Peru - Trade Policy Reform and Structural Adjustment Loans Projects

Document of The World Bank FOR OFICAL USE ONLY Report No. 14157 PROJECT COMPLETION REPORT PERU TRADE POLICY REFORM LOAN (LOAN 3437-PE) AND STRUCTURAL ADJUSTMENT LOAN 4 (LOAN 3452-PE) MARCH 29, 1995 Country Operations I Division Country Department III l Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (As of March 31, 1994) Currency Unit = Nuevo Sol (S/.) US$1.00 = S/.2.17 S/.1.00 = US$ 0.46 GOVERNMENT'S FISCAL YEAR January 1 - December 31  FOR OMCIL USE THE WORLD BANK Washington, D.C 20433 U. S. A Office of Director-General March 29, 1995 Operations Evaluat'on MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Peru Trade Policy Reform Loan (Loan 3437-PE) and Structural Adjustment Loan (Loan 3452-PE) Attached is the Project Completion Report on two loans to Peru-Trade Policy Reform Loan (Loan 3437-PE) and Structural Adjustment Loan (Loan 3452-PE)-prepared by the Latin America and the Caribbean Regional Office, with Part II contributed by the Borrower. The Bank's Board of Directors approved in May 1991 a new policy of "Additional Support for Workout Programs in Countries with Protracted Arrears." Under this new policy a Trade Policy Reform Loan to Peru in the amount of US$300 million was approved on February 4, 1992 and a Structural Adjustment Loan in the amount of US$300 million was approved on March 26, 1992. At the end of the performance period-December 1992-the loans were signed and they became effective and were disbursed on March 18, 1993 as part of an arrears clearance operation. Both loans supported a far-reaching program of macroeconomic stabilization, structural adjustment and trade reform as well as an external financing plan for Peru. The PCR describes the well designed and comprehensive programs and the remarkable performance of the Government in meeting its commitments under the loan agreement. All 67 conditions in the two loans were met satisfactorily. This success was largely due to the firm belief of the Government in the soundness of the program and in the perceived need to act promptly, firmly and in agreement with the external sources of finance. Based on the analysis in the PCR, the outcome of both projects is rated as satisfactory both in terms of sustaining and extending Peru's economic reform program and in terms of effecting a debt workout for the country and reintegrating it to the international financial community. Institutional development is rated as substantial. Sustainability is rated as likely given the degree of commitment of the Government to the program. Long term sustainability is also likely, but ultimately will depend on the political and financial support which it continues to receive from the Government. An audit is planned. JJ , J Francisco guii-Sacasa Acting Director General Attachment. This document has a restricted distribution and may be used by recipients only in the performance of their omdial duties. Its contents mav not otherwise be disclosed witbout World Bank authorization.   Project Complation Report: TPRL and SAL PERU TRADE POLICY REFORM LOAN (LOAN 3437-PE) STRUCTURAL ADJUSTMENT LOAN (LOAN 3452-PE) PROJECT COMPLETION REPORT TABLE OF CONTENTS Page No. PREFACE ................................ .i EVALUATION SUMMARY ..ii PART I: THE PROJECT REVIEW FROM THE BANK'S PERSPECTIVE ... 1 I. Project Identity .1 II. Introduction. 1 III. Policy Reform: The Historical Background. 3 IV. The Debt Workout for Peru. 4 V. The Two Projects. 7 The Structure of the Loans. 7 Stabilization and the Structural Adjustment Program 8 The Trade Reform Program .10 The External Financing Plan .14 VI. Implementing and Monitoring the Loans ................ 16 The Borrower ............................ 16 Project Monitoring ......................... 17 Disbursement ........ .................... 17 The Arrears Clearance Process ................. 18 VII. Conclusions . ............................... 18 Issues in Project Design and Preparation .... ........ 19 The Structural Adjustment Loan ...... ........... 22 The Trade Policy Reform Loan ...... ........... 23  Project Completion Report: TPRL and SAL TABLE OF CONTENTS (continued) Pa-eNo. References ................................ 25 Annex 1: Trade Policy Reform Loan: Policy Matrix ................. 27 Annex 2: Structural Adjustment Loan: Policy Matrix ................ 31 Annex 3: The Structural Adjustment Loan ....................... 42 Historical and Economic Context ..................... 42 The Adjustment Program .......................... 45 Preparation and Design of the SAL ................... 49 Program Results ............................... 53 Overall Evaluation .............................. 63 Sustainability ................................ 66 Conclusions and Lessons from the SAL ................. 67 Annex 4: The Trade Policy Reform Loan ........................ 69 Trade Policy Reform and the Loan .................... 69 Implementation of the Reforms ...................... 71 Recent Developments in Foreign Trade ................. 77 Conclusions ................................ 79 PART Il: THE PROJECT REVIEW FROM THE BORROWER'S PERSPECTIVE 81 I. Introduction ................................ 81 II. Performance of the Bank .......... ................ 81 Trade Sector ............................. 82 Structural Adjustment ............................ 83 III. Performance of the Borrower ....... ................ 83 IV. Trade Policy Reform Loan Objectives ..... ............. 83 a. Trade Policy ............................. 83 b. INDECOPI ............................. 85  Project Completion Report: TPRL and SAL TABLE OF CONTENTS (continued) Page No. c. Customs Reform ............................. 85 d. Ports ................................ 86 e. Tariff Surcharges .87 f. ENCI (National Input Marketing Company) .87 g. ECASA (Rice Marketing Company) .87 V. Objectives of the Structural Adjustment Loan .88 VI. Lessons Learned .90 VII. Bank and Borrower Relations During Loan Implementation 91 PART III: STATISTICAL INFORMATION ...................... 92 Trade Policy Reform Loan ......................... 92 Structural Adjustment Loan ........................ 94   Project Completion Report: TPRL and SAL i PERU TRADE POLICY REFORM LOAN (LOAN 3437-PE) STRUCTURAL ADJUSTMENT LOAN (LOAN 3452-PE) PROJECT COMPLETION REPORT PREFACE 1. This is the Project Completion Report (PCR) for the US$300 million Trade Policy Reform Loan and the US$300 million Structural Adjustment Loan (SAL) to the Republic of Peru. The Board approved the Trade Policy Reforrn Loan on February 4, 1992, and the SAL on March 26, 1992. At the end of the performance period -- December 1992 -- the parties signed the loans. The loans became effective and were disbursed on March 18, 1993 as part of an arrears clearance operation. 2. The Japanese Grant Facility and the German Company for Technical Cooperation (GTZ) provided technical assistance for the preparation and implementation of the SAL. 3. Geoffrey Shepherd was task manager of the Trade Policy Reform Loan and Valeriano Garcia task manager of the Structural Adjustment Loan. Armeane Choksi was the Director and Demetris Papageorgiou the Division Chief responsible for the two loans. 4. Parts I and III of this PCR were prepared by Geoffrey Shepherd and Valeriano Garcia. Michael Fabricius (summer intern) provided assistance on the historical record of the workout. Annex 3 was prepared by Valeriano Garcia, with the assistance of Jorge Canales (consultant), and Annex 4 by Geoffrey Shepherd. This PCR is based on the President's Reports for the two loans (Reports No. P-5666-PE and P-5714-PE), information gathered during supervision missions and collected through a monitoring unit in Peru, and other cited documents.   Project Completion Report: TPRL and SAL PERU TRADE POLICY REFORM LOAN (LOAN 3437-PE) STRUCTURAL ADJUSTMENT LOAN (LOAN 3452-PE) PROJECT COMPLETION REPORT EVALUATION SUMMARY Introduction 1. After three decades of increasing interventionism and instability in economic policy, Perui had reached a state of virtual economic collapse and hyper-inflation by 1990. From 1985 it had begun to repudiate the servicing of its foreign debts, and in 1987 the Bank placed Peru on "non-accrual" status. 2. In 1990, a new Administration, under President Alberto Fujimori, introduced a radical "shock" program to control prices, limit the role of the state, and promote market- oriented structural reforms. The Administration also sought to mend its ties with the international financial community, including the World Bank. To this end and following discussions with the Bank, it resumed the servicing of its current debt to the Bank in October 1990. 3. With the Peruvian case in mind, the Bank's Board approved in May 1991 a new policy of Additional Supportfor Workout Programs in Countries with Protracted Arrears (R91-70). The policy would assist strong-performing countries with large and protracted arrears to the Bank in mobilizing sufficient resources to clear their arrears and to support a sustainable growth-oriented adjustment program over the medium term. The new Workout Program enabled loans to be presented to the Board during a "perfornance period" but not disbursed. Once the country had cleared its arrears at the end of this period, loans could be signed and made effective and the accumulated disbursements released. The Workout Program, analogous to the IMF's Rights Accumulation Program (RAP), required four conditions: (a) an external financing plan agreed with the country; (b) an IMF-supported stabilization program; (c) a Bank-supported adjustment program; and (d) continued payment of current debt service to the Bank. The adjustment program should result in Bank disbursements at least sufficient to clear arrears to the Bank. However, the signing, effectiveness, and disbursement of these loans would not take place until arrears to the Bank had been fully cleared. 4. This report covers two loans to Pern, a Trade Policy Reform Loan, presented to the Board in February 1992, and a Structural Adjustment Loan, presented to the Board in March 1992. The two loans, along with a Financial Sector Adjustment Loan, were part of a Bank program to effect a debt workout for Peru and thereby contribute to reestablishing a normal operational relationship between the Bank and Peru and to help the country return to the international financial community. The three loans were among the first projects presented  Project Completion Report: TPRL and SAL iii to the Board (in February and March of 1992) under the Bank-'s new Workout ipolic). Both loans supported a drastic program of macroeconomic stabilization and an external financing plan for Pern. The first loan also supported a Peruvian program of rapid and far-reaching trade reform, while the second supported deep structural reforms in several areas, as well as a social program. Objectives 5. Under a Rights Accumulation Program agreed with the IMF, a macroeconomic stabilization program for 1991 and 1992 set budgetary targets that were to be achieved through higher taxes, better tax administration, expenditure restraint, and monetary controls. 6. An external financing plan for 1991 and 1992 was agreed between the Peruvian Government and a Support Group consisting of the international financial institutions and major bilateral donors. The plan envisaged that rescheduling Peru's public debt (mostly through the Paris Club) and a continued moratorium on private medium- and long-term debt would cover most of the country's financing requirements. In addition, the IDB would resume lending (following Peru's clearance of its arrears to that institution) as soon as possible, and the Bank and the IMF would resume operations following arrears clearance and at the end of a "performance period", in December 1992. Finally, a Support Group of bilateral donors pledged to provide additional balance-of-payments support in 1991 and 1992. 7. In terms of sectoral conditionality relating to structural adjustment, the SAL undertook to recognize the major structural reformns taken between August 1990 and December 1991 in: macroeconomic policy; the fiscal sector; the social sector; privatization; agriculture; labor; and social security. A total of 45 sectoral conditions covered the maintenance of current reforms (24 conditions) and measures for further reform (21 conditions). 8. In terms of sectoral conditionality relating to trade policy reform, the Trade Policy Reform Loan undertook to recognize the major measures taken between August 1990 and September 1991 and comprising: a reduction in tariff protection; the elimination of most non-tariff barriers; the elimination of export subsidies and improvement in schemes allowing exporters to recover indirect taxes; the abolition of the agency formerly administering trade controls and the initiation of a reform of customs. Of a total of 22 sectoral conditions, the emphasis (16 conditions) was on the maintenance of already existing reforms, with measures for further reform (six conditions) generally being considered secondary. Implementation Experience 9. The macroeconomic stabilization program. The stabilization program met the targets of the IMF. The program implemented by the Government was orthodox and monetary-based, since it stopped domestic financing of the fiscal deficit and imposed targets on expansion of the monetary base. The Government maintained its commitment to strict fiscal discipline. A cash management committee managed central government finances on a cash basis only. The Government also maintained its commitment to the market  Project Completion Report: TPRL and SAL ij determination of key prices, including wages, as well as exchange and interest rates. With no foreign exchange surrender requirements, all external transactions were convertible to a single exchange rate. Monetary growth was limited to financing the quasi-fiscal deficit and increasing foreign reserves of the Central Bank, at rates consistent with IMF targets. 