Bolivia - Updating economic memorandum

Report No. 8623-30 Bolivia Updating Economic Memorandum August 30, 1990 Latin America and the Carinbean Region Country Operations Division I CountrV Department IlI 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.  Fiscal Year Janaury 1 to December 31 Currency Eqauients Currency Unit: Boliviano (Bs) Exchange Rate Effective July 31, 1989 US$1.00 Bs 3.17 Bs 1.00 US$0.32 Abbreviations AASANA - Administracion de Aeropuertos y Servicios Auxiliares a la la Navegacion Aerea (Airport and Air Navigation Auxiliary Services Administration) LAB - Lloyd Aereo Boliviano (Bolivian Airline) CAF - Corporacion Andina de Fomento (Andean Development Corporation) COBEE - Boliviax. Power Company CONIBOL - Corporacion Minera de Bolivia (Bolivian Mining Corporation) CRA - Certificado Reintegracion Arancelaria (Customs Certificate) DINE - Direccion Nacional de Electricidad (Regulatory Authority for Power) ENDE - Empresa Nacional de Electricidad (State Electricity Company) ENFE - Empresa Nacional de Ferrocarriles (National Railways Corporation) ESAF - Enhanced Structural Adjustment Facility ESF - Emergency Social Fund EXI - Export Import Bank of Japan IBRD - International Bank for Reconstruction and Development IDA - International Development Association IDB - Interamerican Development Bank IMF - International Monetary Fund IKBOPIA - Bolivian Institute of Small Industry and Artisans KFV - German Aid Agency LIBOR - London Interbank Offer Rate MACA - Ministerio de Asuntos Campesinos y Agropecuarios (Ministry of Agriculture and Rural Affairs) NCS - North South Central (power grid) SAFCO - Sistema Integrado de Administracion Financiera y Control (Integrated System of Financial Administration and Controls) SIF - Social Investment Fund SISIN - Systema de Informacion y Seguimiento de la Inversion (Information System for Managing Investments) SsC - Servicio Nacional de Caminos (National Road Service) UDAPE - Unidad de Analysis Politico y Economico (Unit for Political and Economic Analysis) UNDP - United Nations Development Program UNICEF - United Nations International Childrun's Emergency Fund USAID - United States Agency for International Development YPFB - Yacimientos Petroliferos Fiscales Boliviaiios (Bolivian :etroleum Corporation)  FoR omCLAL USE ONLY This report is based on a mission in Pebruary 1990 by William Shaw, assisted by Juan Carlos Aguilar of the Bank's Resident Mission. Chapter II is based on reports and discussions with a number of contributors, including Robin Carruthers (transportation), Alvaro Covarrubias (power), Abderrahmane Negateli (hydrocarbons), Benjamin Friedman and Julio Linares (water), Julie Vandomelen (health), Dan Newlon (education), James Cock and Douglas Forno (agriculture), and Felix Remy (mining). Juan Carlos Aguilar provided a background paper on exports and public sector investment. Jamil Mubarak assisted in the production of tables and in preparation of the projections. Ms. Elena Rodriguez and Ms. Diana Cortijo coordinated the production of the report. This document has a restricted distibution and may be uswd by reciPients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bnk authorization.  BOLIVIA UPDATING ECONOMIC MEMORANDUM Table of Contents Page No. SUMMARY AND CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . i-vi CHAPTER I: BACKGROUND AND RECENT ECONOMIC DEVELOPMENTS . . . . . . 1 A: Historical Background . . . . . . . . . . . . . . . . . 1 B: Recent Economic Developments . . . . . . . . . . . . . 4 C: Structural Policies ............. .... . 7 CHAPTER II: MEDIUM-TERH PROSPECTS . . . . . . . . . . . . . . . . . 14 A: Introduction . . . . . . . . . . . . . . . . . . . . . 14 B: Fiscal and Monetary Policy . . . . . . . . . . . . . . 14 C: Export Prospects . . . . . . . . . . . . . . . . . . . 21 D: The Bolivian Economy through 2000 . . . . . . . . . . . 30 CHAPTER III: PUBLIC SECTOR INVESTMENT REVIEW . . . . . . . . . . . . 38 A: Investment Programming . . . . . . . . . . . . . . . . 38 B: Transportation . . . . . . . . . . . . . . . . . . . . 43 C: Agriculture . . . . . . . . . . . . . . . . . . . . . . 48 D: Mining . . . . . . . . . . . . . . . . . . . . . . . . 52 E: Hydrocarbons . . . . . . . . . . . . . . . . . . . . . 53 F: Power. . . ... 56 G: Water . . . . . . . . . . . . . . . . . . . . . . . . . 59 H: Social Sectors .62 ANNEX I: Estimation of the Demand for Mney . . . . . . . . . . 67 ANNEX II: Statistical Appendix .69 ANNEX III: Public Sector Investment Program . . . . . . . . . . . 88 MAP IBRD 16591 Tables 1.1 Macroeconomic Accounts .5...... . .. .. .. . .. .. . S 1.2 Key Economic Variablex, 1986-89 . . . . . . . . . . . . . . 6 1.3 Financial Indicators . . . . . . . . . . . . . . . . . . . . . 10 1.4 Commercial Bank Portfolios ................. . 11 2.1 Financing of the Public Sector Deficit, 1989 . . . . . . . . . 16 2.2 Nonfinancial Public Sector Accounts . . . . . . . . . . . . . 17 2.3 Financing the Public Sector 1990-2000 . . . . . . . . . . . . 20 2.4 Export Receipts, 1987-89 .22 2.5 Medium-Term Export Projections .25 2.6 Required Approvals for Export .28 2.7 Base Case Projections, 1988-2000 . . . . . . . . . . . . . . . 31 2.8 Base Case Balance of Payments Projections . . . . . . ... . . 32 2.9 Financing Investmant, 1990-2000 .............. . 34 2.10 Impact of the Brazil Scenario, 1991-2000 . . . . . . . . . . . 36 3.1 Questionable Projects . . . . . . . . . . . . . . . . . 4 . . 39 3.2 Investment Program, 1987-92 . . . . . . . . . . . . . . . . . 41  Table of Contents--Cont'd 3.3 Road Construction Projects . . . . . . . . . . . . . . . . . . 45 3.4 1990 Programmed Investments in the Health Sector . . . . . . . 63 2.1 Base Case Projections . . . . . . . . . . . . . . . . . . . 19a 2.2 Impact of Non-Interest Deficit of 1.31 of GDP . . . . . . . 19a  - i - SUMKARY AND CONCLUSIONS 1. The Bolivian economy has begun to recover from the hyperinflationary crisis of the early 1980s, when political instability, a crushing debt burden, extensive controls on economic activity, a huge and inefficient public sector, and erratic macroeconomic management severely reduced output and living standards. The Government of Paz Estenssoro restored price stability by increasing public sector prices, raising revenues, and imposing tight controls on expenditures and Central Bank credit. At the same time, the Government initiated a comprehensive liberalization of markets, including an elimination of most quantitative trade restrictions and reduction of tariff rates, elimination of controls on interest rates and on foreign currency transactions, removal of price controls, setting up of an auction system to determine the exchange rate and a reduction of state intervention in private sector wage and employment decisions. The Gover.anent sustained the program in the face of the collapse in the price of tin in 1985 and continued difficulties caused by delays in payment by Argentina for Bolivian gas shipments. 2. Despite the remarkable achievements of the former administration, the Paz Zamora Government faced a difficult financial situation on taking office in August 1989. Uncertainty over the outcome of the electoral process had reduced bank deposits and reserves, and slowness in adjusting public sector prices and the exchange rate, plus the arrears in Argentina's payments for Bolivian gas shipments, had led to some deterioration in fiscal performance. The Government took decisive actions to raise public sector prices, depreciate the boliviano and reject demands for unrealistic increases in public sector wages. These measures, along with Supreme Decree 22407 which confirmed the Government's commitment to the present structure of economic incentives, encouraged a recovery of public confidence. The new Government also made substantial progress in its negotiations with the international financial community, including agreement with the IMF over the second year of the Enhanced Structural Adjustment Facility, elimination of Bolivia's debt to Argentina in return for cancelling Argentina's arrears on gas payments, achievement of further progress in retiring Bolivia's commercial bank debt, establishment of a new mechanism for retiring a portion of Bolivia's debt with Brazil and the receipt of a highly-concessional debt rescheduling agreement from the Paris Club, including the so-called Toronto terms. 3. While the Government has maintained its commitment to stability and the basic structure of incentives, the agenda for policy reform remains long. Proposed revisions to the laws governing investment need to be adopted to encourage private sector investment. The proposed investment code would guarantee stable rules of the game for private investment, ensure equal treatment of domestic and foreign investors, prohibit restrictions on profit repatriation, and simplify procedures for registration of foreign investors.  - il - While many of these provisions are already in force, the investment code would provide more assurance of stability in the policy regime, thus encouraging increased investment. The investment code was approved by the Deputies during the last session of Congress, but still must pass the Senate. 4. Monopolization of promising reserves by relatively inefficient public sector companies has stifled private investment in mining and hydrocarbons. The proposed mining and hydrocarbons codes would provide legislative sanction for joint ventures between COMIBOL and YPFB and the private sector, which is essential for the efficient development of Bolivia's natural resources. The hydrocarbons code also would expand the areas eligible for private sector exploitation and eliminate the restriction on private sector ownership of oil and gas pipelines. The mining code would authorize an optional tax regime that is consistent with tax policy in the home countries of most multinational enterprises. Taxes paid by multinationals under the present regalia system can not be deducted from their tax liability in home countries, placing Bolivia at a significant competitive disadvantage with other countries. 5. Some progress has been made i7 improving public sector administration. Adoption of the SAPCOJ law was an essential step towards establishing uniform procedures for public sector accounting that would enable the central administration to control expenditures more effectively. The SAFCO law also clearly defines responsibilities for public sector financial management and provides for the independence of the Central Bank, a prerequisite to a rational and effective monetary policy. Further work on a number of administrative improvements is necessary, including simplification of bureaucratic approvals (particularly for exports) and implementation of the public sector management program to establish a key group of adequately compensated public servants. Greater efforts to improve the living stmtdards of the most vulnerable groups are a prerequisite to both economic development and a more equitable society. The Government can progress towards this goal by raising the efficiency of public sector expenditures in tne social sectors and reallocating subsidies which presently benefit the middle and upper classes. 6. The Bolivian financial system remains extremely fragile. Interest rates greatly exceed international levels, banks are heavily dependent on short-term dollar deposits and many banks are undercapitalized and hold a large volume of nonperforming assets. Over time, maintenance of the present incentives structure should increase confidence and permit some easing of interest rates, while economic recovery should strengthen bank portfolios. / SAFCO stands for Sistema Integrado de Administracion Financiera y Control, and refers to the system adopted by the Bolivian Government to improve control of expenditures.  - iii - Still, substantial risk of instability remains in the system. The Government must continue the successful effort to improve supervision of the banking system. Imposition of strict capital adequacy standards and stronger provisioning requirements are essential to discourage excessive risk-taking and improve the efficiency of credit allocation. Cessation of lending by the public banks directly to the nonfinancial private sector is necessary to avoid further losses and increase reliance on the private sector for allocating credit. This implies closure or privatization of the Banco Agricola and the Banco Minero, and restricting the activities of the Banco del Estado to serving the public sector. Finally, interest rates on development credit intermediated by the Central Bank should be raised to market levels in order to ensure appropriate pricing of credit. 7. The supply of public goods essential for sustained growth is too low in Bolivia. Transport infrastructure is inadequate and unreliable, many areas remain unserved by power and communications networks, the educational system is wasteful and ineffective, and poor water, sanitation, and health services result in alarmingly high rates of sickness and death. Thus, continued development wi'' require a level of public sector expenditures sufficient to raise the supply of public goods. However, the Government's ability to spend is limited by the availability of non-inflationary finance. A key question for macroeconomic policy is how the expenditures essential to development can be financed without excessive levels of debt or money issuance. 8. To address this question, a consistency framework for the financial position of the consolidated public sector (including the general government, state enterprises and the Central Bank) is presented. This framework shows that the primary deficit (deficit excluding interest payments) must be reduced from 1.32 of GDP in 1989 to near zero in the medium term, in order to avoid a rise in domestic debt and ensure that the private sector receives sufficient resources to support projected levels of investment. To achieve the required decrease in the primary deficit, it will be necessary to increase tax revenues through more rigorous enforcement and to limit the rate of increase in overall expenditures to slightly below the rate of increase of GDP. This constraint on total public sector expenditures can be made consistent with providing the public goods essential to development by% a) reducing current expenditures to permit a more rapid increase in investment; b) reducing the high level of waste in selected categories of current expenditures and reallocating these funds to more effective uses; and c) eliminating inefficient public sector investments now being considered and using the savings in more productive investments. Suggestions for improvements in public sector investments are provided below. 9. Export growth and diversification are essential to Bolivian development. Export performance improved markedly in 1989, as revenues from nontraditional exports nearly doubled and private sector mining increased strongly. Strong export growth was due to maintenance of low inflation and  - iv - the liberal incentives structure, a rise in the real exchange rate,V introduction of export incentives for nontraditional exports and some improvements in transport infrastructure. Prospects for Bolivian exports appear bright. Substantial investment in non-tin private sector mining is now underway with significant participation by foreign firms, which should help to sustain minerals exports for years to come. Exports of a variety of nontraditional products (e.g. soya, coffee, sugar and perhaps processed skins) should continue to rise. 10. Realization of Bolivia's export potential will require continued commitment to the macroeconomic framework, adoption of the revisions to laws governing investment discussed above, maintenance of an appropriate exchange rate, improvements in transport infrastructure and power, and elimination of unnecessary and time-consuming bureaucratic requirements which restrict export growth. Presently, firms must receive several approvals, all of which require time and provide opportunities for corruption, from different offices to export goods. Proposa'ls which should be considered are elimination of the requirement that foreign exchange earnings be deposited in the Central Bank and consolidation of all approvals and registries in a single office, with a system of compensation (for the relevant officials) designed to provide incentives for speedy approvals. 11. Bolivia faces a difficult future, in which ensuring continued development will require courageous and far-sighted economic policy. The base case projections show the domestic policies and international assistance required for an average growth rate of 42, a moderate rise in per capita consumption and reduced dependence on external capital flows. To finance the investment necessary under this scenario, the country must achieve a rise in domestic savings from 9X of GDP in 1989 to 15? by the year 2000, receive continued assistance from official creditors (albeit at a declining level relative to output), attract higher levels of private capital inflows and negotiate generous levels of debt service relief, equivalent to 2.5? of GDP per year over the next ten years. The potential for achieving higher rates of growth through the proposed project to sell gas-produced electricity to Brazil should also be explored. This project is technically feasible and would, if successful, raise government revenues, investment and growth rates. The project would also carry a substantial risk, however, as Bolivia would have to borrow about US$570 million at nonconcessional terms to finance it. Some insurance should be obtained through increased equity participation by the pr4.vate sector and arrangements to reduce Bolivia's debt service obligations in case of failure of the project. 2/ The Latin American Region defines the exchange rate as units of domestic currency per unit of foreign currency. Therefore, an increase in the exchange rate implies a depreciation of the boliviano (prior to January 1987, the Bolivian peso).  12. The base case projections show a vision of the future under which Bolivia can achieve a substantial increase in per capita output, reduce debt and debt service relative to economic activity, and achieve the rise in the capital stock which would serve as a basis for higher growth in the future. But the rise in domestic savings necessary to attain these results means that per capita consumption must improve only slowly from current, depressed levels. Limiting consumption growth today to permit faster growth in the future will present an enormous challenge to the Bolivian Government and society. This observation underlines the importance of transparency and credibility of economic policy. The Government's commitment to macroeconomic stability, an appropriate framework of incentives and social justice must be obvious and convincing. Any deviation fr:om effective policies can have serious implications for the whole economic program. Wasteful investment expenditures, failure to push through legislation which would encourage private sector investment and lack of implementation of necessary improvements in public sector administration all impair the effectiveness of economic policy and help to undermine public confidence. The Bolivian Government has accumulated enormous good will both domestically and internationally for the effectiveness of its adjustment program, but this report shows evidence of difficulties in policy implementation in all of these areas. Decisive measures are now essential to ensure sustained development 13. The severe constraints impeding Bolivian development highlight the importance of ensuring that public sector investment expenditures are made in the most efficient manner possible. The Government has continued and strengthened the improvements in public sector investment programming begun under the previous administration. The Ministry of Planning is expanding the SISIN3 computer system to include physical indicators of progress and an economic evaluation of investment projects. Selection and evaluation of investment projects at the sectoral level remain weak, however. Many sectors lack the financial, administrative, and technical resources necessary to evaluate or propose investment projects. In some sectors, the agencies responsible do not have sufficient information on investment, and project selection is largely determined by donors, leading to a lack of coherence in investment planning, inadequate supervision of projects, and poor coordination among projects, In other sectors, agencies may have detailed investment plans and sufficient technical expertise, but the sharing of information with the central ministries is limited. Weaknesses in management of investment at the sector level severely impair the effectiveness of investment programming by the central ministries, which depend on the quality of data provided by the sectors. 3/ Sistema de Informacion y Seguimiento de la Inversion, a repository of financial information on investment projects.  - vi - 14. Improvements in the selection of projects for the public sector investment program are necessary. The Government is considering a few projects which either are too expensive or would involve the state in productive activities better left to the private sector. Examples include construction of the Misicuni water project in Cochabamba, a huge, excessively expensive, and unnecessary solution to the area's water supply problems; development of a large agroindustrial project in Villamontes; building of expensive new terminals for the Cochabamba and La Paz airports; and construction cf new hospitals when the Ministry of Health is not able to staff the present facilities. We urge the Government and interested donors to eliminate these projects and reallocate the funds to more efficient and higher-priority areas. Bolivia can ill-afford to waste its limited financial resources, or devote scarce technical and managerial personnel to unnecessary projects. There are many useful opportunities for increasing investment expenditures for which funds are not available, particularly basic health care projects, improvements in the road network, power projects consistent with the least-cost expansion plan, and water supply and sewerage projects.  CHAPTER Is BACKGROUND AND RECENT ECONOMIC DEVELOPMENTS A. Historical Backaround 1. The 1952 Revolution and the Role of the State. The 1952 revolution, in which armed civilians defeated an attempt by the army to annul the results of the recent election, brought to power the Movimiento Nacionalista Revolucionario under the presidency of Victor Paz Estenssoro. This party was dedicated to destroying the power of the mining families and landowning elites, -xhich had dominated Bolivian political life since independence. A new electoral law provided for universal adult suffrage, thus increasing the electorate from 10X to 100X of the adult population. An agrarian reform broke up the large estates in the western part of the country and gave the land to those working on it. The larger mines were nationalized under the management of the state-owned Bolivian Mining Corporation (COMIBOL). These measures held the promise of a significant redistribution of income and a more equal distribution of political power, as well as a large increase in the role of the state in the economy. 2. Subsequent Governments steadily increased the share of the economy controlled by the public sector. In the 30 years following 1952, the state set up numerous productive enterprises and accounted for over two-thirds of total investment. At the same time, private sector activities were largely conditioned by Government decisions, through subsidized credit programs directed at particular sectors, an extremely complex and protective system of tariffs and quotas, allocation of scarce foreign exchange, and marketing boards and price controls for most agricultural commodities. State direction of economic activity resulted in an extremely inefficient structure of production and a continued neglect of essential infrastructure and social services. The state's emphasis on the production of private goods (goods that could be produced efficiently by the private sector) led to a neglect of public goods. Productive enterprises had a source of income independent from the budget, and powerful unions of state enterprise employees were able to capture additional funds from the Treasury. The productive enterprises thus absorbed the lion's share of public resources, while services normally provided by Government languished for lack of funds. 