably increased (see table 1.10, Statistical Appendix). Infectious diseases continue to be the principal cause of death in Peru. For example, in 1960 for every 100 deaths, 43 were caused by infectious diseases. In 1972, the situation had deteriorated to the extent that 47 percent of deaths were caused by preventable infectious diseases. Respiratory and dysentery/gastrointestinal infections are the most prevalent illnesses listed in discharge records from the Children's Hospital of Lima (Hospital del Nino). These are commonly interpreted as indirect 1/ A. Bodenstedt et al.: Acceptance of Lupine Products: Findings of a Nutritional Survey, First International Lupine Workshop, Lima, 1980. 2/ See Amat et al., op. cit.  - 36 - measures of malnutrition. The strong upward trend in infant mortality asso- ciated with hypovitaminosis and other nutritional deficiencies as well as deaths caused by measles also serve as indicators of the existence of malnutri- tion (see table 1.11, Statistical Appendix). Children who are well nourished usually have the capacity to survive measles, whereas malnourished children are too weak to fight off the disease effectively. The combined trends of morbidity and mortality data, although only indirect measures of malnutrition, suggest that the nutritional status of Peruvian children has declined probably as a result of decreased food intake by young children and of the deterioration of health services. 1/ Policy Implications 64. This brief assessment of the present nutritional situation in Peru has been based on incomplete and sometimes contradictory data, on judgment, and on estimates derived from income and price trends. Given these weaknesses, the conclusions have to be cautious, and more complete and profound knowledge of the nutritional situation, based on careful study of the ENCA data and -- preferably -- an additional quick survey to spot the population in critical conditions, is urgently required for the design of rational policies. This would also have to include an assessment of the (beneficial and deleterious) impact of present food subsidies. 65. The most effective long-term measure to improve the nutritional situation is accelerated income growth through more productive employment and basic needs programs in education, health, and housing, which would release certain portions of disposable income to be increasingly spent for food and other essential consumption items. This presupposes greater availability and improved distribution of foodstuffs, particularly of food that is important in the diet of low-income households such as potatoes, rice, and low-cost animal protein. These considerations underline the high priority for employment generation and agricultural production identified in other sections of this report. In addition, the situation could be greatly improved, particularly in the short run, through specific interventions. 66. The food subsidy scheme followed until recently affected all consum- ers of particular products. It had approximately the same relative impact on all income strata of mostly urban consumers, but in absolute terms the higher income groups benefited more. The nutritional situation, however, seems to be more severe in rural areas of the Sierra where the subsidies had little or no impact on consumption but, on the contrary, may have depressed incomes through their negative impact on the price of domestically produced food crops such as quinua, barley or potatoes. Even without this disincentive effect, the food subsidy program is a relatively inefficient manner of protecting low income 1/ Expenditures for public health in real terms stagnated throughout the 1970s and declined on a per-capita basis and as a share of government recurrent expenditures, see table 9.  - 37 - diets. For every additional calorie reaching the lowest quartile through the food subsidies, there are at least 3 others reaching the higher income groups. 1/ Even expensive direct feeding programs have lower overheads, e.g. in Honduras administrative costs of direct feeding programs are about equal to the food costs. 67. Nutritional interventions should be more specifically targeted to the extremely poor. These interventions could be financed from resources previously used for food subsidies (see para. 34). The health sector offers potential for cost-effective nutritional interventions and targeting, partic- ularly through community self-help approaches. If targeting is to be con- sidered as a replacement for the food subsidy program, direct feeding programs through health centers, schools, and work places should be evaluated as possible alternatives. Low-cost food distribution outlets may also have some merit. For all these possible mechanisms of intervention, the location of the facilities in low-income areas and neighborhoods is critical to reach the target population effectively and to discourage use by better- to-do people. The provision of low-cost meals through an expansion of the number of popular canteens (comedores populares) in connection with health centers should be conceived of as element of a comprehensive system of primary health care delivery. The recent establishment of a special nutrition fund prepared the way for the implementation of some of the recommendations developed in this report. The food-stamp program was expected to become effective in March 1981. 