10. The external financing plan. In September 1991, after the IMF's Board approved the RAP. the plan achieved two major objectives with: the Paris Club rescheduling, on exceptional terms, for the period October 1, 1991, to December 31, 1992; and the debt workout with the IDB (followed by the IDB's resumption of normnal lending). During 1991 the Support Group gave $370 million in balance-of-payment support and another $128 million in 1992. These amounts were well below the original pledge. The shortfall was partly the result of suspended disbursements after the Government's partial suspension of the Constitution in April 1992. Arrears with the Bank and the IMF were finally cleared in March 1993, three months behind schedule. 11. Structural adjustment. The Government fulfilled all the agreed conditions. 12. Trade policy reform. The Government fulfilled all the agreed conditions. 13. The Workout. Following Board presentation of the two loans covered in this report, the Bank closely monitored project implementation, partly through local consultants. It reported the results of its supervision in three reports to the Board during 1992. The final report in December, at the end of the performance period, noted that the Government had fulfilled the requirements of the two loans (and first-tranche requirements of the third adjustment loan) and that it had also maintained its servicing of current debt to the Bank. In the final report to the Board, Final Review of the Bank's Workout Program (R92-226), the Board's approval was sought, and obtained, to allow the signing of the loan agreements, but not their effectiveness and disbursement, prior to arrears clearance as an exception to the policy established in the paper Additional Support for Workout Programs in Countries with Protracted Arrears (R91-70). In March 1993, in an intricate arrears clearance procedure also involving the IMF and bridge-financing institutions, the Trade Policy Reform, Structural Adjustment, and Financial Sector Adjustment Loans were, following Perui's clearance of its arrears, made effective and disbursed. (The first two loans were fully disbursed, along with the first tranche of the Financial Sector Adjustment Loan.) Arrears clearance then enabled the Bank and Peru to resume a normal relationship. Results and Lessons Learned 14. Between August 1990 and December 1992 (the date when the performance period set by the Bank and the IMF ended), a new Administration laid the basis for one of the most fundamental and rapid economic reforms witnessed in any country. These reforms may take a long time to bear fruit, if the experience of other radical reformers such as Chile and New Zealand is anything to go by. The economic situation remains fragile, but the resumption of growth -- so far sustained -- since the end of 1992 and a palpable revival in investor confidence augur well.  Project Completion Report: TPRL and SAL V 15. The macroeconomic stabilization program. The program was successful in curtailing hyperinflation, but it has not yet abated high inflation. The monthly inflation rate declined from an average of 40 percent per month through mid-1990 to a figure around two percent per month by the end of 1993. Notwithstanding the largle improvement. Peru is still a high inflation country. In addition, domestic real interest rates both in soles- and dollar- denominated operations, though still high, have dwindled from post stabilization levels. In 1990-92 there was a strong perception that the real exchange rate was over-valued. thereby penalizing the production of tradable goods. In 1993, the real exchange rates depreciated somewhat, enhancing the competitiveness of exports. 16. Peru's experience contains some lessons about the course of stabilization of a highlv repressed economy. * In a scenario of historical instability and persistent dollarization, the increase in the demand for domestic real balances will be small despite a reduction in the inflation rate. * In this framework, the efforts of the Central Bank to depreciate the real exchange rate through direct purchases of foreign exchange will generate inflation. * Financial intermediation in dollars reduces the effectiveness of monetary policy but deepens financial intermediation more generally and provides a "strong" currency which facilitates trade and exchange. * Real interest rates may remain high despite the opening of the capital account, reflecting a combination of country risk, expectations of a real exchange depreciation, and the level of taxation. In turn, this may attract foreign capital and further affect the real exchange rate. 17. Structural adjustment. The reforms supported by the SAL have proven to be among the most important changes in the country's economic framework since 1968. The reform program encompasses a change in development strategy from an inward-oriented, import substitution scheme to a market-oriented open economy. The program aims to limit the long- run role of the Government to those activities in which it will be most efficient. In particular, the State is abandoning its role as producer and planner. It is concentrating instead on providing a stable legal framework for property rights, health, education, security and basic infrastructure and fostering an environment of competition designed to promote a more efficient allocation of resources. 18. Trade policy reform. The essence of the reform was to move trade policy to a stance approaching neutrality, i.e. where there is minimal policy discrimination between different economic activities, between firms, or between imports and exports. Peru's trade reform was in general as radical and rapid as that observed in any other country, including Chile and Bolivia. The reforms have been completely effective in moving trade operations to a more market-oriented system of incentives and greater integration with the world economy. While the Peruvian economy has now begun a strong recovery from decades of stagnation  Project Completion Report: TPRL and SAL and a subsequent period of recession (induced by the stabilization). it is as \-e difficult to fully measure changes in the structure or level of trade (beyond a rapid growth in imports and some change in their composition), hence to measure the gains from trade reforllls. Nevertheless, a recent Bank report found Peruvian firms now listed trade regime problemsc as the least of their worries (it had been their ereatest before). and noted the herinninms ol improved industrial efficiency. If these economic reforms are maintained. measurable benefits are soon likely to be apparent. 19. The experience of the Trade Policy Reformn loan contains some lessons ol a narrowver. more technical kind. * The Loan provided support to an agrictultural surcharges scheme. The scheme has, in the event, operated most unsatisfactorilv, neither stabilizing prices nor benefitting farmers, and it stands as a precedent encouraging other sectional interests to lobby for protection. * As more and more Bank member countries undertake fundamental trade reforms, Bank expertise needs to encompass new sets of issues. The Loan supported a custon7s reform program. The Bank relied heavily on the IDB in the design and supervision of this component, which appears to have been very effectively implemented. The Bank could have made a better contribution if it had its own expertise in this area. Similarly, the Bank needs to develop more expertise to deal with the public-health and administrative issues associated with residual non-tarif barriers imposed for health, safety. and security reasons. 20. The external financing plan for 1991 and 1992. The success of this plan was realized with the achievement of Peru's final arrears clearance with the IMF and the Bank. 21. The Workout. Some of the discussion preceding the establishment of a Bank workout program centered on issues of sequencing between the international financial institutions and of sharing the burden in the clearance process. In the case of the Peru workout, it is not easy to come to firm conclusions. but some relevant points can be made. * Burden sharing. Lending to Peru6 is risky, though the perceived risks have fallen as Peru has sustained its recovery efforts. In the case of Peru's debt workout for the Bank (as for the IMF), disbursements were approximately the size of arrears. In fact. the Bank's disbursements were US$33 million larger than Per-u's arrears of US$867 million. Thus the rise in the Bank's country exposure (i.e. the sum of principal and interest outstanding) was minimal, and it incurred little new direct risk. On the other hand, any new lending to Perui associated with arrears clearance posed a risk to the Bank's standing in capital-markets. This in itself might provide a reason to lend as little as possible. Support Group disbursements in 1991 and 1992 allowed Peru to defray the costs of servicing its debt to the Bank and the IMF. These countries thus bore a greater burden of risk.  Project Completion Report: TPRL and SAL vii Timing and sequencing of clearance. By waiting to clear late -- at the end of the performance period and 18 months later than IDB -- the Bank postponed the resumption of its lending. It thus temporarily forewent part, but not all, of its developmental role. But it can be argued that the Bank (like the IMF) reaped financial advantages. First, the Bank was the recipient of net transfers from October 1990 to February 1993. During this period Pern paid the Bank over US$200 million in current debt servicing. Second, the discipline which the Bank encouraged in Peru - - in terms of economic policy and debt servicing -- cannot in itself have had a negative impact on capital markets. The later clearance lowered the risk of the Bank being associated with a failed reform and being perceived to have rolled over Peru's debt. In the event, the indicators are that the arrears clearance operation has not jeopardized the Bank's standing on capital markets. * The effect of later clearance on Peru. As a development institution, the Bank must be as much concerned with its development impact as its financial standing. The Bank's late clearance imposed an immediate cost on Pern inasmuch as Peri spent two-and-a-half years servicing its current debt without receiving any development assistance. Against this, it may, of course, be argued that the discipline of the performance period provided its own benefits to Peri. 22. Procurement and Disbursement procedures. Since the debt workout aimed at Bank disbursements roughly equivalent in size to the arrears that Pern owed, there was in reality little net transfer of funds from the Bank to Peru. Nonetheless, the Bank's rules required that disbursements be made against import expenditures. This imposes a burden on borrowers -- albeit minor compared to the size of the loan -- without any effect on the procurement of imports from Bank member countries. A Country Procurement Assessment Report (CPAR) prepared by the Bank correctly identified the issues related to reimbursement of funds when no evidence of payment can be obtained, which permitted a broad discussion and prompt resolution of the issue in the Bank. As a result of problems with documentation of imports in Peru, the Bank changed its disbursement policy for structural adjustment loans, somewhat simplifying the Bank's documentation requirements. But it might be preferable, if this could be done consistently with the Bank's Articles of Agreement, to simplify disbursement procedures even more for adjustment loans, especially for those carried out in the context of an arrears clearance. Sustainability 23. The current Administration remains committed to the structural reforms and to current economic policy, and is expected to maintain that position until the end of its term. Furthermore, the Administration has signed a three-year Extended Fund Facility Program with the IMF, that has defined an economic program for the period, setting goals and targets consistent with increased stability. 24. However, inflation and real interest rates are very high relative to international standards. The exchange rate remains appreciated relative to historic levels, and financial intermediation remains limited. There are still concerns about the sustainability of the  Project Completion Report: TPRL and SAL viii economic program beyond 1995. On the macroeconomic side, the fears are based on the fragile situation of the fiscal balances over the medium term, unless there is an increase in the level of tax revenues and an increase in the efficiency of public expenditure. 25. In addition, some positive economic achievements are required to fully consolidate the stabilization program. In particular, the recent recovery in growth must be sustained and the banking system must recover its health. The long-term sustainability of the broad structural reforms and economic improvement implemented by the Fujimori Administration will depend on long-term political support. Maintaining democratic procedures, given the political turmoil of recent years, while providing continuity in economic policy is a large challenge. On the other hand, after a quarter-century of economic mismanagement and decline, many people share a stake in, and hope for, Peri's economic reforms.   PERU TRADE POLICY REFORMI LOAN (LOAN 3437-PE) STRUCTURAL ADJUSTMENT LOAN (LOAN 3452-PE) PROJECT COMPLETION REPORT PART 1. THE PROJECT REVIEW FROM THE BANK'S PERSPECTIVE I. Project Identity Operation Trade Policy Reform Loan Loan number P-3437-PE Operation Structural Adjustment Loan Loan number : P-3452-PE Region : Latin America and the Caribbean Country Republic of Peru Sector Non-project Lending II. Introduction 1. This report covers two loans to Perui, the Trade Policy Reform Loan and the Structural Adjustment Loan. The first supported a Peruvian program of rapid and far- reaching trade reform, while the second supported a drastic program of macroeconomic stabilization, as well as a social program and deep structural reforms in several areas. The two projects were also part of a Bank program to effect a debt workout for Peru and thereby contribute to reestablishing a normal operational relationship between the Bank and Peru and to help the country return to the international financial community. 