3. The Economic Crisis. The problems inherent in this strategy of development were masked during the 1960s and 19708 by a high rate of investment financed by foreign aid, increased inflows of direct investment in the petroleum sector, terms of trade gains owing to strong commodity prices, and the discovery of sizeable petroleum and gas deposits which made the country an attractive cliert for foreign lenders. However, towards the end of the 1970s it was apparent that many of the investments financed by foreign loans at commercial terms were poorly conceived, reflected distorted prices, and/or resulted from political pressures. A significant portion of foreign borrowing ended up as capital flight. Thus Bolivia built up a huge debt burden during the 1970s, without achieving the increase in productive capacity necessary to service the debt. By 1980, political instability and concerns over economic performance led to a drying up of foreign ioans, which together with the rise in real interest rates on the outstanding debt forced a severe cut in imports. The fall in imports caused production bottlenecks,  - 2 - contributing to the decline in output and fueling inflation. A severe drought in the Altiplano in 1982-83 and floods in the lowlands in 1983 further reduced output. 4. While reduced external savings initiated the crisis, its severity .. length were caused by disastrous economic management, particularly an overvalued official exchange rate and a huge public sector deficit financed by money creation. Despite the sharp fall in external finance, political instability and social conflict prevented a sufficient cut in expenditures, which were increasingly financed through issuing money and building up arrears to domestic and foreign creditors. At the same time, the overvalued exchange rate and declining tin prices reduced the export receipts on which the Government depended for substantial revenues. As revenues declined, the Government issued more money to cover its bills, and inflation accelerated. Competition over wage increases intensified. Real money holdings dropped substantially as the public sought to protect the real value of their assets, a process given impetus by the forced conversion of dollar deposits into pesos at the overvalued cfficial rate. The shrinking of the monetary base in turn required an accelerating rate of money creation to finance Government expenditures, while rising inflation sharply reduced the rial value of tax revenues. Inflation reached 28,000% (at an annual rate) in the first 9 months of 1985. 5. Hyperinflation had a disastrous impact on the economy. Inflation is a regressive tax paid by the poor and poorly organized, who lack the power to protect the real value of their incomes. Forced savings through the inflation tax and increases in arrears reduced the resources available for private investment, while chaotic economic conditions made investment extremely unattractive. The decline in economic activity as a result of the crisis is difficult to determine. Official estimates show a fall in real GDP of over 102 from 1980 to 1985, 242 in per capita terms. Per capita consumption is estimated to have dropped by a total of 16? over the period. Private fixed investment averaged about 3? of GDP in 1983-85, compared to over 72 in 1980. These figures may overstate the decline in output, as price controls and the overvalued exchange rate greatly encouraged the conduct of economic activity through unrecorded channels, while the illegal cocaine trade also increased during the 1980s. However, the trends of a deteriorating economy and falling consumption are probably an accurate representation of Bolivia's experience. 6. The 1985 Stabilization. The new Government which took power in August of 1985 (headed by Dr. Paz Estenssoro, also president during the 1950s and 1960s) viewed the perilous state nf the economy as an indictment of the development model pursued since the 1952 revolution, and moved quickly to stabilize the economy and reduce the role of the state. A massive devaluation of the exchange rate, increases in public sector prices, and reductions in Government expenditures to the level financeable by available funds lowered the deficit on a cash basis to almost zero. Inflation halted within two weeks of the announcement of the program; the consumer price index actually declined on average in October 1985.  7. In conjunction with the stabilization program, the Government instituted a far-reaching liberalization of markets to increase reliance on the price system for the allocation of resources and encourage greater private sector participation in the economy. Price controls and marketing boards were virtuallj eliminated. Public sector prices were raised using neighboring countries' prices as guidelines. An auction system was established to determine the exchange rate, taxes and commissions on foreign exchange transactions were eliminated, and capital controls were abolished. Quantitative restrictions and export licensing requirements were eliminated, with the exception of controls on wheat and sugar, and import tariffs were reduced and simplified. The Government instituted a major reform of the financial system which abolished controls on interest rates and other restrictions, reorganized the Central Bank to strengthen its traditional functions of monetary control, and improved banking supervision and the soundness of the banking system. Restrictions on the hiring and firing of employees were eased and private sector wages were to be set in negotiations at the level of individual firms. Public sector employment was reduced, and efforts begun to improve the efficiency of public sector administration. 8. The Economy After Stabilization. The first year following the end of the hyperinflation was extremely difficult. GDP declined by 2.9% in 1986 and unemployment rose. The principal reason was the collapse of tin prices in late 1985, which led to a massive layoff of tin miners and a sharp fall in Government revenues, requiring even more restrictive policies to limit the budget deficit. The abrupt liberalization of economic policies also may have reduced output in the short run. During the hyperinflation, the bulk of production in the formal sector of the economy occurred in industries owned or subsidized by the state. The liberalization disrupted these activities by revamping the tariff structure, raising the prices of public sector goods, eliminating the opportunities for profit involved in the dual exchange rate system, and reducing subsidized credit. Over time, greater reliance on the market should lead to a more efficient structure of production and to higher growth. Still, it takes time for the private sector to recover from the loss of state protection and undertake new productive activities in response to the new system of incentives. 9. Higher growth also requires increased investment, and initially the experience of the hyperinflation and the many failed stabilization attempts was far too fresh to encourage a sharp rebound in entrepreneurial activity. Uncertainty over the stability of the new policy regime also hampered the supply of investment funds. While a significant repatriation of assets held abroad did occur in response to the stabilization, the risk premium necessary to obtain funds, even at very short maturities, was extremely high. The real interest rate on peso-denominated loans equalled 522 at end-1986, and dollar deposits in Bolivian banks earned 15%, or about 8 percentage points above the return available in the international market. 10. From 1986-88 GDP increased by 2.5X a year, less than the rise in population but a dramatic improvement over the early 1980s. Relatively slow growth was due to a number of factors. Confidence improved only slowly, which maintained interest rates at high levels and limited the availability of long- term credit. Falls in natural gas prices and frequent interruptions in  - 4 - payment by Argentina for Bolivian gas shipments reduced reserves and kept the public sector accounts in a state of crisis. A severe drought reduced agricultural production in the altiplano. The Government maintained a fairly tight grip on inflation; consumer prices increasee by 162 a year from end-1986 to end-1988. B. Recent Economic Developments 11. National Income Accounts. Preliminary data show that GDP may have increased by 2.72 in 1989, but the large share of unrecorded transactions in the economy raises doubts concerning the reliability of this figure and makes it difficult to analyze the determinants of GDP growth. The available data show substantial inconsistencies among the trade, balance of payments, and national accounts. For example, according to official trade statistics the current account deficit declined sharply in 1989 compared to 1988. due to a large decrease in imports. However, recorded capital inflows (including reserves) in 1989 were only slightly smaller than in 1988, implying only a small improvement in the current account deficit. Further, the drop in the trade deficit in the official statistics, coupled with the estimated rise in investment and slow GDP growth, would imply that consumption (the residual in the national income accounts) fell in absolute terms. This does not appear probable. Most likely, the fall in imports and the rise in investment are both overstated, so that consumption actually increased slightly, which still implies a 22 fall in per capita terms. 12. Table 1.1 shows the picture of the economy which emerges by adjusting the official statistics to impose consistency among the accounts, and assuming that the fall in per capita consumption was moderate. Private investment may have increased, but public sector investment fell from US$352 million in 1988 to US$341 million in 1989. Lack of improvement in public sector investment was due to lower than expected disbursements from official donors. Total investment remained only slightly above 12? of GDP. A 22? increase in the volume of exports (see discussion of exports in 1989 below), coupled with a small terms of trade improvement maintained import growth in the face of the decline in external finance.  Table 1.1t Macroeconomic Accounts 1986 1987 1988 1989 Percentage Change at Constant Prices GDP -2.9 2.1 2.8 2.7 Investment la -34.3 48.1 2.0 4.6 Exports 16.1 -3.0 10.8 21.7 Imports -2.3 8.3 -13.9 8.7 Consumption per Capita -7.9 0.0 -3.8 -2.1 Percentage of GDP at Current Prices Current Account Deficit 10.6 12.1 9.8 8.8 National Savings -2.7 -1.0 1.9 3.4 Investment /a 7.9 11.1 11.9 12.2 Public 4.9 6.4 8.2 7.2 Private 4.6 3.9 5.3 5.2 Change in Stocks -1.6 0.8 -1.6 -0.2 ia Includes change in stocks. Sources: National Institute of Statistics and IMF 13. Fiscal and Monetary Policy. Despite the remarkable achievements of the Paz Estensooro administration, the new Paz Zamora Government faced a difficult financial situation on taking power in August. Problems in controlling Government expenditures and some slowdown in revenues were evident in the first half of the year, particularly due to the failure to adjust public sector prices and the build-up of arrears on Argentina's payments for Bolivian gas shipments. Further, uncertainty over choice of the new Government led to a sharp decline in bank deposits, a drop in international reserves, and a growing divergence between official and parallel exchange rates. The Government moved immediately on taking office to resolve the growing financial crisis. Increases in public sector prices and a more rapid depreciation of the boliviano boosted revenues. Public confidence returned, bank deposits increased sharply, and international reserves recovered. 