68. The rural poor, particularly in small communities in the Sierra and Jungle, should receive priority attention for health related interven- tions and through agricultural service and development schemes. In particular, efforts should be directed at increasing farm incomes, off-farm employment and the production of calorie and protein sources. 2/ Potatoes, rice and low- cost animal protein, essential elements of the low-income diet, are very important in this regard. Food imports and the development of the poultry industry have prevented a more serious nutritional situation. The production of animal protein should be stimulated. In this regard increased availability of grains such as sorghum and maize is important, either as imports or as local products. 1/ This does not take into account that most of the subsidized items are more important in the diet of higher-income households than in that of low-income households. If e.g. the higher three quartiles of the population consumed 80 percent of a subsidized product, the ratio would be 1 to 4 instead of the assumed 1 to 3. 2/ See para. 109  - 38 - 69. Young children have to be considered the highest risk segment of the population. The next-to-last child in families with four or more children is particularly vulnerable. By the fourth birth, especially if each birth comes in close order, the nutritional status of low-income mothers has deter- iorated to the point where breastfeeding does no longer provide the full nutrient value of a well-nourished mother. The next-to-last child is fre- quently caught by malnourishment in the critical period between 6 months and 2 years of age. A family planning program that would primarily aim at the spacing of children by two or more years would effectively and quickly reduce this risk besides having a positive impact on population growth with its short and long-term benefits (see para. 45). 70. Malnutrition is to be viewed as a multi-sectoral problem and its solution, therefore, involves the effective coordination of different programs sponsored by different government agencies. For the specifically targeted interventions outlined in paras. 67 and 69, the Ministry of Health should take the lead through a restructured and strengthened Nutrition Institute. Present efforts to reorient health policies towards preventive medicine and primary health care provide an excellent opportunity to integrate nutritional programs as well as efforts to improve sanitary conditions (see para. 76). This, however, presupposes substantial institutional strengthening of the Ministry of Health. 2. Economic Aspects 2.1 Economic Infrastructure Energy 71. Peru's energy resource base is diverse, consisting of oil, coal, gas, hydropower, some geothermal potential, and renewable sources such as firewood. Total oil, coal, and gas reserves are estimated at 970 - 3,500 million TOE, 1/ presently used at an annual rate of about 12 million TOE. The usable hydropower potential is estimated at 30 - 60 GW, of which only 1.4 GW are used. Known (proved and probable) oil reserves total 1 billion barrels or 140 million TOE, enough for 12 years at current output levels; total reserves could be as high as 2,800 million TOE. At present, oil accounts for about 54 percent of total energy consumption, firewood for 27 percent, hydro- power for 6.5 percent, natural gas for 5 percent, coal for 0.5 percent, and non-commercial sources for about 7.5 percent. Oil will continue to be the most important source of energy throughout this century, although the acceler- ated development of the hydropower potential and of the coal deposits could reduce its share to about 50 percent by the year 2000. 72. Energy sector planning, coordinated by the Ministry of Energy and Mines, is at an advanced stage with a national energy balance study completed, a power sector master plan to determine the optimal sequence of investment in new generating and transmission facilities, and some strategy documents. The main task ahead is to increase petroleum production, to 1/ TOE = tons of oil equivalent = 14.415 x 10 kcal.  - 39 - tnake more and better use of alternative energy sources (particularly hydro- power and other renewable sources), and to contain demand growth through conservation and adequate pricing policies. The core of a successful energy program is petroleum and hydropower development, which critically depends on the financial and managerial capacity of the relevant sector institutions. 73. Primary production and secondary recovery from presently developed oil fields are expected to allow oil production at a level of some 220,000 to 250,000 b/d through the mid-1980s, which would be sufficient for domestic consumption and exports (if on a declining basis). The longer-term prospects depend on successful new exploration as well as on the growth and pattern of energy consumption. Exploration, which was quite active during the first half of the 1970s, has sharply dropped off since 1976 for both technical and political reasons. New investment in exploration and production virtually came to a standstill because of PETROPERU's financial difficulties and the lack of a coherent strategy towards foreign capital. It is estimated that exploration investment would have to amount to about US$400 million per year throughout the 1980s to expand production at a rate that would allow to satisfy growinm7 domestic demand and to continue to export. Although PETROPERU is expected to embark on new exploration as its financial position improves, a substantial part of future exploration will have to be undertaken by foreign companies because of their expertise and the large volume of investment required. Financial conditions apt to attract risk capital to the high cost - high risk ventures are, therefore, very important. With the recent enactment of a new law introducing a tax credit scheme the investment climate improved markedly, and initial reactions by foreign investors have been quite positive. 