2. These were among the first projects presented to the Board (in February and March of 1992) under a new approach to address the problem of arrears to the Bank of countries in non-accrual status. To address the problem, the Board adopted a policy, on May 2, 1991,1 to assist members with protracted arrears to the Bank in mobilizing sufficient resources to clear their arrears, and to support a sustainable growth oriented adjustment program over the medium term. For strong-performing countries with large arrears, this new Workout Program enabled loans to be presented to the Bank during a "performance period" but not disbursed (hence the "shadow adjustment program"). Once the country had cleared its arrears at the end of this period, loans could be signed and made effective and the accumulated disbursements released. The Workout Program, analogous to the IMF's Rights Accumulation Program (RAP), required four conditions: (a) an external financing plan agreed with the country; (b) an IMF-supported stabilization program; (c) a Bank-supported "shadow" adjustment program; and (d) continued payment of current debt service to the 'Additional Supportfor Workout Programs in Countries with Protracted Arrears, R91-70, April 11, 1991.  Project Completion Report: TPRL and SAL 2 Bank. The Board agreed that the adjustment program should result in Bank disbursements at least sufficient to clear arrears to the Bank. However, the signing, effectiveness. and disbursement of these loans would not take place until arrears to the Bank had been fully cleared. 3. Perfi had gone into arrears with the Bank in 1987 and resumed the servicin- of its current debt to the Bank in October 1990. On July 30, 1991, the Board approved the application to Peru. of the new Workout Program (see Peru. the Bank's Approach to a Country with Protracted Arrears, R91-171, July 12, 1991). The Bank thereafter participated in formulating an external financing plan with the government, the IMF, the IDB. and bilateral donors. This involved the formation, in 1991, of a Support Group of donors. In September 1991 the IMF's Board approved a RAP for Perui. The Bank's Board approved three adjustment loans in the first half of 1992 (the Trade Policy Reform Loan, the SAL, and a Financial Sector Adjustment Loan). Thus Bank staff requested permission to sign the three adjustment loans prior to arrears clearance, with effectiveness of the loan agreements and disbursements conditioned upon arrears clearance. This change allowed the Government to complete expeditiously the legal steps required to ensure the validity of the loan agreements. The performance period was completed, and the three loans signed with the Bank, in December 1992. Peru repaid its arrears in March 1993, using two bridge loans, and the Bank immediately disbursed an equivalent amount, made up of the single tranche of the trade loan and the SAL and the first of two tranches of the third loan, the Financial Sector Adjustment Loan. After the completion of the Workout, the Bank then resumed normal lending to Pern. 4. This report considers the two first projects of the Peruvian Debt Workout together because of their shared objectives, common background, and contemporaneous completion. The report describes the application of the Workout Program to Peru, but it does not comment on the Program itself, which has been evaluated in a paper of the Joint Audit Committee.2 During the period of implementation of the project, the Bank made three reports to the Board.3 The last of these asked the Board to approve certain amendments. It included the request to sign the three adjustment loans prior to arrears clearance, with effectiveness of the loan agreements and disbursements conditioned upon arrears clearance. That approval was critical to the arrears clearance operation. In addition, this last report (R92-226) analyzes the evolution of the macroeconomic situation in this period, describes the evolution of sectoral policy covered by the three adjustment loans in the workout (providing the details of fulfillment of conditionality in matrix form -- reproduced as Annexes 1 and 2 to this Project Completion Report), and describes the fulfillment of the external financing plan. Annexes 3 and 4 to this Project Completion Report provide a more detailed account of the implementation of the two projects. 2joint Audit Committee, Review of IBRD Policy on Workout Programs for Countries wvith Protracted Arrears, JAC93-17, April 30, 1993. The paper concludes (para. 15) that 'The policy has worked well, and has supported both country and Bank objectives. ... there is no need for any change to the policy". 3Peru: QuarterlN Reviest' of Progress in the Bank's Workout Program, SecM92-697, May 28, 1992; Peru: Quarterlh Review of Progress in the Bank's Workout Program, SecM92-1310, October 1, 1992; and Peru: Final Review of the Bank's Workout Program, R92-226, December 10, 1992.  Project Completion Report: TPRL and SAL 3 III. Policy Reform: The Historical Background4 5. After an orthodox pro-market, export-oriented regime in the 1950s, Pern experienced almost three decades of increasing interventionism and instability in economic policy (1962-90) -- interventions in pricing, interest rates, exchange rates, trade, credit allocation, land and labor markets, and so on. This had profound effects: economic stagnation (per capita GDP in 1990 at 72 percent of its 1980 level), the withering of the state as an effective governing force, the growth of a huge informal sector, repudiation of foreign debts and isolation from the international community, and the growth of a vicious brand of terrorism. The culmination of these trends was, at the end of Alan Garcia's presidential regime in 1990, economic collapse and hyper-inflation (inflation at 36,000 percent per annum in late July 1990). By any standards, this was a brutal collapse of a country. 6. In June 1990, Mr. Alberto Fujimori was elected President. He had run for office as a political outsider and on a platform of populist economic policies. His election was followed by a period of intense debate among his advisers and with representatives of the World Bank and the IMF on the need for a shock program to stabilize the economy. (On June 29, he met the heads of the World Bank, IDB, and IMF in New York to discuss his economic reform program and the possibility of help from the international financial institutions.) 7. On August 8, a few days after the new Administration took office, Prime Minister Hurtado Miller announced a radical and orthodox program to control inflation, adjust prices, and free markets. On the fiscal side this included management of the budget on a cash basis, public-sector wage controls, a drastic rise in public sector prices, and the elimination of most fiscal incentives and subsidies. On the monetary side it included a policy of tight money, tight domestic credit, freeing of the exchange rate, and elimination of exchange-rate controls. Most price controls were removed. The Government also began a process of reforrning the structure and administration of taxes and it took the first measures in trade reform (including tariff reductions, a preliminary elimination of most non-tariff barriers, and the elimination of export subsidies). 8. In March 1991, when a new Minister of Economy and Finance, Carlos Bolofia took office, the program of economic reform entered a new and powerful phase, covering many areas. * In trade, most remaining non-tariff barriers were eliminated (including those on most second-hand goods), a two-tier tariff was introduced, as were variable tariffs to stabilize the prices of leading agricultural products, and a customs reform was begun. * In the regulatory area, most state monopolies were eliminated, the ports and urban transport were deregulated, and, from late 1991, a huge privatization program was initiated. * The financial system was liberalized. 4 See Annex 3.  Project Completion Report TPRL and SAL 4 * The labor regime was made more flexible (through easier layoff provisions and compensation for lavoffs). * Foreign investment was liberalized. * Steps were taken to improve private propert a rights in land. 9. In August 1990 the government also introduced a Social Emergency Program safety net, which developed into a National Fund for Social Compensation and Development (FONCODES) in August 1991. IV. The Debt Workout for Peru 10. The Peruvian Government had resumed servicing debt to the IMF in 1989. In the aftermath of President Fujimori's election, the Bank and the Goverrnment entered into discussions on the resumption of a normal relationship. The Goverrnent wished thereby not only to gain access to the Bank's capital and technical assistance but also to take a step that would facilitate the normalization of its relations with the international financial community. To this end, on October 14, 1990, the Government resumed servicing its current debt to the Bank.5 This cleared the way for two large Bank missions which prepared and discussed reports in the field. One report (Perti: Sector Reform and Investment Review, November 14, 1990) analyzed the country's reform and investment needs, particularly in the public sector. The other (Economic Reforms to Sustain Stabilization and Lay the Foundations for Development, December 8, 1990) proposed a range of reforms to stabilize the economy and induce reforms in specific areas, including the labor market, public administration, the fiscal area, trade, and the financial sector. 11. In mid-1990, Board discussion of debt workout exercises with Guyana and Honduras gave expression to some dissatisfaction with the lack of an agreed Bank workout policy and to the view that the Bank had played an insufficient role vis-a-vis the IMF and had taken too large a share of the risk. Perni was the first case of a non-IDA country for which arrears clearance came under discussion. It had the highest arrears in the Bank, accounting for 1.24 percent of the Bank's portfolio in July 1990. Thus it became the catalyst for a more widely applicable workout instrument. Actually, discussions within the Bank on 5Between March and September 1991, the Govemment began once more to accumulate arrears on the current debt service to the Bank and the IDB. This action represented the Government's private dissatisfaction with a situation in which the servicing of current debt to the Bank and the IDB was consuming about one tenth of the budget, a situation which would not improve until after the workout with these two institutions. In this delicate situation, the Bank consulted with the IMF, who made it a condition of its Board presentation (in September 1991) that arrears on current debt service to the other international financial institutions would be settled, and the problem was thus solved. 'The reports were later combined, in shortened, slightly updated form, as Peru: Economic and Sector Reforms to Sustaini Stabilization anid Lay the Foundations for Development, Green cover, February 18, 1992. The combined report added little, existing mostlv to fulfill a bureaucratic requirement for a formal Bank document on which to base adjustment lending.  Project -Completion Report: TPRL and SAL 5 various options to deal with Peril's arrears had been ooing on since Peru resumed its debt servicin2 to the IMF in 1989. From 1990, various Bank- departments cooperated to produce proposals for a Bank debt workout policy, with the idea that Peru would be the first country to have this policy applied.7 As a result, a paper was submitted to the Board in April. receiving Board approval on May 2, 1991. This paper (Additional Support for Wnor/-'it Programs in Countries with Protracted Arrears, R91-70) provided the basis for the Bank's new workout policy, hence the framework for the adjustment operations in Pern (see section V below). 12. In April 1991, a Bank mission to Lima met with the gov.rnment and laid the basis for a series of three adjustment loans to effect such a workout for Peru. 1 July tb- Board approved the application of the new workout policy to Peri by giving its blessinm . July 12 paper, Perfi: the Bank's Approach to a Country wiith Protracted Arre,-rs. R91-171. The preparation of these loans began thereafter. The Japanese Grant Facilitt and the German Company for Technical Cooperation (GTZ) provided technical a- -`tance in 1991 for preparing and implementing the SAL. 13. Following the Bank-Fund Annual Meetings in September 1990, the Bank and the IMF agreed, at the urging of the Peruvian Government, to form a Support Group for Pern.8 The leading donor countries were at first reluctant to make large scale commitments to Peri, and it took some time for the Group to form. The Group, consisting of international donors and the three international financial institutions, first met in June 1991, co-chaired by the U.S. and Japan, with the IMF playing the leading "secretarial" role. The Group's purpose was to mobilize resources to fill the US$1.3 billion external financing ga.- that had been identified (mostly on the analysis of the IMF), in addition to quick-disbursing support from the international financial institutions, for 1991 and 1992. By September, the Support Group had pledged US$1.1 billion. Following the formation of the SunporL Group, the Bank took a secondary role in mobilizing donor support through the Group, concentrating later on mobilizing support, through a Consultative Group, formed in 1993, for Pern's social sectors. 14. On September 12, 1991, the IMF Board, satisfied that Peru'~ external financing requirements could be met and that Perd would maintain its payments on current obligations to the international financial institutions, approved a Rights Accumulation Program (RAP) for Peru.9 Under the program, Peru's adherence to IMF performance criteria and continued servicing of debt to the international financial institutions would lead to the accrual of rights to future disbursements once arrears to the IMF had been cleared at the end of 1992. 7This notably involved the LA4 Country Department and the Risk Management & Financial Policy Department. In January 1991, following a reorganization in the Latin Ai !rica and Caribbean Region, responsibility for Pern shifted from LA4 Department to LAI. Some key country personnel were transferred to the new Department. 8Support Groups, usually chaired by the IMF, have been established when extraordinarily large amounts of external financing are to be mobilized quickly. Consultative Groups, usually chaired by the Bank, are formed to address longer-term resource requirements. 