14. Success in controlling public sector wages was mixed. Wage rates increased by less than the inflation rate, despite demands for higher wages supported by strikes and considerable public unrest towards the end of the year. However, these data may not adequately reflect reported increases in bonuses and non-wage payments. There appear to have been significant increases in employment in the public enterprises, and there is some evidence that the wage bill of the nonfinancial public sector increased in the fourth quarter (after taking into account seasonal factors). This increase could  - 6 - imply difficulties in 1990 if future increases in wage levels are based on the fourth quarter level. However, the Government has taken steps to control wage increases (particularly in Social Security) and reduce employment in the central administration. 15. The increase in public sector prices and more rapid depreciation of the boliviano contributed to a rise in inflation to 30? (at an annual rate) in the second half of 1989. Initially, many firms increased prices by much more than required by the impact of higher energy prices on costs, perhaps reflecting fears of a renewed inflationary spiral. By the end of the year, when prices continued to rise by 22 a month, there was some concern that the new Government's more aggressive exchange rate policy would have too high an inflationary cost. Fortunately, inflation moderated in the first half of 1990. Table 1.2: Key Economic Variables. 1986-89 (percentage change) 1986 1987 1988 1989 Real Exchange Rate la 239.8 3.8 5.1 4.5 Real Interest Rate /b 18.8 22.0 17.9 16.1 Consumer Prices 276.3 14.6 16.0 14.3 Terms of Trade -32.8 -9.1 -14.6 1.2 /a Real effective exchange rate calculated by the IMF. /b Average interest rate on bank lending, deflated by change in the consumer price index. Sources: IMF, Banco Central de Bolivia, National Institute of Statistics 16. Debt Negotiations. Bolivia achieved considerable success in reducing its debt burden last year. An agreement with Argentina extinguished US$697 million in Bolivia's long-term debt to Argentina, along with US$107 million in short-term arrears. In return, Bolivia renounced claims to US$328 million of Argentina's arrears in payments for gas shipments. Bolivia concluded an agreement with Brazil which established a menu of options for retiring Bolivia's arrears and for paying future debt service. In accordance with this agreement, Bolivia retired its US$140 million of arrears through purchasing Brazilian debt (at an average discount of 74Z) in the secondary market and swapping this debt for Bolivia's obligations to Brazil. Further negotiations still will be necessary to settle the remainder of the debt. Progress also was made in retiring commercial bank debt. Bolivia's debt to the commercial banks stood at US$683 million in 1987, of which US$253 million was retired through the buyback operation that ended in 1988. Bolivia also  has swapped US$204 million for investment bonds and received US$16 million as a donation, leaving a total of about US$210 million remaining. Further retirement of debt will depend on the willingness of commercial banks to offer the remaining debt. Finally, the Paris Club granted Bolivia the concessional debt relief terms proposed at the Toronto summit, rescheduling US$288 million due in 1990-91. 17. Altogether, these agreements have had a substantial impact on easing Bolivia's debt burden. Debt stood at 99% of GDP in 1988, and declined to 79% of GDP in 1989, despite net long-term borrowing of 6.5Z of GDP. We estimate that the Argentina and Paris Club agreements will reduce debt service by about US$241 million in 1990 (compared to scheduled payments in the absence of these agreements), or 5X of GDP. Still, debt citstanding is projected to equal 782 of GDP by end-1990, and debt service owed 441 of exports. C. Structural Policies 18. Overview. The Government of Paz Zamora has maintained the basic commitment to macroeconomic stability and minimal state interference in market decisions initiated by the previous Government. The agenda for reform remains considerable, however. The investment code should be adopted by Congress to ensure equal treatment between domestic and foreign investors and simplify registration requirements. The laws governing hydrocarbons and mining investment should be revised to provide for joint ventures between the public and private sectors, adopt a more efficient tax regime, and permit greater private sector participation in the exploitation of Bolivia's natural resources. Work must progress on the privatization program, to reduce actual and potential drains on public sector revenues and improve efficiency. Much remains to be done to simplify administrative procedures, reduce the steps necessary for export approvals, and avoid other bureaucratic constraints which slow production and provide opportunities for corruption. Reforms to the financial system are necessary to facilitate a reduction in real interest rates and increase the supply of capital at longer maturities. A reallocation of social sector expenditures is essential to improve efficiency and focus public sector efforts on assisting the poor. Provisions of the recently issued Supreme Decree 22407 directed at poverty alleviation remain to be clarified by regulations, and need to be reviewed in terms of their efficiency and implications for expenditures. 19. Investment Laws. The Government recently submitted a set of changes to the laws governing private sector investment to Congress. An investment code would guarantee stable rules of the game for private investment, ensure equal treatment to domestic and foreign investors, prohibit restrictions on profit repatriations, and simplify procedures for registration of foreign investors. Passage of this code is essential to reassure investors of the public sector's long-term commitment to encouraging private sector development. While most of the provisions of the code are already in force, legislative sanction would increase the credibility of the policy regime and greatly encourage increased :nvestment. Codes for mining and hydrocarbons would provide legislative sanction for joint ventures between COMIBOL and YPFB and the private sector, thus increasing the potential for private sector  participation in developing Bolivia's natural resources. The hydrocarbons code would also expand the areas eligible for private sector exploitation, and the mining code would authorize an optional tax regime that is consistent with tax policy in the home countries of most multinational enterprises. In the past, monopolization of promising reserves by relatively inefficient public sector companies has constrained development. These laws would facilitate access to foreign capital and technology, and encourage more efficient exploitation of Bolivia's considerable natural resources. 20. Public Sector Administration. The Government has proposed necessary revisions to laws governing public sector administration. The SAFCO law establishes uniform procedures for public sector accounting that will enable the central administration to control expenditures more effectively. The initial stages of the SAFCO system are already in place, and have proven invaluable in improving the efficiency of administration. The recent approval by Congress of the law will ease the acceptance of the new procedures throughout the public sector. The Government has also proposed going forward with a privatization program. Privatization would remove actual and potential drains on public sector revenues, particularly in the Regional Development Corporations which inherited the smaller state enterprises decentralized early in the Paz Estenssoro administration. Privatization also should be considered for some municipal services. The former Government created a commission to study the potential for privatization, but its work was suspended due to failure to enact the privatization law. Thus, considerable work remains to be done to identify candidates for privatization, estimate their value, and establish procedures for public auctions. 21. Little progress has been made on efforts to rationalize public sector salary levels. The Bolivian public sector has a high level of employment at low wages. Inadequate public sector wages imply poor administration, because the public sector can not attract sufficiently qualified personnel, workers are forced to undertake additional jobs to protect their standard of living, and the acceptance of corruption increases. The generally low level of salaries has meant that high-priority activities, especially if financed by donors, have used wages outside the normal salary scale. For example, one of the reasons for the considerable success of the Emergency Social Fund was that employees were paid higher salaries than in other central government agencies. Presently, donors finance a significant proportion of high-level public sector employees, mostly as local consultants serving in line positions. This ad-hoc system developed because it was impossible to attract qualified personnel to carry out donor programs at normal salaries. However, this practice has in turn contributed to the chaos in Bolivian salary policy, and competition among donors may have raised the cost of higher-level personnel unnecessarily. As a preliminary step to addressing this problem, a recent agreement was reached among donors in La Paz to ensure more uniform salaries in donor-financed activities. As part of a more comprehensive solution, IDA has proposed to assist establishment of a unified scale of salaries for a key group of professional and technical personnel. Salaries for this group would be supported by donor agencies, but in a transparent way that would eliminate excessive job-switching in search of higher salaries. A concerted effort to rationalize salaries, in conjunction  - 9 - with improvements in management, is essential to improve the efficiency of public sector administration. 22. Reliance on foreign agencies for procurement has speeded processing and reduced corruption, compared to the previous system. However, further improvements are necessary to make the present system more efficient and eventually to raturn responsibility for procurement to Bolivian agencies. In the short term, a number of changes should be considered to reduce delays and lower costs for procurement, including: a) raising the threshold below which goods do not need to go through the procurement agencies; b) encouraging all donors to accept the procurement agencies' fees as eligible expenditures for financing; c) encouraging the procurement agencies to specialize in some technical fields; d) requiring the agencies to provide more information on their prices and services; e) setting target periods of time within which key steps in the procurement process should be completed; f) reaching agreements with the procurement agencies on the amount of work (including in which technical areas) expected in the near future, to improve planning; g) giving procureme-nt agencies the power to award contracts tnemselves in exceptional cases whexe time is very short; and h) holding an annual seminar on procurement to discuss these measures. Over the long term (on the order of 5- 10 years) Bolivian public agencies must assume responsibility for procurement, and steps should be taken now to begin the transition back to a Bolivian- managed procurement process. Measures which should be considered to facilitate this transition include gradually raising the threshold above which procurement must be entrusted to the foreign agencies, encouraging the agencies to hire progressively more Bolivians, and continuing efforts to strengthen accounting systems and financial management in public enterprises. 