74. It has been proven in many countries that energy consumption-- above a certain level--is fairly price-elastic. Prices, therefore, play a key role in determining the growth of demand and the effort going into conservation. During the first half of the 1970s, inadequate pricing policies stimulated the demand for petroleum products in Peru. Continuous price increases, particularly since 1976, brought gasoline prices to internationally reasonable levels while kerosene, diesel and fueloil prices were still kept artificially low. The average ex-refinery price for all petroleum derivatives is way below the international price. Even after the recent price increases, anticipat- ing further increases during the year, and taking taxes into account, the estimated average domestic price in 1981 of about US$20.80 per barrel falls over 50 percent short of the average international price (see table 16). This represents an economic subsidy of over US$1,000 million equivalent to roughly 4.5 percent of GDP. This in part also represents a direct financial loss, since PETROPERU has to buy part of the domestically sold petroleum from foreign contractors at the international price. Action to eliminate these subsidies is urgently required not only to cut the financial losses but also to contain the growth of domestic demand and encourage conservation. The -'erage price for all petroleum derivatives should be gradually increased to Lhe international level. If prices for kerosene and diesel are held down for social reasons, gasoline prices would have to be increased more to make up for the difference. But cross-subsidization of kerosene and diesel, which necess- arily will trigger more rapid demand growth, has to take into account technical constraints of the refining process that allow to produce derivatives only in certain fixed proportions.  - 40 - Table 16: ESTIMATE OF ECONOMIC AND FINANCIAL SUBSIDIES FOR PETROLEUM SOLD IN THE DOMESTIC MARKET, 1981 Volume Price Value (millions (US$/b) (US$ million) of barrels) (incl. taxes) Sales at domestic price 51.0 20.78 a/ 1,059.7 Sales at international 51.0 41.87 b/ 2,135.4 price Difference = implicit economic subsidy - 21.09 1,075.7 Memo item: public sector deficit 1981 (projected) 950.5 a/ Annual average taking recent and anticipated price increases and gradual devaluation of the sol into account. b/ Average OPEC price (US$36/b) multiplied by average refining cost factor of 1.163. This is also about in line with the average ex-refinery price in the Carribean region. Source: Central Bank; Bank staff estimates 75. Similar considerations apply to power tariffs: regular adjustments are necessary to maintain the financial viability of the power companies, and to provide a reasonable share of self-financing of the expansion of generating capacity and transmission facilities, and to bridle demand growth. The rapid expansion of the country's hydropower generating capacity and transmission lines, which is an essential element of the overall energy sector strategy and extremely costly, crucially depends on rational tariff policy to keep sector finances manageable. The Government is now following a policy of price increases at short intervals (at present: quarterly) with the objective to achieve a self-financing ratio of investment of 30 percent by 1983. Water and Sewerage 76. With about half of Peru's population living in the desert Costa region and a relatively unfavorable health situation as reflected by high infant mortality and high incidence of communicable diseases, water and sanitation are sectors that deserve high priority. Present service levels are low: only half of the population has access to piped water (60 percent in urban, 25 percent in rural areas); about 34 percent to sanitation (51 percent in urban areas, very little in rural areas). 1/ The sectoral objec- tives for 1990 envisaged at the Habitat conference are ambitious: to provide 1/ The information basis in rural areas is particularly weak, and many of the existing facilities like latrines are not reported by the Ministry of Health.  - 41 - 85 percent of the urban and 50 percent of the rural population with piped water as well as 75 percent of the urban and 30 percent of the rural popula- tion with sanitation. This would require investments of US$1,450 million (at 1978 prices) between 1979 and 1990 -- an annual average of US$120 million which compares to an average of US$20 million (also at 1978 prices) during 1970-78. Even a less ambitious expansion program would strain the sector's financial and institutional capacity. Given these constraints, it would be worthwhile examining whether better pollution control of river water would not be a less expensive alternative to individual water treatment in small towns. 77. Inadequate financial policies are the cause for insufficient coverage and low quality of services. Water rates are among the lowest in Latin America. In Lima, ESAL's rates averaging 0 6.6 per m3 (as compared to