9The RAP had been adopted by the IMF Board in April 1990.  Project Completion Report: TPRL and SAL 6 15. The agreement with the IMF led the way to Peru's clearance of its arrears with the IDB on September 13. (After some initial hesitation, the international financial institutions agreed that the IDB should lead the way on clearance as it had the smallest arrears outstanding). On September 18, the IDB's Board approved a Trade Sector Loan to Peru for USS425 million, a first tranche of which (for US$325 million) was disbursed on September 25. The IDB was then able to undertake an active program of adjustment and investment lending (including a financial sector adjustment loan in 1992) and resume disbursement on existing projects. 16. In their September 1991 meeting Peru's Paris Club creditors agreed on exceptional terms for the country in the form of cash-flow relief from October 1991 to the end of 1992. 17. On February 4, 1992, the Bank's Board approved a US$300 million Trade Policy Reform Loan (3437-PE). On March 26, 1992, its approved a US$300 million Structural Adjustment Loan (SAL -- 3452-PE). On June 17, 1992, it approved a US$400 Financial Sector Adjustment Loan (3489-PE). 18. In early 1992, the Bank and the Peruvian Government discussed the possibility of bringing forward the arrears clearance to June 1992. Discussions were quite advanced when President Fujimori, in an April 5 "auto-golpe" ("self-coup"), dissolved the Congress and the judiciary, and suspended parts of the Constitution. Disbursements by Support Group countries and the IDB were suspended. The auto-golpe scuttled the idea of early arrears clearance with the Bank. Bank staff requested permission to sign the three adjustment loans prior to arrears clearance, with effectiveness of the loan agreements and disbursements conditioned upon arrears clearance. This change allowed the Government to complete expeditiously the legal steps required to ensure the validity of the loan agreements. By the end of 1992, Perui was making progress, at the urging of the international community, in returning to democratic rule. A Democratic Constitutional Congress (CCD) was elected in November. The performance period was completed, and the three loans signed with the Bank, in December 1992. 19. At the Government's request, the Bank made first contacts with financial institutions to arrange two bridge loans in March 1992. There was a positive reaction on the part of various banks, but the Government was, in the end, unable to come to an agreement. The US Treasury and the Japanese Export-Import Bank then agreed to provide the bridge loans. 20. In early 1992, the IMF had to consider a successor arrangement to the RAP. In September 1992, it started preparing an Extended Fund Facility (EFF) for 1993-95. The IMF estimated that a new Support Group would need to raise US$410 million to cover the expected external funding shortfall of 1993. But only US$270 million was pledged. "'The loan was among the first that IDB made under a new policy permitting it to undertake adjustment lending without having to co-finance with the Bank.  Project Completion Report. TPRL and SAL 7 21. The Bank's three loans were signed on December 18. 1992. Nonetheless, it took a further three months before the arrears could be cleared and the loans made effectiVe. One reason for this was that, following the Bank's requirement that the loans receive congressional ratification, Per-Ci's political timetable did not allow ratification before mid- January. In addition, the IMF had difficulties in coming to an agreement with the Government on its 1993 economic program, and this held up the finalization of the EFF from the last few months of 1992 onwards. Given that the External Financinc Plan envisaged concurrent clearance of Bank and IMF arrears, the Fund did not want the Bank to disburse on the adjustment loans until it was ready to do so (which happened in early 1993)." 22. Finally, on March 18, 1993, a complex sequence of transactions completed the debt workout: Peri cleared its arrears with the Fund using the two bridge loans; the IMF disbursed; the proceeds were used to clear the Bank's arrears; the Bank then disbursed the full proceeds of two adjustment loans and the first tranche of the Financial Sector Adjustment Loan; and Peru paid back the bridge loans. V. The Two Projects The Structure of the Loans 23. The three adjustment loans contributing to the Peruvian debt workout had a common structure reflecting the peculiarities of the workout. Each loan underwrote the same macroeconomic stabilization program and external financing plan, while supporting separate "sectoral" adjustment programs. (In the discussion below that covers the sectoral adjustment programs of the two loans covered by this report, the macroeconomic stabilization program is considered along with the structural adjustment program.) 24. For each loan the Letter of Development Policy played a particularly important role. The signature of the loan agreements came (in December 1992) at the end of the performance period, well after Board presentation (10 months later, in the event, for the Trade Policy Reform Loan and 9 months later for the SAL). Under these circumstances, the loan agreement, contrary to normal practice, was a simple document containing a recognition of what had been done, rather than a program of what was to be done. It was the Letter of Development Policy which, effectively, detailed the understanding that the Bank and the Government reached during loan negotiations. This understanding covered the process and conditions under which the loans would be presented to the Board and thereafter signed and made effective. This included the conditions covering the macroeconomic stabilization program and the external financing plan, the requirement for PerI to remain current on its debt servicing, and the precise details of sectoral conditionality. Thus the loans were implemented (and supervised) before they were signed. "The resignation of the Minister of Economy and Finance, Carlos Bolofia, on January 4, 1993, did not in itself appear to slow the clearance process. The new US Administration that came into office in January 1993 sought assurances on several human-rights issues from the Fujimori Administration. Assurances were promptly given (shortly before arrears were cleared), and this did not appear to add any delays to the clearance.  Project Completmon Report: TPRL and SAL 8 Stabilization and the Structural Adjustment Program'2 25. For tCe SAL, the Government of Perna agreed with the Bank on a set of 45 sectoral conditions covering macroeconomic and structural reforms. Twenty four of these conditions prevented reversal of policy actions implemented prior to loan presentation to the Board. The other 21 were conditions for further refonn. 26. Stabilization. The 6. )ilization program implemented by the Fujimori Administration can be characterized as orthodox and monetary-based, since it stopped domestic financing of the fiscal defi t and imposed targets on money base expansion. The Government maintained its commitment to strict fiscal discipline. A cash management committee managed State finance, -,n a cash basis only. The Government also maintained its commitment to the market determination of key prices, including wages, as well as the .xchange and interest rates. With no foreign exchange surrender requirements, all external transactions were convertible to a single exchange rate, at the time considered convenient to the exporter or importer. Monetary growth was limited to financing the quasi-fiscal deficit and increasing foreign reserves of Central Bank, at rates consistent with IMF targets. The program was succezsful in curtailing hyperinflation,'3 but it has not yet abated high inflation. The monthly rate declined from an average of 40 percent per month through mid 1990 to a filurc iround two percent per month by the end of 1993. Notwithstanding the large improvement, Perd is still among high inflation countries. In addition, domestic real interest rates both in soles and dollar-denominated operations, though still high, have dwindled from post-stabilization levels. In 1993, the real exchange rates depreciated somewhat, enhancing the competitiveness of exports. 27. Fiscal policy. Drastic changes in tax legislation reduced to five the number of taxes collected by the central government, allowed for inflation adjustments to account for 12See also Annex 3. 13The Bank's new workout policy required the presence of an IMF-supported stabilization program. The IMF duly supported Peru's stabilization program through its RAP, and, at the end of 1992, pronounced all performance criteria under the RAP observed. The Bank also chose to monitor the stabilization plan independently by reference to the performance of a set of relevant indicators for 1992. The purpose of this approach was not to set up alternative indicators -- they were consistent with the IMF program -- but to enable the Bank to emphasize those indicators it thought were most important. These indicators, not in themselves strict performance conditions vould help support the Bank's own judgements on the progress of stabilization. 1992 performance under the i,idicators was as follows. (a)Central Government current tax revenue: target of about 9.0 percent of GDP; actual was 10.2 percent. (b)Primary balance of the non-financial public sector: target of at least 0.6 percent of GDP; actual was 0.1 percent (c)Rate of creation of monetary base (December 1991 to December 1992): target was up to 40 percent; actual was 71 percent. (d) Stock of other Central Bank monetary liabilities in Soles: target was up to 0. 1 times monetary base; actual was 0.  Prolec Comp/etlon Reporn. TPRL and SAL 9 collection lags, and eliminated many exemptions and loopholes. The Government introduced a new tax code allowing more efficiency in the tracking of infrinoements. and stricter penalties (including prison terms) for certain infractions. The modification of statutory rates increased the share of the value added tax in total collections, reducing the level of more distorting taxes. The institutional framework for the implementation of the law was improved, providing the basis for higher tax enforcement compliance. The tax adminis- tration institution, SUNAT, reorganized its personnel and modernized its monitoring tools in order to improve its quality and effectiveness. These changes in the fiscal system permnitted the central administration to collect about nine percent of GDP in tax revenues in 1992, five percentage points higher than when the new Administration took office. But with tax collections still at a low level, the Government was obliged to continue restricting expenditure in order to achieve a negligible deficit of the consolidated non-financial public sector in 1992. It was obliged to postpone public sector investment, to observe tight discipline on public sector wages, and to reduce the number of employees through voluntary retirement. However, the Government managed to resume payment to all international financial institutions. 28. Labor. Among the reforms supported by the SAL, the labor stability law was relaxed, expanding conditions for layoffs and increasing the probationary period in specific cases. In addition, new labor contracts were allowed on a fixed-term basis (up to three years), allowing for fluctuations in temporary employment to adjust for new market conditions. Finally, the Compensation for Time and Services Rendered (CTS) became a fully-funded severance-cum-retirement mandatory savings scheme, managed by financial institutions. This change has improved labor mobility, because it provided workers with guaranteed savings available in case of severance while they search for a new job. The Government also redefined the framework for collective negotiations and the rules that govern a strike. 29. Social security. The Government has redefined the nature of the mandatory saving for retirement. A new legal framework will allow workers to choose between joining a pension system managed by the State and one handled privately. The new system may significantly increase the saving rate and improve income distribution. It has also eliminated discriminatory treatment favoring some pressure groups and changed the legal requirement for indexation of the pension to periodic rises to account for inflation depending on the financial resources available to the managing institution. 30. Agriculture. In 1991, the Government passed a new Agricultural Investment Promotion law which abolished the earlier Agrarian Reform Law and strengthened the basis for private property rights and market freedoms in land and water usage. Significant steps have been taken toward the full implementation of the law. However, some difficulties remain for land titling and registration. Most rural land has not been registered yet. Titling will enable peasants to use their land as collateral for credit. State participation in agriculture -- through price-setting, credit and subsidies, trading monopolies -- is being cut drastically. 31. Privatization. The legal and institutional framework for privatization was defined in 1991 and 1992. Perd's bold program aims to privatize about 224 companies,  Project Completion Report: TPRL and SAL 10 leaving the State to concentrate on basic infrastructure, health, education, and justice. As part of the effort to promote investment, the Government has made its foreign investment legislation among the most liberal in the world. Foreign investors now have the same rights and obligations as Peruvians. There are no restrictions on capital remittances in any form. 32. From May 1992 to April 1994, 33 companies have been privatized. This process has accrued US$ 2.07 billion in revenues, and has helped the Government balance its budget. Of particular note was the privatization of Empresa Nacional de Telecomunicaciones - Entel/Compania Peruana de Telefonos - CPT - Telecommunications. On February 28, 1994, a control package of 35% of Entel and CPT--including a capital increase in CPT--, was auctioned to a consortium led by Telefonica Internacional (Spain), for a total of US$2 billion. Out of this amount, the State will receive US$1.39 billion, while US$0.61 billion will be the additional capital in CPT. Up to 10% of Entel's shares will be offered to Entel's workers and the remaining shares will eventually be offered in the market. All the remaining mayor companies will be privatized by early 1995. These include the two mayor electricity companies (ELECTROLIMA and ELECTROPERU), the national oil company (PETROPERU), the water and sewerage company (SEDAPAL) and the remaining mining companies (CENTROMIN and MINEROPERU). 