23. Financial System and Investment. The low supply of capital continues to constrain Bolivian development. Real interest rates remain very high. Lending rates are now about 22Z in dollar terms,iJ and most loans are made at very short maturities. (The Banco de Santa Cruz recently introduced a limited supply of longer maturity loans, but time will be required to judge the impact on overall lending practices.) It is very difficult to undertake even profitable investments on short-term, high interest rate loans. High interest rates and short maturities are due to uncertainty over t".e permanence of recent policy reforms. Deposit rates of 5-6 percentage points above LIBOR are required to keep short-term dollar deposits in Bolivian banks (see Table 1.3). The experience of 30 years of state intervention in markets and the hyperinflation are too-vivid reminders of the potential for a deterioration in policy performance. A number of years of low and stable inflation will be necessary before intere3t rates decline to international levels. 24. Financial sector weaknesses have contributed to the high level of interest rates by maintaining a large spread between deposit and lending rates. Some banks hold a significant share of their assets in companies in very poor financial condition. These companies are a strong source of demand We refer to bank lending rates. Informal sector moneylenders charge much higher interest rates.  - 10 - for further loans to cover debt service payments and fnrestall default. Banks may accommodate this demand as an alternative to taking a loss on a noticeable share of their portfolio. Further, the weaker banks remain saddled with high average costs as a result of the dedollarization mea sure of 1982, the redu-tion in their scale of operation since the early 1980, and the high infrastructure costs remaining from expansion of personnel and branches during the hyperinflation (although some adjustments have been undertaken). Table 1.3: Financial Indicators (percent, end of period) 1986 1987 1988 1989 Lending Rate /a 22 26 22 22 Deposit Rate /b 15 18 16 16 Spread Ic 7 8 6 6 Real Lending Rate /d 19 22 18 17 LIBOR le 7 6 7 9 Difference Between Domestic and International Rates 8 12 9 7 la Average dollar interest rate on short-term loans. /b Average dollar interest rate on short-term deposits. /c Difference between lending and deposit rates. /d Deflated by the US GNP Deflator /e Six-Month London InterBank Offer Rate Source: Superintendency of Banks 25. It also is possible that the small number of banks has muted competitive pressures, permitting higher than normal spreads (line 3 of Table 1.3) and slowing the necessary adjustment to present economic conditions. It is difficult to judge the extent of collusion among banks, but the small number of banks dominating the system provides the opportunity for anticompetitive practices. Lack of competition will constrain efficiency improvements, even given effective banking supervision and market determination of interest rates. The return of the international banks which left Bolivia in the early 1980s would increase competition and help to lower spreads between deposit and lending rates. This return would be facilitated by the retirement of the remaining commercial bank debt, a project in which the Government has achieved considerable success and which deserves donor support (see above).  - 11 - 26. This description of the financial sector has disturbing implications beyond the level of interest rates. While supervision of the banking system has improved greatly over the past few years, the financial position of banks remains precarious. Table 1.4 shows that some indicators of solvency and liquidity have shown a deterioration over time, although this may reflect improvements in information due to the Superintendency's program of audits. Still, it is disturbing that capital and reserves have declined relative to assets and to overdue loans. Considering that the deposit base of the banks is largely short-term dollar deposits and subject to considerable instability (as demonstrated in the run on deposits during last year's political transition), it is difficult to overstate the problems affecting the Bolivian financial system. Table 1.4t Commercial Bank Portfolios (Percent, end of period) 1987 1988 1989 1990 (March) Overdue Loans/Total Loans 11.8 9.7 9.3 11.7 Provisions/Overdue Loans 38.1 27.6 25.6 18.7 Capital+Reserves/Assets 12.9 7.5 6.1 5.5 Overdue Loans/Capital+Res. 56.2 82.9 98.7 138.5 Note: Refers to private commercial banks only. Excludes banks closed in 1987. Source: Superintendency of Banks 27. Thus, strengthening of the financial sector is essential to maintain stability and facilitate a reduction in interest rates. The Government has made considerable progress in this area. Creation of the Superintendency of Banks has strengthened supervision and greatly enhanced the availability of information on the banking system, while assistance from international donors has been used to improve bank portfolios. These efforts must be continued. It is particularly necessary to move towards market interest rates on development credits to reduce distortiona in the financial system. In addition, the elimination or reorganization of public sector banks would improve the soundness of the banking system. The Government has moved slowly in this area. Reorganization plans for the Banco del Estado, the Banco Minero, and Banco Agricola were submitted by the previous Government to fulfill conditions relating to IDA's Financial Sector Adjustment Credit, but little further progress has been made. It appears now that the most efficient solution would be to eliminate the two sector banks while limiting the operations of Banco del Estado to serving the public sector.  - 12 - 28. Social Sectors. The Government's policy statements have stressed the need to improve the position of Bolivia's poor. Some initiatives have been undertaken to address poverty. The creation of the Fondo de Desarrollo Campesino holds some promise of assistance directed at poor communities. The Ministry of Health, with assistance from international donors, is beginning an ambitious program to increase the coverage of basic health services. The Government has established the Social Investment Fund, the successor institution to the Emergency Social Fund, which will finance investment in the social sectors. While these programs appear well-designed, it is too early to evaluate their impact. 29. Supreme Decree 22407 included plans to expand public services to the poor. However, neither the proposals nor the sources of financing are sufficiently explained. The Decree proposes that all Bolivians receive a minimum income, including those working in the informal sector. It is not clear how this would be administered; it would be extremely difficult to collect objective information on wages paid to inform:i sector workers. The implications for expenditures, while unknown, could well be significant. Finally, setting a minimum income is not the most effective means of assisting the poor, given the potential for abuse. The Decree also mentions expanding the coverage of the Social Security System. The Social Security system is inefficient and inequitable, suffers from a number of organizational problems, represents a drain on resources for the underfunded public health system, is devoted to curative care rather than higher-priority primary care, and perhaps should be closed. At a minimum, a thorough review of procedures and a radical reorganization is necessary before expansion could be done in an efficient manner. As stated in the Policy Framework Paper, the Government intends to evaluate a transformation of Social Security to a capitalization system with private sector participation. 30. Instead of proposing new programs with uncertain financing, the Government needs to come to grits with the issue of improving the efficiency of social sector expenditures.2- Given the shortage of resources, a reallocation of expenditures within health and education is essential to ensure that efforts in these sectors address the poor. Subsidies to universities must be reduced and underutilized hospitals closed, while increasing access to primary education and basic health care.3/ In education, ghost teachers must be removed from the books; personnel rules changed to provide more flexibility in hiring, teacher assignments, and salary levels; and a rational system adopted for coordinating investment and current expenditures. Expenditure reform is certain to be met by considerable political opposition, but is necessary to achieve any substantial progress in alleviating poverty. 21 A discussion of efficiency in social sector spending is included in Bolivia: Public Sector Expenditure Review with a Special Emphasis on the Social Sectors (7746-BO), dated September 15, i989. 3/ For an analysis of expenditures on higher education, see the Poverty Report in Bolivia (8643-BO). A discussion of investment in the health sector is included in Chapter III of the present document.  - 13 - 31. Conclusion. Maintenance of low and stable inflation, improvements in the laws governing investment, and strengthening of the financial system are all necessary for development. However, confidence and sustainabil'ty of the economic program depend on more than these. For lack of alternatives, limiting the fiscal deficit has required strict controls on public sector wages and extremely low expenditures on social services. In addition, limitations on expenditures has made it difficult to effect necessary infrastructure investments which would increase the productivity of private investment. There is a fundamental dilemma that, while stability is a prerequisite for growth, measures to achieve stability can undermine long-term development. Private agents will not be ignorant of the potential for social disruption and policy reversals inherent in such a fragile stability. Since the budget constraint can not be avoided, the only way out of this dilemma is to improve the efficiency of expenditures. These measures in themselves entail risks, and are certain to be resisted by some groups. However, development depends on such improvements, as much as it depends on reducing the public sector deficit and maintaining a liberal economic environment.  - 14 - CHAPTER IIs MEDIUM-TEBM PROSPECTS A. Introduction 32. Bolivia over the past four years has reduced inflation to low levels and made important progress towards establishing an appropriate framework of incentives to encourage private sector growth. However, recovery from the crisis of the early 1980s has been slow. Despite the high quality of the Bolivian adjustment program, difficult structural problems and uncertainty over the maintenance of current policies remain impediments to growth. Policy reforms discussed in this report, including a more efficient use of investment funds, increased expenditures on health and education, more vigorous tax administration, establishment of an adequate legal framework to encourage investment, and improvements in administrative efficiency, are essential to development. In this chapter, we discuss the link between these policies and the sustainability of fiscal and monetary policy, prospects for the growth and diversification of exports, and the outlook for the balance of payments and debt. D. Fiscal and Honetary Policy 33. Introduction. Providing the public services necessary for long- term development is a difficult task in Bolivia. The public goods essential to growth are in extremely scarce supply: infrastructure is inadequate; health and education services are insufficient; and low public sector salaries seriously impair the efficiency of administration. Maintenance of a iow fiscal deficit at inadequate levels of public sector expenditures will ensure both stability and stagnation. Substantial opportunities exist for efficient reallocation of expenditures. Many areas of potential savings were discussed earlier in this report: privatization of state enterprises, elimination of inefficient public sector investments, reduction in public sector employment, and more efficient management of current expenditures. Still, even taking into account potential savings, it is likely that achieving an adequate level of public services will require increasing expenditures above present levels. 