33. The social sector. To alleviate poverty, the Government will promote the generation of wealth as much as the redistribution of income. The process of labor market deregulation, the elimination of the regressive inflation tax, and the promotion of other structural reforms should both improve real wages and expand the number of people in formal occupations. In addition, the Government will concentrate on the provision, rehabilitation, and expansion of basic public services in health, education, and water and sanitation. This will require considerable improvement in the Government's administrative capacity. As a short-term response to critical poverty, the Government designed a poverty alleviation strategy establishing a minimum safety net for the most vulnerable groups in the society. It began with an outline of policies in health, nutrition, education, and employment; the identification of vulnerable sectors and priority programs; and an institutional framework for the implementation of social programs. One of the principal safety net schemes, FONCODES (the National Fund for Social Compensation and Development), created in 1991, finances small labor-intensive projects for the rehabilitation of social and economic infrastructure and for the provision of basic social services, identified by poor local communities. Since it started, it has achieved notable improvements in efficiency and management. It relies on both internal and external resources. The Trade Reform Program'4 34. In August 1990, the newly elected Fujimori Government began a fundamental trade reform concurrently with the introduction of a stabilization policy and the initiation of a broad range of economic reforrns. The exchange rate was immediately unified and floated, and almost all rationing of foreign exchange was eliminated. Many non-tariff barriers, most import tariff preferences, and all export subsidies were eliminated in short order. By March 14See also Annex 3.  Project Completion Report: TPRL and SAL 11 1991, virtually all remaining non-tariff barriers had been eliminated. At that time, a two-rate tariff (15 and 25 percent) was introduced (with a few exceptions for steel products). A system of variable tariff surcharges was introduced for a limited number of agricultural products in an effort to provide greater price stability in the domestic market. In mid-1991 an anti-dumping code was passed. By this time, the Government had eliminated most of the activity of the Instituto de Comercio Exterior (ICE -- the public body that had formerly administered import controls and export subsidies), and begun a program of reforming the customs service. In September, the Government gave the strength of law to many of the decrees that had achieved these policy changes. 35. The Bank -- more than satisfied with the amount and quality of reform already having taken place -- was concerned to agree on conditionality which would require Peri to undertake to maintain all its actual reforms and undertake only a few remaining reforms it had already announced (notably tariff unification by early 1993), rather than to seek new policy concessions. In this respect, the Bank sought to defend the trade policy positions already established by the Government and enjoying substantial public support against any future opposition that might arise. Of the 22 conditions agreed in the Trade Policy Reform Loan (see Annex 1), 16 were to maintain existing reforms and six to achieve further changes. The main actions under the Loan can be summarized as follows: (a) the exchange regime: maintain a single freely convertible exchange rate for all transactions; (b) tariffs: maintain a simplified tariff structure which has substantially reduced the level and variance of protection; maintain the elimination of most special regimes allowing discriminatory preferences on the domestic market; maintain the agricultural surcharges scheme as it is (that is, not expanding or changing it), with the possibility of revising it following a study; revise the anti-dumping code (with the help of a study of the issue); (c) non-tariff import barriers: maintain the elimination of formally protective barriers, including prohibitions, minimum-local-content regulations, controls on most second-hand imports, and state agricultural import monopolies; reduce or simplify some technical/safety/health controls on imports (with the help of a study of the issue); (d) export regime: maintain the elimination of fiscal and financial export subsidies; improve schemes to allow imports to recuperate indirect taxes when the fiscal situation permitted this; maintain the reduction in non-tariff export barriers; (e) trade institutions: carry out a program for customs reform. 36. The loan was prepared between June and December 1991. From the beginning, the Bank worked in close cooperation with the IDB, which presented its own Trade Sector Loan to its Board on September 18, 1991. The Bank and IDB agreed on  Project Completion Report: TPRL and SAL 72 virtually identical trade conditionality. IDB took the lead in designing the project component on customs reform. (IDB also provided a US$2.3 million component of a Technical Cooperation project to fund technical assistance for the customs reform.) 37. The Board document Perni: Final Reviewv of the Bank's Workout Program (R92-226, December 10, 1992) reported that the Government had observed all measures agreed (see Annex 1, reproduced as Annex 1 in this report, for details) and that its commitment to an open trade regime had not wavered during the performance period."5 This is still the case more than one year later. In some cases, however, the trade reform encountered temporary reversals or other problems of implementation. 38. Tariff reform and the Andean Pact. Shortly before Board presentation, the Presidents of the Andean Pact committed themselves to create a customs union. This had tariff implications for Peru in conflict with the loan conditionality initially proposed by the Government and acceptable to the Bank. To solve the conflict, the Bank and the Government then agreed on "either/or" conditions for tariff reform, depending on whether the Government opted to maintain the tariff strategy announced in early 1991 (first a two-tier tariff, then a low single rate) or opted to negotiate a common external tariff within the Andean Group (which was likely to be a multi-tier tariff, with higher average rates). In the event, the Government, wishing to avoid raising the level of protection, has not agreed a common external tariff with its Andean-Group partners, and the Government's tariff policy continues to be to move to a flat 15-percent tariff. This outcome bodes well for maintaining the momentum of Perd's trade reforn process. 39. The agricultural surcharges scheme, created in March 1991, provides for a variable surcharge, in addition to the normal 15-percent tariff, based on the average of the previous five years' c.i.f. import price. Much of the revenue from these tariffs provides resources for the Ministry of Agriculture. The Government agreed not to extend the scheme beyond the 18 products originally specified and to undertake a study to evaluate the scheme. This study, completed in August 1992, found that, had the scheme been consistently implemented as originally intended, greater price stability would have brought welfare gains, particularly for sugar."6 But the frequent changes in the rules -- changes in products covered and in methodology -- led instead to welfare losses. Moreover, the presence of close substitutes and apparently imperfect competition in food distribution meant that the surcharges were not translated into increased farm-gate prices. The study recommended the 15 The procedure in this loan, as in other Bank adjustment loans, was to require the fulfillment, without exception in principle, of a list of conditions. Formally, this gives the Bank little flexibility, short of seeking a Board waiver: if one condition remains unmet while 19 are met, the conditionality is deemed not having been fulfilled, even if some of the other 19 are fulfilled beyond expectations. In this Loan, there were undoubtedly some minor cases of backtracking, but on balance conditionality was amply fulfilled. The Loan further required the Government to prepare studies in three areas (the anti-dumping code, tariff surcharges, and non-tariff barriers), the Bank and the Government to agree on further reforms based on these studies, and the Government to implement these. This kind of conditionality does not always make sense: it is sometimes unwise for governments and the Bank to commit themselves to agreeing and acting on a study whose findings they do not know in advance. 16 Javier Escobal and Arturo Brisceno, El Sistenma de Sobretasas Agricolas en el Peru: Ev'aluacion Y Recomendaciones, GRADE, 28 de Agosto de 1992.  Project Completion Report TPRL and SAL 73 direct provision of budgetary resources to improve farmer welfare, measures lo-increase competition in distribution, and a flat 10-percent ad valoremn tariff surcharge. 40. The variable surcharge has been potentially damaging to the overall thrust of trade reform because it provides the thin end of the wedge for protectionist interests. The current situation is that the scheme, now covering 20 products, has been more or less brought back to its September 1991 situation. Given opposition within the Government to the flat-10-percent-tariff recomrnendation, and the view that evolved in the Bank that the scheme should be changed wholesale (preferably eliminated) or not at all, the Bank has accepted the scheme in its present form, but has undertaken to keep the matter under review in its policy dialogue with the Government. 41. Non-tariff barriers related to health, technical, security, and miscellaneous regulations. The Government agreed to undertake a study to improve import procedures in this area. A study, completed in March 1992, analyzes procedures for importing agricultural goods and inputs, and proposes criteria and measures for non-discriminatory health controls. 17 It criticizes the protectionism of pre-Fujimori measures, but also suggest that health risks may be posed by the extent of liberalization associated with some of the post- Fujimori reforms. The study was originally intended as the basis for Bank-Governrment agreement on new policy measures to be taken. However, the complexities of the public- goods problems involved in health and safety controls suggest that thorough-going reforms will require more study. 42. Nonetheless, the Government has been assiduous in fighting the lingering bureaucracy of some of its ministries. In the area of certifying agricultural and pharmaceutical imports, it has made progress -- at times slow and halting -- in establishing procedures allowing private agents to certify imports. Surveillance of non-tariff barriers is now the responsibility of a new National Institute for the Maintenance of Competition and Defense of Intellectual Property (INDECOPI). INDECOPI continues to be active in studying methods ol reducing the discriminatory impact of non-tariff barriers, and may take over accreditation responsibilities for health and quality certification from the Ministries of Agriculture and Health. 43. Customs Reform. The Government agreed to formulate and carry out an Action Plan to restr-ucture the Customs Superintendency (SUNAD) and reform the legal framework lolr customs. The Action Plan has been carried out, and SUNAD has made impressive progress in changing its structure and practices. Customs bureaucracy has been redluced, and imports are now processed more rapidly: it now takes less than a day, on average, to clear customs. There has been a dramatic increase in revenue collection: from 1990 to 1992 the value of imports increased by 40 percent while revenues doubled. But the present reform may not go htr enough. There is, for instance, further scope for privatizing customs clearance, leaving a streamlined SUNAD to issue rules and to supervise. The Government has been considering further reformn along these lines. 17 Hcriiogeines Pinedo R., Criterios y Nortmas de Imporracion: Eliminacion de Barreras No Arancelarias al Conlercio Exterior: Inventario iv Criterios para Mejorar la Aplicacion de las Normas de Control Sanitario en la lnporlacion tie Producros e Insumos Agrarios, Lima, Marzo 1992.  Project Completion Report: TPRL and SAL 14 44. A pre-shipment inspection (PSI) scheme, designed to increase tfie efficiency and honesty of collecting tariff revenue, has been working since March 1992. The Bank had no conditionality in this area. Indeed, the President's Report was equivocal about the benefits of the scheme (para. 90). (In general, the Bank has embraced such schemes more positively than this.) Few have been caught cheating, but the services of PSI companies must have played a significant role in the increase in tariff revenues. The Government has explained that the PSI scheme is intended to last for no more than one to two years, by which time customs will have a decent customs valuation data bank. A Bank study has looked at the Peruvian PSI scheme in the context of a broader research project on the costs and benefits of PSI schemes.'8 The study acknowledges the benefit of the scheme as a transitional aid to customs reform by removing the valuation process from customs and giving the service a breathing space to concentrate on other aspects of reform. But the net benefit is likely to decrease over time as customs and trade reform reduces the returns to false declarations. Thus, SUNAD must begin to take over progressively customs valuation responsibilities from the PSI companies. The External Financing Plan 45. Peru's arrears grew rapidly from 1983 onwards. In July 1985, the Government announced that it would cap total foreign debt payments at 10 percent of exports. It had achieved this by 1988, by which time it had also extended its moratorium to the international financial institutions. Thus Peri became largely uncreditworthy in international financial markets. 46. With the Fujimori Government's announced intention of reintegrating Peri into international capital markets, the international community sought to develop a coordinated approach to address the problems of Peru's arrears and the heavy debt-service obligations it had undertaken (in spite of a fragile fiscal situation) by resuming current debt-servicing to the international financial institutions. Given that, at the beginning at least, international donors were skeptical of Peru's capacity for recovery, the approach taken was step-wise. The donors and the Government adopted a 1991-92 external financing plan that addressed the issues of rescheduling Peru's arrears to bilateral official creditors and accomplishing the normalization of Peru's standing with the three international financial institutions."J The resolution of arrears to private creditors was to be unilaterally deferred. 47. The IMF took the lead in the forecasts on which the plan was based, and the Bank adopted these forecasts. As is traditional in the approach of donor groups and agencies, the "bottom line" of these forecasts is an estimated financing gap which donors are called on to fill. This kind of analysis is, of course difficult; some of the items projected are residuals, and flexible exchange rates (as is Perui's case), reduce, ex-post, the projected gaps. Nonetheless, the projection serves the purpose of justifying aid levels. 18 Geoffrey J. Bannister, The Peruvian Pre-Shipmnent Inspection Program, International Trade Division, World Bank, July 1993. '9See paras. 54-72 of Report and Recommendation of the President of the International Bank for Reconstruction and Development to the Executive Directors on a Proposed Trade Polic) Reformri Loan in an Amount Equivalent to US$300 Million to the Republic of Peru, P-5666-PE, January 10, 1992.  Project Completion Report: TPRL and SAL 15 Table 1: Peru - External Financing 1991-93: Planned and Actual (US$ millions) 1991 a. 1992 a. 1991-1992 1993 b. A. ESTIMATES: Financing Requirements: 1. Non-Interest Current Account Deficit 536 492 1028 1025 2. Debt Service Obligations 2616 2398 5014 2483 3. Arrears to be Settled in Current Year 12055 1800 13855 1799 4. Increase in Gross Reserves 454 303 757 324 5. Gross Financing Requirements (I +2+3+4) 15661 4993 20654 5631 6. Loan Disbursements in Pipeline 255 200 455 283 7. Private Capital Flows 908 545 1453 1445 8. Net Financing Requirements (5-6-7) 14498 4248 18746 3903 Sources: 9. Debt Rescheduling and Deferral 13598 1467 15065 1220 Official Bilateral 6352 769 7121 692 Private 7246 698 7944 528 10. Additional Disbursements 900 2781 3681 2682 Multilateral 654 2328 2982 2272 Official Bilateral 246 453 699 410 11. Additional Financing Required 0 0 0 0 12. Total Sources of Financing (9+10+ 11) 14498 4248 18746 3902 B. ACTUAL: Financing Requirements: 1. Non-Interest Current Account Deficit 877 1159 2036 1149 2. Debt Service Obligations 2925 2133 5058 2456 3. Arrears to be Settled in Current Year 4890 37 4927 1725 4. Increase in Gross Reserves 904 257 1161 275 5. Gross Financing Requirements (I +2+3 +4) 9596 3586 13182 5605 6. Loan Disbursements in Pipeline 217 244 461 174 7. Private Capital Flows 1892 1898 3790 1698 8. Net Financing Requirements (5-6-7) 7487 1444 8931 3733 Sources: 9. Debt Rescheduling and Deferral 6352 1285 7637 1484 Official Bilateral 6352 777 7129 893 Private 0 508 508 591 10. Additional Disbursements 1135 159 1294 2249 Multilateral 698 64 762 2048 Official Bilateral 437 95 532 201 11. Additional Financing Required 0 0 0 0 12. Total Sources of Financing (9+ 10+ 11) 7487 1444 8931 3733 a. Estimates are from the beginning of 1992. b. Estimates are from the beginning of 1993; actual is preliminary figures.  Project Completion Report TPRL and SAL 16 48. In September 1991, after the IMF's Board approved the RAP' the plan achieved two major objectives with: the Paris Club rescheduling, on exceptional terms, for the period October 1, 1991, to December 31, 1992; and the debt workout with IDB (followed by IDB's resumption of normal lending).20 During that year the Support Group gave US$370 million in balance-of-payment support and another US$67 million in project support (see Table 1). The Support Group contributed US$128 million of balance-of- payment support in 1992 and another US$50 million in project support. In September 1991, the Support Group had sought to raise US$1.3 billion for 1991-92. By the time that the Bank presented its three adjustment loans to the Board (first half of 1992), this figure had been revised down to US$700 million. The actual Support Group contribution for the two years (balance-of-payments support only) totalled US$595 million. The shortfall was partly the result of suspended disbursements after the "auto-golpe" of April 5, 1992, including concerns about human rights. Of the two largest contributors (and co-chairs of the Support Group), Japan, less affected by these concerns, gave more than it had initially pledged, while the US gave far less.2' Postponing the arrears workout for the Bank and the IMF from the end of 1992 to the beginning of 1993 meant that the final result of the 1991-92 external financing plan was achieved a little behind schedule. 49. Once Peru had normalized its relations with official bilateral creditors and the international financial institutions, the Government in 1993 began negotiations with its commercial bank creditors. In May 1993, Perfi also benefitted from a further Paris Club rescheduling which reduced Peru-'s debt service due to Paris Club countries by about US$1.88 billion for 1993 to 1995. The success of this settlement was deemed to virtually eliminate the need for a Support Group in 1994 and 1995. The Support Group met for the last time in March 1993, pledging US$265 million for 1993. VI. Implementing and Monitoring the Loans The Borrower 50. The President appointed well-qualified professionals to design and manage the reform and stabilization programs. Two Ministers of Economy held office during the performance period, but the reforms followed a single direction. Moreover, many of the advisors remained at their positions, giving continuity to the economic policy. The principal Ministries responsible for the Structural Adjustment Program were Economy and Finance, Labor, Agriculture, Health, and Education. In addition, the Central Bank and the Commission for the Promotion of Private Sector Investment in State Enterprises (COPRI) had a direct participation in the SAL. The Bank worked closely with a special coordinating unit set up in the Ministry of Economy and Finance to monitor the specific targets agreed on both loans and to report on their status to the Bank. A special unit was set up in the Central Bank to prepare disbursement documentation. 20The Latin American Reserve Fund (FLAR) also contributed a bridge loan of $325 million in connection with the IDB workout, but the Central Bank repaid this almost immediately. 21This was made up as follows: $20 million from the US; $422 million from Japan; $16 million from France; $25 million from the Netherlands; $5 million from Sweden; and $10 million from Switzerland.  Pro1ect Completion Report: TPRL and SAL 1 7 Project Mlonitoring 51. The Bank supervised the maintenance and implementation of measures agreed under both loans not only through supervision missions, but also by establishing a local monitoring unit, staffed by consultants, which provided regular and detailed reports to the Bank on policy changes and the fulfillment of project conditionality. The monitoring unit was extremely valuable in providing accurate and timely information over a broad range of policy areas and in the timely detection of any problems that might arise in the fulfillment of conditionality. The Bank also consulted closely with IDB on common concerns arising from the conditionality of its loans (mostly in issues related to trade). 52. As the Bank's workout policy requires, the Bank reported regularly to the Board on the implementation of these two projects, as well as the Financial Sector Adjustment Loan, in the context of the Peru workout program. Three reports were submitted to the Board after the Trade Policy Reform Loan and SAL had been presented to the Board, in May, October, and December of 1992. The final report, indicating a successful conclusion to the "performance period", sought the Board's approval for arrears clearance and permission to sign the three adjustment loans prior to the arrears clearance, with effectiveness of the loan agreements and disbursements conditioned upon arrears clearance. The permission to sign allowed the Government to complete expeditiously the legal steps required to ensure the validity of the loan agreements. Disbursement 53. One of the biggest problems in loan preparation -- and one internal to the Bank -- was the disbursement issue. Arrears clearance was to be accomplished through the instantaneous disbursement of around US$900 million from three projects. This required, according to the Bank's rules, documentation of payment for eligible imports; and it posed difficulties on two fronts. First, US$900 million (about 30 percent of Peru's annual imports) was a large amount to document, especially given that an estimated US$1.4 billion of IDB and Support-Group financing due by the end of 1992 also needed to disburse against similar documentation. Second, obtaining evidence of payments for imports would be very problematic: the very reforms that our loans were supporting had eliminated the need for import transactions to go through the Central Bank, while bank secrecy laws made it potentially difficult for the Bank to obtain evidence of payment for imports from commercial banks. These difficulties have also to be understood in the particular context of the Peru workout: Bank disbursements were to be more or less equivalent in size to the arrears that Peru would pay the Bank. In the event, there was a net transfer of funds from the Bank to Peru of US$33 million. 54. Notwithstanding this, the solution to these difficulties maintained the principle of disbursing against imports. The solution had two principal elements. First, the Bank permitted an unusually long period of retroactivity. The performance period for Peru was defined, with some logic, to begin when Peru's reforms began, i.e. in August 1990. This justified an expected 28-month period (that is, until December 1992) of imports eligible for disbursement. Second, for the first loan to go to the Board (the Trade Policy Reform Loan in February 1992), the Bank made an exception to its normal rule of disbursing against proof  Project Completlon Report: TPRL and SAL 78 of payment for imports. It accepted instead evidence of the act of importing contained in customs declarations as a proxy for evidence of payment. The issue of disbursing adjustment loans had been recently raised elsewhere in the Bank, and as a result of the new Peru precedent, the Bank quickly established a new policy for disbursement of adjustment loans which accepted proof of importing as the basis for disbursing adjustment loans. By the time the SAL went to the Board, it was covered by the new policy.22 55. The disbursement issue constituted a costly, contentious, and arcane part of project preparation. Even though the Bank solved its difficulties and the loans were disbursed smoothly, the Peruvian Govermment, through its special unit in the Central Bank-, was still involved in considerable expense in compiling the necessary documentation. The Arrears Clearance Process 56. Arrears were finally cleared on March 18, 1993, in a complex, multi-party transaction which, in order: 3 provided bridge financing from the U.S. Department of the Treasury and the Export- Import Bank of Japan (both via the Federal Reserve Bank of New York) to permit IMF arrears clearance; * aused the proceeds of the IMF disbursement (plus a small, additional amount of funds from the Peruvian Government and the US Treasury) for clearing the arrears of the Bank; and * ldisbursed Bank funds to the bridge financiers who, once they had taken back the amount of the bridge financing, disbursed the remainder to the Peruvian Government. The transaction needed to be fast and minutely planned to minimize the cost of the bridge loan and the chance of the process going wrong. To this end, a Bank inter-Departmental arrears clearance team, formed in April 1992 (and modelled on a team approach to the earlier clearance of arrears for Zambia), had been meeting regularly to prepare the clearance. In the event, the above three steps were completed in 95 minutes -- including a record 33 minutes from clearance of the Bank's arrears to Bank instructions to disburse to Peru. VII. Conclusions 57. The Trade Policy Reform and Structural Adjustment Loans had a double objective: first, to sustain and extend Peru's economic reform program; and second, to effect (along with the Financial Sector Adjustment Loan) a debt workout for the country, thereby helping reintegrate it into the international financial community. The operation appears so far to have been a complete success. 22ln disbursing its Trade Reform Loan (first tranche in September 1991) the IDB had already adopted a similar approach.  Project Completion Report: TPRL and SAL 19 58. Between August 1990 and December 1992, the performance period set by the Bank and the IMF, a new Administration laid the basis for one of the most fundamental and rapid economic reforrns witnessed in any country. These reforms may take a long time to bear fruit, if the experience of other radical reformers such as Chile and New Zealand is anything to go by. Moreover, the economic situation remains fragile: a still-delicate fiscal balance translates into obstinately high inflation and interest rates, though they have been falling. But the resumption of growth -- so far sustained -- since the end of 1992 and a palpable revival in investor confidence augur well.23 The success of the reform program benefitted from the single-mindedness and pragmatism of the Peruvian Government. 