34. These expenditures must be financed without either endangering price stability or incurring unacceptable levels of debt. Sources o' financing include taxes, sales of goods produced by the public sector, external borrowing, internal borrowing, arrears, and inflation. While it is essential to increase tax collections through more effective administration, in Bolivia tax revenues tend to be highly inelastic with respect to tax rates, due to the substantial opportunities for evasion. Thus, the rise in revenues to be expected from domestic taxes is strictly limited. Efforts are underway to raise revenues through sales of goods, particularly through public sector exploitation of Bolivia's hydrocarbons reserves. However, these projects entail considerable risks and could be managed more efficiently by the private sector. The supply of external borrowing at concessional terms is limited, and Bolivia lacks the ability to service loans at harder terms. Few expenditures can be financed through internal borrowing because capital markets are extremely thin in Bolivia. The value of Central Bank Certificates  - 15 - of Deposit (the only form of Government borrowing in the internal market) traded is low, and domestic interest rates are high in real terms. Any expenditures not covered by the measures listed above imply increasing arrears or money issuance. Private sector confidence and efficient operation of markets require strict limits on public sector arrears and the inflationary finance of expenditures. Given recent history, inflationary expectations in Bolivia are very sensitive to money financing of deficits. The credibility of the Government's economic program requires low and stable inflation, with little opportunity for resort to the inflation tax. 35. Public Sector Deficit in 1989. The deficit of the nonfinancial public sector was 5.0? of GDP in 1989, composed of a 1.32 primary deficit (total revenues minus non-interest expenditures) and 3.8Z of GDP in interest due on external debt (see Table 2.1). Additional demands on public sector resources resulted from some expansion of domestic credit (probably tied to operations to assist banks in difficulty during the run on deposits last summer) and the need to repay arrears. The 5.2Z of GDP in long-term external loans was not sufficient to cover all of these expenses, so that changes in reserves financed 3.1X of GDP. Further progress in deficit reduction was achieved in the first half of 1990, when the deficit of the nonfinancial public sector fell below 3Z of GDP (at an annual rate). Even so, a shortfall in disbursements from official donors resulted in a rapid expansion in domestic credit to finance public sector expenditures. 36. While the deficit fell both in 1989 and in the first half of 1990, this presentation of the public sector accounts raises some troubling questions for the future. The large fall in reserves is disturbing, as Bolivia's net reserves reached very low levels in the first few months of 1990. Perhaps more importantly, the high level of the nonfinancial public sector deficit, and particularly of the primary deficit, implies the need for further corrections in fiscal policy to avoid an unsustainable rise in public sector liabilities. This issue can best be explored by considering medium- term projections for the public sector accounts.  - 16 - Table 2.1t Financing of the Public Sector Deficit. 1989 Million Bolivianos Percent of GDP Need for Finance 978 8.0 Deficit, Nonfinancial Public Sector 613 5.0 Primary Deficit 161 1.3 Interest Owed 452 3.8 Net Domestic Credit la 182 1.5 Reduction in Arrearp 183 1.5 Financed By: Money Issuance -26 -0.2 Change in Long-Term External Debt /b 626 5.2 Nonfinancial Public Sector 258 2.1 Central Bank 368 3.0 Change in Reserves Ic 378 3.1 /a Also includes official capital and surplus and unclassified assets. /b Does not include stock adjustments due to exchange rate changes, the retirement of commercial bank debt, or the elimination of the debt to Argentina. /c Includes IMF lending under the Enhanced Structural Adj3stment Facility, and thus differs in definition from the change in reserves shown in the balance of payments. Note: Details may not sum to total due to rounding. 37. Base Case Proiections. Our base scenario illustrates a possible evolution of public sector accounts which would achieve the rise in public sector expenditures necessary for development while limiting the increase in public sector debt and avoiding recourse to excessive money creation (see Table 2.2). The base case projections envision an increase in total revenues of the nonfinancial public sector from 28.6Z of GDP in 1989 to 31.02 of GDP by 2000. This rise in revenues is accomplished in the face of an anticipated fall in trade taxes of 0.82 of GDP, owing to a reduction in import duties. The rise in tax reform revenues from 5.72 of GDP in 1990 to 6.82 of GDP in 2000 is due to continued efforts to improve enforcement, which would be a preferable means of raising revenues than increasing tax rates. However, the latter also may be necessary if the revenue gains from administrative measures are not suffi:ient. The Government also is projected to benefit from a rise in energy prices, which will increase revenues from domestic and foreign sales of natural gas and liquid fuels. On the expenditure side, control of the public sector wage bill coupled with reductions in public sector employment to permit payment of adequate salaries is essential to achieve the base case projections. However, some savings in wages will be balanced by increases in  - 17 - operations and maintenance expenditures. Altogether, non-interest current expenditures are projected to decline only slightly, from 22.6? of GDP in 1989 to 22.32 in 2000. The increase in revenues will permit a rise in public sector investment relative to income, from 7.42 of GDP in 1989 to 8.5? by 2000. This rise in investment will only make a real contribution to development if unnecessary projects of the kind discussed in Chapter III are avoided. Table 2.2: s onfinwcial Public Sector Accouts. 1989-2000 (percent of GDP) 1989 2000 Revenues 28.6 31.0 Tax Reform Revenues 5.7 6.8 Trade Taxes 1.8 1.0 Sales of Public Sector Goods 17.8 19.6 Other 3.3 3.6 Primary Expenditures 30.0 30.8 Current Expenditures 22.6 22.3 (excluding interest) Investment 7.4 8.5 Primary Balance -1.3 0.2 Interest Owed 3.8 1.7 overall Balance -5.0 -1.5 Notet Details may not sum to total due to rounding errors. 38. Assuming that the policy targets described above are achieved, the primary deficit of the nonfinancial public sector shou d fall from 1.3? of GDP in 1989 to a surplus of 0.2Z of GDP by the year 2000.41 The primary deficit averages 0.32 of GDP per year from 1990-2000. Other demands on public sector resources, on average over the next 10 years, would include: 1.O of GDP per year to finance the Central Bank's contribution to net domestic credit 4/ The primary deficit is the most relevant indicator of fiscal performance, since once the primary deficit is determined, the interest burden which results is largely independent of Government decisions.  - 18 - expansion, largely through credit lines funded by external donors; 0.5S of GDP per year to maintain a minimum level of net reserves; and 2.52 of GDP per year to meet projected external interest obligations. Altogether, the demand for finance should average 4.3% of GDP per year from 1990-2000 (second half of Table 2.3). 39. The public sector's demand for resources equal to 4.32 of GDP per year should be financed almost entirely though external borrowing and revenues from seignorage. Net external lending to the public sector, largely at concessional terms, is projected to average 3.3Z of GDP a year from 1990-2000. We assume that Bolivia borrows all it can in the external market at an average interest rate of about 3Z, rather than increasing domestic debt at an interest rate of 152 (both interest rates are on dollar-denominated debt). Since the rise in external debt necessary to finance the deficit is slower than that of GDP, the external debt to GDP ratio improves from 792 in 1989 to 53? by the year 2000. Econometric estimates of the demand for money sbow that the increase in the supply of money base consistent with low inflation would average 0.8% of GDP per year.51 In conclusion, the public sector can finance the necessary increase in expenditures without an unsustainable rise in debt or resorting to inflationary levels of money creation. 40. There are two reasons why the base case provides a rather conservative estimate of the financeable deficit. As time goes on, increased private sector confidence should raise money demand. The monetary base equals only about 9? of GDP in the heavily-dollarized Bolivian economy, so that substantial room remains for monetization. Increased demand for money would represent higher seignorage to the Government, which would enable the public sector to run a higher deficit without increasing its liabilities. However, the increase in seignorage would be a one-time gain only, whose magnitude is not clear. We therefore have not included this potential gain in the base case projections. In addition, the Government could finance a higher level of expenditures through increasing domestic debt, which is now equivalent to only about 2% of GDP. Still, given the excessive interest rates on domestic debt, it is more prudent to limit reliance on domestic borrowing and to finance increased expenditures through a moderate rise in revenues (relative to GDP) and external borrowing. 41. These results show that the base case projections of public sector accounts are feasible while maintaining the economic program, but they do not imply that the projected deficit or expenditures are optimal. This latter judgment would depend greatly on the efficiency of the expenditures undertaken, the productivity of alternative use of resources, the distortionary impact of taxation, and intertemporal consumption choices. A more rigorous analysis may well show that a different level or time path of expenditures, revenues, and financing would be desirable. The purpose of this exercise is not to show how the economy should evolve, but rather to illustrate the constraints which must guide public policy. 5I The demand for money is estimated as a function of inflation, interest rates, and lagged money (see Annex I).  - 19 - 42. Implications of a Hither Primary Deficit. Fs- lure to achieve even the small primary surplus assumed in the base case projections would have serious implications for public sector finances. It is possible that the improvements in tax administration and tight control of public sector wages underlying the base case would not occur. To illustrate the very thin margin for error facing the Bolivian public sector, we explore the implications of a continuation of present fiscal performance, represented by a primary deficit averaging 1.3Z of GDP (the 1989 level) for the next ten years. 