59. Peru has now cleared its arrears with the Bank and the other financial institutions. The Bank's arrears were cleared, and an equivalent amount disbursed in adjustment lending, only after a performance period during which the Bank carefully monitored: Peru's compliance with macroeconomic stabilization program and structural adjustment programs; the execution of an internationally coordinated external financing plan; and Peru's continued servicing of its current debt to the Bank. The indicators are that the arrears clearance operation has not compromised the Bank's standing on capital markets. The Peruvian case had the added benefit of having catalyzed a Bank-wide workout policy. Issues in Project Design and Preparation 60. The project timetable. The preparation and implementation of both projects suffered various delays, although these delays may in the end not have been too costly. * The Bank first started discussing a Bank-wide workout policy in 1989 and took until 1991 to put one in place. This could perhaps have been achieved a year earlier, and it took developments in Peru to bring the matter to a conclusion. T he Bank took 16 months from Peru's resumption of debt servicing (in October 1990) to present its first adjustment project to the Board (in February 1992). The Bank had maintained its economic work on Peru after it stopped lending in 1987 and was quick to establish contacts with, and offer advice to, the new Administration in 1990. The transfer of responsibility for Peru from one Department to another at the beginning of 1991 may have cost a little momentum. Once the Bank had decided to go ahead with the clearance exercise and prepare three projects, the first two were presented to the Board a few months later than initially projected (the Trade Policy Reform Loan was three months late, the SAL two months). Most aspects of project preparation went very smoothly, because of the good knowledge base and the virtual absence of disagreement with the Government. Coordination within the Bank proved more difficult. In particular, the disbursement issue and the normal bureaucratic clearance 23Peru's political ups and downs have affected investor confidence. The "auto-golpe" of April 1992 harmed the recovery, but progress in returning to democratic institutions, as well as the considerable damage that the Government has inflicted on Sendero Luminoso, the terrorist movement, have been positive developments. The commercial success of the privatization program is one indicator of the new confidence.  Project Comp/etion Report: TPRL and SAL 20 requirements consumed a large amount of time.24 Board presentation was an important political signal, and earlier Board presentation would have been beneficial. 61. The debt workout. Some of the discussion preceding the establishment of a Bank workout program centered on issues of sequencing between the international financial institutions and of sharing the burden in the clearance process. In these discussions there may have been something of an implicit presumption in the Bank that bearing a smaller burden and earlier clearance were better. This is not necessarily so. The Bank's financial health may not necessarily be best served in this way, while the Bank's financial concerns may often conflict with its development role. In the case of the Peru. workout, it is not easy to come to firm conclusions, but some points can be made. * Burden sharing. In the case of Peru's debt workout for the Bank (as for the IMF) disbursements were approximately the size of arrears. In fact, the Bank's disbursements were US$33 million larger than Peri's arrears of US$867 million. Thus the rise in the Bank's country exposure (i.e. the sum of principal and overdue interest outstanding) was minimal, and it incurred little new direct risk. On the other hand, any new lending to Peru associated with arrears clearance posed a risk to the Bank's standing in capital-markets. This in itself might provide a reason to lend as little as possible, while the developmental impact of lending (for policy reforms, for example) would presumably stand in direct relation to loan size. The IDB's first disbursement on its arrears clearance (the first tranche of its adjustment loan) was slightly less than its arrears. Support Group disbursements in 1991 and 1992 allowed Peru to defray the costs of servicing its debt to the Bank and the IMF. Lending to Peru is risky -- though the perceived risks have fallen as Peru has sustained its recovery efforts -- and official bilateral lenders or donors thus bore a greater burden of risk than the international financial institutions. * Timing and sequencing of clearance. By waiting to clear late -- at the end of the performnance period and 18 months later than IDB -- the Bank postponed the resumption of its lending. It thus temporarily forewent part, but not all, of its developmental role. But it can be argued that the Bank (like the IMF) reaped financial advantages. First, the Bank was the recipient of net transfers from October 1990 to February 1993. During this period Peru paid the Bank over US$200 million in current debt servicing.25 Second, the discipline which the Bank encouraged in Peru -- in terms of economic policy and debt servicing -- cannot in itself have had a negative impact on capital markets. The later clearance lowered the risk of the Bank being associated with a failed reform and being perceived to have rolled over Peri's 24The IDB began to prepare an adjustment loan at the same time as the Bank -- and with less expenise on Peri -- and got to its Board by mid-September 1991. 251n 1991-92, the Support Group disbursed a similar amount to Peru. Officials from some of the Support Group governments privately complained, at the beginning of the process at least, that the international financial institutions expected bilateral aid to shoulder a large burden.  Project Completion Report: TPRL and SAL 21 debt. 26 * The effect of later clearance on Peru. As a development institution, the Bank must be as much concerned with its development impact as its financial standing. The Bank's late clearance imposed an immediate cost on Peru inasmuch as Penr spent two-and-a-half years servicing its current debt without receiving any development assistance. Against this, it may, of course, be argued that the discipline of the performance period -- and the public record of prompt debt service payments -- provided its own benefits to Peru. 62. Procurement and Disbursement procedures. The debt workout required, as a minimum, Bank disbursements equivalent in size to the arrears that Per6 owed, and there was in reality only a modest net transfer of funds (US$33 million) from the Bank to Peru. Nonetheless, the Bank's rules required that disbursements be made against import expenditures. This imposes a burden on borrowers -- albeit minor compared to the size of the loan -- without any effect on the procurement of imports from Bank member countries. A Country Procurement Assessment Report (CPAR) prepared by the Bank correctly identified the issues related to reimbursement of funds when no evidence of payment can be obtained, which permitted a broad discussion and prompt resolution of the issue in the Bank. The loans to Peru did succeed in somewhat simplifying the Bank's requirements in respect of import documentation. But it might be preferable, if this could be done consistently with the Bank's Articles of Agreement, to simplify disbursement procedures even more for adjustment loans, especially for those carried out in the context of an arrears clearance. 63. The Bank's relationship with the IMF and EDB. Peru resumed its current debt servicing to the IMF earlier than it did to the Bank or the IDB, while only the Bank and the IDB, not the IMF, suffered interruptions in current debt servicing in the course of 1991. (The IMF, through of its power of expulsion, enjoys leverage that the Bank does not have.) In spite of this differential treatment, all three international financial institutions came to cooperate in encouraging the Government to maintain current debt servicing to the three institutions equally. 64. The Bank had an exceptionally close working relationship with the IDB, the result largely of the transfer of a Bank staff member to the IDB in mid 1991 to spearhead IDB's own arrears clearance exercise with Peru. The Bank also enjoyed a close working relationship with the IMF. A division of labor emerged between the two institutions. The IMF took the lead, as it normally does, in agreeing on a macroeconomic stabilization plan with the Government, and the Bank sought to emphasize those policy aspects of the plan it considered most vital. The IMF also coordinated the external financing plan (leaving the Bank, after the conclusion of the debt workout, to coordinate aid in the social sectors). The Bank took the main role on structural reforms, sharing this with the IDB in the area of trade (and, later, financial sector reform). 26Early on in the process of formulating a coordinated international approach, the international financial institutions were keen not to be last in the clearance process. There were obviously political gains to be made from being the first to clear, not least with the Peruvian Government. The financial gains are less clear.  Project Completion Report. TPRL and SAL 22 The Structural Adjustment Loan 65. The reforms supported by the SAL have proven to be among the most important changes in the country's economic framework since 1968. The reform program encompasses a change in development strategy from an inward-oriented import substitution scheme to a market-oriented open economy. The program aims to limit the long-run role of the Government to those activities in which it will be most efficient. In particular, the State is abandoning its role as producer and planner. It is concentrating instead on providing a stable legal framework for property rights, health, education, security and basic infrastructure and fostering an environment of competition designed to promote a more efficient allocation of resources. 66. The current Administration remains committed to the structural reforms and to current economic policy, and is expected to maintain that position until the end of its termn. Furthermore, the Administration has signed a three-year Extended Fund Facility Program with the IMF, that has defined an economic program for the period, setting goals and targets consistent with increased stability. 67. However, inflation and real interest rates remain high relative to international standards, and financial intermediation remains limited. There are still concerns about the sustainability of the economic program beyond 1995. On the macroeconomic side, the fears are based on the fragile situation of the fiscal balances over the medium term, unless there is an increase in the level of tax revenues and an increase -- very difficult to achieve -- in the efficiency of public expenditure. 68. In addition, some positive economic achievements are required to fully consolidate the stabilization program. In particular, the recent recovery in growth must be sustained, real interest rates must fall further, perhaps the real exchange rate must still depreciate further, and the banking system must recover its health. The long-term sustainability of the broad structural reforms and economic improvement implemented by the Fujimori Administration will depend on long-term political support. Maintaining democratic procedures, given the political turmoil of recent years, while providing continuity in economic policy is a large challenge. On the other hand, after a quarter-century of economic mismanagement and decline, many Peruvians share a stake in, and hope for, the economic reforms. 69. Peru's experience contains some lessons about the course of stabilization of a highly repressed economy. * In a scenario of historical instability and persistent dollarization, the increase in the demand for domestic real balances will be small despite a reduction in the inflation rate. * In this framework, the efforts of the Central Bank to depreciate the real exchange rate through direct purchases of foreign exchange will generate inflation. * Financial intermediation in dollars reduces the effectiveness of monetary policy but  Project Completion Report: TPRL and SAL 23 deepens financial intermediation and provides a "strong" currency which facilitates trade and exchange. * Real interest rates may remain high despite the opening of the capital account, reflecting a combination of country risk, expectations of a real exchange depreciation, and the level of taxation. In turn, this may attract foreign capital and further affect the real exchange rate. The Trade Policy Reform Loan 70. The Trade Policy Reform Loan was based on a sweeping and simple reform program which took place within a broader and supporting program of macro- and microeconomic reforms. The essence of the reform was to move trade policy to a stance approaching neutrality, i.e., where there is minimal policy discrimination between different economic activities, between, firms, or between imports and exports. Peru's trade reform was in general as radical and rapid as that observed in any other country, including Chile and Bolivia. The relative roles of the Peruvian Government and World Bank (and IDB) in making the case for and designing the reform are hard to distinguish. In the very early days of the Government, the Bank's advice was important, but from early 1991 onwards, the initiative in design was clearly that of the Government. There is no doubt of Peruvian "ownership". 71. The trade reforms have been completely effective in moving trade operations to a more market-oriented system of incentives and greater integration with the world economy. While the Peruvian economy has now begun a strong recovery from decades of stagnation and a subsequent period of recession (induced by the stabilization), it is as yet difficult to identify measurable changes in the structure or level of trade (beyond a rapid growth in imports and some change in their composition), hence to measure the gains from trade reforms. If the economic reforms are maintained, measurable benefits are soon likely to be apparent. 