43. Since the supply of concessional loans to Bolivia is limited and the public sector is not creditworthy for commercial bank lending, the higher deficit would have to be financed through issuing some combination of money or domestic debt. We do not believe that Bolivia could generate significant revenues through the inflation tax, because the experience of hyperinflation has greatly increased the sensitivity of the Bolivian public to excessive money creation. Any indication that the Government intends to increase money issuance above the demand for real balances would immediately and sharply reduce the demand for money. Thus, the public sector would have to issue domestic debt to finance the increased deficit. To finance a primary deficit averaging 1.3Z of GDP from 1990-2000 plus related interest payments, domestic debt would have to increase by 2.6Z of GDP per year. 44. Increases of domestic debt of this magnitude would be unacceptable. Chart 2.2 shows the increases in corresponding domestic interest payments, the overall deficit, and debt which would result, as a percentage of GDP. At present levels of interest rates on Government debt (152 on dollar-denominated certificates of deposit), domestic borrowing to finance the non-interest deficit and interest payments on the additional debt would increase domestic debt to over 192 of GDP by the year 2000, compared to about 21 in 1989. Interest payments on domestic debt would reach 2.6? of GDP by 2000. Note that the private sector would have to be willing to lend the Government the requisite finance at the current real interest rate of 1OZ. This is doubtful, and in any event continued high interest rates would strangle the necessary recovery in private sector investment.  - 20 - Table 2.1S linanclna the Public Sector. 1990-2000 (yearly averages, as a percent of GDP) Continued Primary Base Case Deficit at 1989 Level Projections (1.3% of GDP) (-0.12 of GDP) Need for Financet 6.7 4.3 Deficit, Nonfinancial Public Sector 5.2 2.8 Primary beficit 1.3 0.3 External Interest 2.5 2.5 Domestic Interest 1.4 0.0 Central Bank Domestic Credit 1.0 1.0 Change in Reserves 0.5 0.5 Financed by: External Lending 3.3 3.3 Money Issuance 0.8 0.8 Domestic Debt 2.6 0.2 Memorandum Items Domestic Interest Payments, 2000 2.6 0.1 Net Domestic Debt, 2000 21.0 1.0 45. This dramatic increase in domestic debt results in part from the abnormally high real interest rates in the Bolivian economy. With continued macroeconomic stability, it is likely that interest rates would decline over time. It is useful to explore the implications of lower interest rates for the scenario described above (first half of Table 2.3), to demonstrate that a continued high pimary deficit would be unsustainable even with relatively low interest rates.-1 A primary deficit which averaged 1.31 of GDP with a real interest rate of 6? from 1990-2000 (instead of the 102 assumed in the scenario) would imply a rise in debt to 15? of GDP by 2000. Thus, even assuming that interest rates fall substantially, debt still would increase at an unsustainable rate. 46. Conclusion. Further improvements in fiscal performance are requireu to ensure the sustainability of the public sector financial accounts while achieving the increase in expenditures necessary for development. Improvements in policies must involve both the level of expenditures and revenues and their composition. Controls on current expenditures are essential, but can not be enforced at the price of a deterioration in public 61 To some extent this is an artificial exercise, as interest rates would be unlikely to decline in the face of a continued high rate of borrowing by the public sector.  - 21 - sector admiuistration. The Government has no choice but to reduce public sector employment while increasing salary levels for key personnel. The failure of the Government to make any progress in implementing the public sector management scheme and reported increases in the wage bill in 1989 and early 1990 (discussed in Chapter I) thus have disturbing implications for the sustainability of fiscal policy over the long term. Similarly, increases in public sector investment are necessary to provide the public goods essential to development. However, the inclusion of unnecessary and overly-expensive projects (discussed in Chapter III) would represent an added fiscal burden with little contribution to development. C. Export Prospects 47. Overview. Export growth and diversification are essential to Bolivian development. Historically, exports have been dominated by the exploitation of Bolivia's vast mineral and hydrocarbon resources, along with occasional export booms in agricultural products (for example rubber, cotton, and most recently, soya) which have been quickly reversed with changes in market conditions. Bolivia needs a healthy, diversified export sector to produce at efficient scale and assure a stable supply of foreign exchange, so that development of industrial and agricultural exports (referred to hereafter as non-traditionals) is essential. However, the obstacles to improving export performance and increasing diversification are considerable. Poor infrastructure and the difficult terrain impair the competitive position of Bolivian goods in the international market. Inadequate health and educational services, a history of labor disputes, and deep racial and class divisions limit the flexibility of the economy to respond to changes in market conditions. The preponderance of hydrocarbons and minerals exports, heavy inflows of official capital, and the supply of foreign exchange from illegal coca exports have kept the market exchange rate below the level compatible with substantial increases in industrial or agricultural production. 48. Since 1986, low inflation and a liberal incentive structure have provided the framework necessary for an expansion of private sector production and exports. These policies, along with a moderate depreciation of the boliviano and introduction of direct export incentives, contributed to the rapid growth of private sector mining and non-traditional exports registered in 1989 (see Table 2.4). Bolivia has the potential to achieve a radical shift in export composition in favor of non-traditional exports and non-tin mining. Realizing Bolivia's export potential will require maintenance of the present macroeconomic framework, along with institutional reforms to remove bureaucratic obstacles to export development.  - 22 - Table 2.4s Elxort ReceiPts. 1987-89 (US$ millions) History Estimate 1987 1988 1989 Total Exports 519 542 723 Hydrocarbons 256 219 214 Minerals /a 158 215 305 Non-traditionals 106 108 204 Memorandum Item Export Volume Growth (Z) -9.4 12.9 21.7 /a Net of realization costs. 49. Hydrocarbons. Bolivia's experience with natural gas exports to Argentina demonstrates the benefits and dangers involved in heavy dependence on a single export commodity, particularly to a si..gle consumer. Bolivia supplied natural gas to Argentina worth US$214 million in 1989, but received only US$119 million (not including partial payments on 1988 arrears). The total of US$314 million in arrears accumulated by Argentina between 1986 and 1989 were swapped for US$803 million in Bolivian liabilities to Argentina, composed of Bolivia's interest arrears and the balance of Bolivia's long-term debt to Argentina. This agreement did little to improve Bolivia's serious cash flow problem. Bolivia also accepted a 101 cut in the price of future gas shipments. However, the agreement did eliminate US$55 million per year in interest obligations and cut Bolivia's long-term debt by 162 relative to the stock outstanding at end-1988. The crucial issue remains Argentina's willingness and ability to make current payments in light of the chaotic economic conditions in that country. While payments resumed immediately following the August 1989 agreement, as of end-June 1990 Argentina was one month in arrears. Thus, the level of Bolivia's export receipts and public sector revenues remains uncertain. 50. Bolivia's hydrocarbons reserves provide a significant opportunity for increasing export receipts, albeit with considerable risk. Bolivia and Argentina have agreed to set up a new company which would undertake to market Bolivian natural gas for the ten years following expiration of the present contract in 1992. Preparation of a projec; to sell electricity, urea, and polyethylene to Brazil is also underway.7i A project to sell natural gas directly to the Sao Paulo market also has been discussed, although this would be a substitute to the latter project rather than an additional source of export revenues. Increased exploration and development of natural gas fields 7/ Section 3 of this chapter explores the risks and benefits of the Brazilian project.  - 23 - to serve these projects will provide greater opportunities for liquids production, which may permit some increase in petroleum exports. The Brazil projects, as now conceived, involve heavy public sector participation, the borrowing of large sums at nonconcessional terms, and dependence on continued payments from Brazil. The risks involved in this scheme of development have been dramatized by the recent interruptions in payments by Argentina. These risks should be reduced by obtaining sufficient guarantees of payment from the purchasers and by increasing private sector participation in investment and management of the projects. 51. Mining. Preliminary data indicate an increase in metals export revenues, from US$215 million in 1988 to about US$305 million in 1989, despite the sharp fall in the price of tin in the latter half of the year and slowness in reactivating COMIBOL's mines. This increase was due to higher exports from private sector mining (including cooperatives), which made up slightly more than 50? of the value of mineral exports in 1989. 52. The decline in importance of tin in minerals exports since the collapse of international prices in late-1985 is likely to continue. Revenues from tin equalled 712 of total minerals exports in 1985, but by 1989 had fallen to 41Z. Tin exporters have fallen on hard times. Tin prices dropped to almost US$2 a pound in late 1989, well below the costs of production for most Bolivian tin mines. Failing a stronger recovery in prices than now anticipated, it will be necessary to close some of COMIBOL's mines. Exports of tin are projected to fall by 282 in current prices in 1990. 53. Prospects for non-tin mining are brighter. Revenues from non-tin metals exports increased by 30? in 1989, owing to a more than doubling of zinc exports with the sharp increase in international prices. For the future, we expect significant increases in silver, zinc, and gold exports, the two former products due to likely price increases and the latter because of large investments now being undertaken by the private sector. Presently there are at least 14 foreign businesses working or negotiating contracts with local mining interests; two large international firms have bought shares of the most important Bolivian mining companies. These investments show the likelihood of continuing growth in non-tin mining for some years to come. 54. Non-traditional EMDorts. Non-traditional exports (in Bolivia meaning all goods exports other than mining and hydrocarbons) rose well above expected levels last year. Official data show a near doubling of non- traditional export revenues, from US$108 million in 1988 to US$204 million in 1989, and to 282 of total export revenues compared to 202 in 1987-88. Major export products included timber (US$44 million), soya (US$54 million), sugar (US$19 million), hides (US$15 million), and coffee (US$13 million). These increases are a welcome sign of a more diversified export base and the growing importance of the private sector in Bolivian exports. However, higher non- traditional exports do not necessarily imply a transition from extraction of raw materials to greater local processing. More than 702 of the value of non- traditional exports are considered primary goods, 20? semi-processed goods, and only 10? are final goods. For example, exports of food are generally of basic crops, Bolivia's wood exports are mostly logs, and skins are exported after application of a simple preservative.  - 24 - 55. The increase in non-traditional exports was due to a number of factors. The boliviano depreciated by 4.5? in real terms in 1989 and by 5.1Z in 1988, and anecdotal evidence indicates that competitiveness has improved. Two years ago, interviews with private sector representatives emphasized the exchange rate as the key constraint on domestic production, while this year there was a general perception that the exchange rate was at a reasonable level. Improvements in river transport helped to remove one of the principal constraints on soya exports. Exports of various products rose sharply to both Peru and Argentina, perhaps aided by shortages in the former country. However, the most important influence on raising non-traditional exports was implementation of the Certificado Reintegracion Arancelaria (CRA), under which exporters of non-traditional products received a payment equal to 102 of the gross value of their exports, intended to compensate for import duties on their inputs (see below). 56. Short-term prospects for non-traditional exports appear good. The area under cultivation of soya has increased rapidly, in part thanks to rotation with winter wheat which permits much higher profits than soya alone could generate. However, this potential will not be realized if the drought affecting parts of the county persists this year. Plans exist for increasing production of coffee in a number of regions, although some recovery in international prices will be necessary. The United States agreed to more than double Bolivia's sugar quota in 1990 (worth about US$5 million in revenues), although the US sugar quota is scheduled to be eliminated in September 1990. The US will also permit a larger number of products from Andean countries to enter without payment of tariff, under the Generalized System of Preferences. Bolivian firms have improved their cutting and preparation of skins, and some companies have the capacity to increase their production of more processed goods, which may have a significant role in raising exports in the next few years. 57. Medium-Term Prospects. Bolivia has the opportunity to achieve an historic shift in the composition of its export products, from an export sector dominated by state-controlled tin mining and natural gas to private sector non-tin mining, agricultural products, and semi-industrial goods. This more diversified structure would, in turn, provide the base from which Bolivian firms could increase the level of processing and the technological sophistication of production processes. The beginnings of this change are already apparent: private sector production of metals has eclipsed that of the public sector, and the importance of agricultural products in exports has grown significantly. 58. Our base case export projections illustrate the potential of this shift in export composition. While growth in tin exports will remain limited due to international market conditions, Bolivia could rapidly increase exports of gold, silver, tungsten, antimony, and lead. Exports of natural gas are assumed to remain at present levels, due to the recent agreement to extend the contract to sell gas to Argentina. The agreement to sell electric power to Brazil is not included in the base case projections, but is considered in the scenario in section IV. Some increase in the volume of hydrocarbons exports results from projected sales of petroleum. Among non-traditional exports, the  - 25 - brightest prospects are for soya, coffee, sugar, and skins. Export revenues will be further increased by an expected improvement in the terms of trade. Table 2.5 provides a summary of the base case projections. Table 2.5& Medium-Term Export Pro1ections (percent) Commodity Volume Growth Composition 1986-88 1989 1990 1990-2000 1988 2000 Total Exports 2.3 21.7 6.9 5.5 100.0 100.0 Metals la -0.1 25.0 10.6 4.9 39.7 36.4 (of which)s Tin -19.8 35.0 -5.2 -0.5 10.9 7.6 Gold 164.8 -15.3 52.7 7.6 8.9 8.8 Silver 19.1 48.4 5.4 7.5 6.4 9.8 zinc 23.1 47.2 -12.6 4.5 8.6 13.7 Hydrocarbons 0.5 -2.5 0.8 0.2 40.3 23.3 Non-traditionals 7.5 84.5 15.5 9.3 20.0 40.2 Memorandum Item 1987 1988 1989 1990 2000 Export Revenues 519 543 723 738 1990 (US$ millions) 59. Government Policies. Reforms in public sector policies, beyond the basic necessity of maintaining macroeconomic stability and avoiding controls, would improve export performance. Some further increase in the real exchange rate would facilitate export growth. To encourage increased metals exports, it is essential that the Government permit private sector participation in the more promising minerals deposits, such as the Bolivar mine, and that the new tax code and joint venture provisions of the mining code be approved by Congress (see chapter III). 60. Improvements in infrastructure are needed. Greater investment is required (and is underway) in Bolivia's transport links to Brazil and to Chile, which handle the bulk of legal exports. Improvements in the administration of the railway could have a significant impact in reducing costs by avoiding unnecessary delays and reducing opportunities for corruption. The Government should consider permitting the private sector to operate wagons on ENFE's tracks. This would provide some healthy competition to ENPE's operations and lower the costs of transport, although it raises  - 26 - difficult problems concerning coordination between public and private sector operations. Improvements in the supply of power also are necessary. Interruptions in electrical service are common in areas of the country not served by the main power grid. To ensure continuous service and avoid damage to machinery, some companies have had to invest in relatively expensive energy sources, such as oil. Adequate and continuous availability of hydroelectric power would lower costs significantly. Of course, energy investments would have to be evaluated on an individual basis to determine their profitability. 61. One difficult issue of public policy concerns the CRA, an export subsidy under which the exporters of non-traditional products (excluding lumber) receive a certificate worth 1OX of the gross value of exports. This certificate can be used in payment of taxes, and is a negotiable document. Little difficulty is involved in obtaining cash for the CRA on the secondary market, at a varying discount which appears, on the basis of interviews, to average about 5? of the face value of the CRA certificate. As most non- traditional exports involve minimal processing, a 102 subsidy on gross value can be a very significant subsidy on value added. 62. Export subsidies of this type have a number of troubling implications. If all entitled exporters received the CRA and all of the certificates were redeemed last year, the program would have cost the Government about US$17 million, or about 5X of domestic tax revenues. Further, providing what may well amount to a considerable subsidy on value added will distort resource allocation. The often-expressed view that the CRA was essential to the boom in non-traditional exports in 1989 is evidence that a significant efficiency loss occurred by encouraging the export of goods that otherwise would not be produced or would be consumed at home.81 We also heard reports of fraud related to the CRA, for example cattle moving across the border to Bolivia in order to be re-exported to Brazil, and unknown firms appearing on the lists of exporters. The exporters associations are responsible for enforcement of the CRA system. While they have some incentive to catch cheaters, because a perception of widespread fraud would lead to cancelling the entire system, it is not clear how effective these organizations are in enforcement. Interviews with private sector representatives confirmed the likelihood of some violations, but it was felt that the number was minor compared to the level of export revenues covered. 63. A number of arguments are often presented for maintaining the CRh. Abrupt changes in the rules of the game lessen public confidence and penalize businessmen who invested on the basis of the former policy. Export diversification provides some benefit to the society as a whole by reducing the risk of a sharp reduction in foreign exchange due to changes in commodity prices. Government intervention may be necessary to enable firms to compete with the illegal coca trade for labor and capital inputs (although it is not clear why all legal products are not then subsidized). However, given the costs and distortionary impact of the CRA, it would be preferable to eliminate 8/ Bolivia exported 67 products in 1989 with a value greater than US$100 last year, compared to only 20 such products in earlier years.  - 27 - it or replace it with some other system. The Policy Framework Paper agreed to by the Government, the World Bank, and the INP provides for a phased elimination of the CRA in line with the reduction in import duties, and its replacement by a duty drawback scheme. This process is to be completed by December 1990. 64. Considerable scope exists for improvements in public sector administration to reduce impediments to exports. Presently, exporters must receive a number of approvals from different offices, all of which require time and provide the opportunity for corruption. Table 2.6 provides a summary of the administrative procedures involved.  - 28 - Table 2.6t Reauired APDrovals for EXport Requirement Office Company Registrations List of Tax Contributors Internal Revenue, Ministry of Finance Municipal Registry Municipality Commercial Registry Ministry of Industry (Directorate of Commercial Registry) Export Registry Ministry of Industry (Directorate of External Trade) Central Bank Export Registry Central Bank Health Certificate Ministry of Agriculture (Directorate of (agricultural products) Health) Coffee Certificate (Coffee) Bolivian Coffee Committee Artisans Registry (handicrafts) Bolivian Institute of Small Industry and Artisans (INBOPIA) Cooperative Registry National Institute of Cooperatives Individual Exports Commercial Invoice Ministry of Industry (Directorate of External Trade) Certificate of Origin Ministry of Industry (Directorate of External Trade), Customs Sanitary Certificate Ministry of Agriculture (Directorate of (agricultural products) Health) Sanitary Certificate Ministry of Agriculture (Directorate of (meat and skins) Health) Wood Certificate Forestry Center Artisans Certificate Bolivian Institute of Small Industry and Artisans (INBOPIA) Inspection Certificate Bureau Veritas Notice of Conformity Bureau Veritas Customs Reauirements Export Papers Ministry of Finance Cargo Manifest Ministry of Finance (If transport by rail, various other papers required) Approval Required After Export Deposit of Foreign Exchange Central Bank Source: Manual del Exportador, Camara de Comercio e Industria  - 29 - 65. The importance of these requirements in suppressing potential exporters or in increasing costs is difficult to determine. The larger exporters, while not in favor of the system, generally felt it did not disrupt their activities unduly. However, required approvals probably represent a significant barrier to smaller firms interested in expanding into export markets. One issue concerns the requirement to deposit foreign exchange earned with the Central Bank. This is not a serious disincentive to legal exports (as similar requirements are in some other countries), because the exchange rate is determined by an auction system and there are no restrictions on purchasing foreign exchange. Still, firms calculate that payments to banks to manage this service come to 1? of gross revenues, a substantial tax on exports. On the other hand, the requirement does increase the stability of the auction system by providing the Government with the foreign exchange necessary to avoid excessive short-term fluctuations in the exchange rate. It is neither desirable nor feasible for the Government to use these resources to maintain an inappropriate level of the exchange rate. However, given the potential for volatility in the Bolivian economy, it may be desirable to ensure that the Government remains a major actor in the market, which may not be possible in the absence of mandatory deposit of export earnings with the Central Bank. The Government should consider the pros and cons of this issue and determine whether it would be feasible over the long term to eliminate this requirement. 66.