72. There are several features of Peru's trade reform that augur well for its sustainability. First, the program was bold and rapid. This made it politically convincing. Second, the rapid and virtually complete elimination of quantitative restrictions further added to its credibility. Third, Peru has maintained a stable macroeconomic environment. If there is a feature of the reform that bodes less well, it is that the reform took place without any apparent real depreciation of the currency. Indeed, the perception among economic agents was especially prevalent in 1991-92 that the currency was overvalued. There is no evidence that, under the circumstances, the currency could have been much more depreciated, if only because there was a strong inflow of short-term capital over which the Government did have (and could have) only limited control. On the other hand, a more depreciated currency would undoubtedly have helped in the "political economy" of trade reform by raising the profitability of exporting and thereby more rapidly creating a new political constituency for trade reform. The currency has depreciated in real terms since 1992, so that the problem of perceptions has receded and the opportunities for profitable exporting have grown. More generally, domestic politics are likely to be the main determinant of the sustainability of Peru's economic reforms, including trade reform.  Project Completion Report: TPRL and SAL 24 73. The experience of the Trade Policy Reform loan contains some lessons of a narrower, more technical kind. The Loan provided support to the agricultural surcharges scheme on the argument that food price stabilization could benefit the economy. The scheme (providing a price floor, but not a ceiling) was never the best design to stabilize prices. It has, in the event, operated most unsatisfactorily, neither stabilizing prices nor benefitting farmers. And it has threatened to open a protectionist breach that might be exploited in attempts to reverse other measures of the trade reform. In retrospect, the Bank's efforts should have been applied to fundamentally changing the scheme (a flat surcharge, for instance, but preferably a complete elimination). Failing this, the Bank should have left the scheme alone. As more and more Bank member country undertake fundamental trade reforms, Bank expertise needs to encompass, in addition to the "why" and "how" of trade reform, a new set of issues which, broadly speaking, come under the heading of "trade facilitation". Prominent among these are issues such as customs reform (including the role of pre-shipment inspection), port reform, and implications of reform for transport infrastructure. The Loan supported a customs reform program. IDB provided the major input, negotiating project conditions with the Government and closely supervising implementation. The Bank relied heavily on the IDB in the design and supervision of this component, which appears to have been very effectively implemented. This may have been a somewhat too passive stance for the Bank. The Bank could benefit from its own expertise in customs issues. Perul, having eliminated a large array of clearly protectionist non-tariff barriers, now has to deal with residual non-tariff barriers imposed for health, safety, and security reasons. Many of these barriers respond, in theory at least, to valid problems of public health and so on. The issue is to be able to distinguish justifiable cases of public-good barriers from unjustifiable cases and to design an efficient and non- discriminatory mechanism. The Bank has played a leading role in identifying, and developing techniques to measure, non-tariff barriers. It could now benefit from developing its own expertise in regulations that minimize the costs and discriminatory nature of health and safety controls.  Project Completion Report: TPRL and SAL 25 REFERENCES The World Bank-, Perti: Sector Refonn and Investment Review. November, 1990 Economic Reforms to Sustain Stabilization and Lay the Foundations for Development, December 8. 1990 Demetris Papageorgiou, Armeane M. Choksi, and Michael Michaely, Liberalizing Foreign Trade in Developing Countries. the Lessons of Experience, Washington, D.C.: the World Bank, 1990 Additional Support for Workout Programs in Countries with Protracted Arrears, R91-70, April 11, 1991 and Chairman's summing-up remarks Peru: the Bank's Approach to a Country with Protracted Arrears, R91-171, July 12, 1991 Report and Recommendation of the President of the International Bank for Reconstruction and Development to the Executive Directors on a Proposed Trade Policy Reform Loan in an Amount Equivalent to US$300 Million to the Republic of Perui, P-5666-PE, January 10, 1992 The World Bank, Peru: Economic and Sector Reforms to Sustain Stabilization and Lay the Foundations for Development, green cover, 10361-PE, February 18, 1992 Pinedo R., Hermogenes, Criterios y Normas de Importacion. Eliminacion de Barreras No Arancelarias al Comercio Exterior: Inventario y Criterios para Mejorar la Aplicacion de las Normas de Control Sanitario en la Importacion de Productos e Insumos Agrarios, Lima, Marzo 1992 Report and Recommendation of the President of the International Bank for Reconstruction and Development to the Executive Directors on a Proposed Structural Adjustment Loan in an Amount Equivalent to US$300 Million to the Republic of Perul, P-5714-PE, March 2, 1992 Peru: Quarterly Review of Progress in the Bank's Workout Program, SecM92-697, May 28, 1992 Escobal, Javier, and Arturo Brisceno, El Sistema de Sobretasas Agricolas en el Peru. Evaluacion y Recomendaciones, GRADE, 28 de Agosto de 1992 Peru: Quarterly Review of Progress in the Bank's Workout Program, SecM92-1310, October 1, 1992 Per.: Final Review of the Bank's Workout Program, R92-226, December 10, 1992 Bolofia Behr, Carlos, Cambio de Rumbo: el Programa Econ6mico para los '90, Segunda Edici6n, Lima: Instituto de Economia de Libre Mercado, 1993  Project Completion Report: TPRL and SAL 26 Cooperacion Tecnica a Superintendencia de Aduanas (SUNAD): Supervision de la Tercera Fase: Informe de Mision, IDB, 1993 (mimeo) Joint Audit Committee, Review of IBRD Policy on Workout Programs for Countries wvith Protracted Arrears, JAC93-17, April 30, 1993 The World Bank, Perua at the Crossroads. Building a Modern State, Green Cover, 11943- PE, June 30, 1993 Geoffrey J. Bannister, The Peruvian Pre-Shipment Inspection Program, International Trade Division, World Bank, July 1993 World Bank, Peru: a Private Sector Assessment, Green Cover, 12096-PE, December 20, 1993  - 27 - Annex 1: TRADE POLICY REFORM LOAN: POLICY MATRIX ISSU'ES AND OBJECTIVES ACCOMPLISHMENTS FROM MID-1990 CONDITIONS OF LOAN STATUS TO BOARD PRESEN'TATION SIGNING INIPORT TARIFFS Structure By March, 1991, 3-rate structure of 5, 15, 25%; Eliminate 5% rate (steel-industry Completed. (D. Lg. average of 17%; coeff. of variation of 23%. inputs) by March 1992; unless No. 668) Increase neutralitv of tariff structure. implementation during 1992 of an (The alternative Andean-Group common external tariff Andean-Group option appears likely by that time. has not been pursued.) Preferences on the Domestic Elimination of most regimes by September, No reintroduction of discriminatory Maintained. Market 1990 (major exceptions are educational & preferences. cultural institutions; treaty agreements. Increase neutrality of tariff structure. Specific Tariffs Removal of all surcharges by March 1991; Publicize, by Board presentation, the Study completed and and Tariff Surcharges variable surcharge on 5 agricultural products, existing method of setting the variable surcharge scheme introduced in May 1991. surcharge. Reform of surcharge revised (D. Ley No.. Increase transparency and efficiency of scheme: agree study TOR by March 25528.) agricultural protection. 1992, agree implementation guidelines by June 1992, enact reform by September 1992. Safeguard Mechanism Introduction of an anti-dumping/subsidy code in Reform of anti-dumping code: agree Study completed and June 1991. study TOR by Board Presentation, code revised (D.S. No.. Minimize protective effect of enact reform by March 1992. 051-92-EF.) anti-dumping protection.  - 28 - Annex 1: TRADE POLICY REFORNM LOAN: POLICY MIATRIX ISSUES AND OBJECTIVES ACCOMPLISHMENTS FROM MID-1990 CONDITIONS OF 10).4N STAsT1IS TO BOARD PRESENTATION SIGN ING NON-TARIFF IMPORT BARRIERS Fornmal Protective Barriers All prohibitions/ restrictions suspended by No reintroduction ot non-larnl Mdannined. September 1990, permanently liberalized by barriers. Increase neutrality of protection March 1991. structure. Health, Technical. Security, and Various reforms from March to May 1991, Reform of health and sanitary Studv completed and Miscellaneous Regulations removing or simplifying controls: reintroduction regulations & technical standards: agricultural and of controls in a few cases. agree study TOR by Board pharmaceutical import Reduce discriminatory effect of health presentation, agree implementation controls made more and technical regulation. guidelines by March 1992. enact flexible.(D.S. No.. reform by June 1992. 093-92-EF and D. Ley No.. 25596). Inmort Monopolies All public-enterprise monopolies removed in No reintroduction of import Maintained. principle in March 1991; ENCI & ECASA monopolies. Increase neutrality of protection monopolies removed in March 1991; Petroperu structure. monopoly removed in August 1991. Local-Content Regulations All local-content regulations eliminated in March No reintroduction of local-content Maintained. 1991. regulations. Increase neutrality of protection stnucture. Controls on Second-Hand Imports of most second-hand goods allowed in No reintroduction of controls in Maintained. Imoorts November, 1990 and of machinery and vehicles second-hand imports. in March 1991; only controls on clothing, shoes, Increase neutrality of protection and bath fixtures remain. structure.  - 29 - Annex 1: TRADE POLICY' REFORM" LOAN: POLICY NtATRIX ISSUES AND OBJECTIVES ACCOMPLISHMEENTS FROM N MIID-1990 CONIDITIONS OF LOAN STATUS TO BOARD PRESENTATION SIGNING EXPORT REGIME Taxes on Traditional Exports After 10% surcharge from August to November No raising of tax rates or application Maintained. Increase neutrality of export regime. 1990, taxes range from 0% to 10% by February of tax to new products. 1991. Subsidies for Non-Traditional Reduction (August), then abolition (November No re-introduction of export Maintained. Exports 1990) of CERTEX; abolition of FENT in subsidies November 1990. Increase neutrality of export regime. Indirect Tax Treatment Automation of Temp. Adm. scheme and its No further action required. Letter of Development broadening to all exporters in March 1991; Policy undertaking to Reduce fiscal discrimination against introduction of drawback scheme for non- extend the drawback exports. traditional exports in March 1991. system has been signed and sent to the Bank. Export Contracts No new contracts are being issued and scheme is No further action required. Maintained. defunct. Increase neutrality of export regime. Free Trade Zone Any new or expanded zone may only Existing free tmde sell to the domestic market if import zones not expanded Reduce unfair competition in the taxes are paid. domestic market. Non-Tariff Export Controls Removal of controls in March 1991. No reintroduction of non-tariffs Maintained. export controls. Increase neutrality of export regime. Export Certification No further action required. Maintained. Increase neutrality of export regime.  - 30 - Annex 1: TRADE POLICY REFORMI LOAN: POLICY MNATRIX - ISSUES AND OBJECTIVES ACCOMPLISHMENTS FROM MID-1990 CONDITIONS OF LOAN STATUS TO BOARD PRESEN'TATION SIGNING TRADE INSTITUTIONS Non-Tariff Barriers ICE de-activated in June 1991, and its No further action required. Maintained. promotional functions transferred to MICTI. Eliminate institutional basis for non-tariff protection. Tariff Administration (MEF) Creation of Control Commission for anti- Procedures to ensure open, impartial Completed. dumping rules. anti dumping hearings to be agreed by (D.S. No.. 133-91-EF Minimize protective effect of anti- loan negotiation. and dumping legislation. D.S. No. 051-92-EF) Customs Service Transfer of some functions to private agents; Agreement by Board presentation on Action Plan carried out monopoly on customs warehouses removed. Action Plan; compliance with three according to schedule. I;.prove efficiency in processing phases of Action Plan, by Board i:nports and raising revenue. presentation (1), by March 1992 (2), and by June 1992 (3). Export Promotion Function transferred in June 1991 from ICE to No further action required. Maintained. MICTI. Shift emphasis from selective promotion to commercial intelligence. Trade Neaotiation Creation in June 1991 of an inter-ministerial No further action required. No change. committee, with an Office of Trade Improve intergovernmental Representative in MICTI. coordination. Trade Law August 1991 passage of a legislative Decree No funher action required. No change. elevating to the status of law many of the trade Provide legislative stability for reforms passed since August 1990. reformed trade regime.  - 31 - Annex 2: STRUCTURAL ADJUSTMEN!T LOAN: POLICY MIATRIX ~~~~~~~~~~~~~~~~~~- -. ISSUES AND OBJECTIVES ACCOMPLSHMENTS FROM MID-1990 CONDITIONS OF LOAN SIGNING STATUS TO BOARD PRESENTATION MACROECONOMIC ISSUES Exchange Rate Reeime Unification and float. Maintain domestic-currency Completed. convenibility for all external Improved resource allocation. transactions to a single type of exchange rate. Foreisn Exchange AUocation Elimination of foreign exchange surrender Non-reversal of policy. Completed. requirements and all other controls on current and capital account transactions. Foreign Currency Holdings Removal of freeze on foreign exchange The use of foreign currencies in the Completed. certificates of deposit. Dollar deposits local financial system will continue. Keep a fluid payments system in increased 125% between August 1990 and July the presence of a persistent 1991, up to a level of US$ 1814 million, trend of dollarization of the compared with US$ 1297 million in Sol- economy, denominated liquidity. External Debt Service Resumed payments to all IFIs. Completed Maintain payment to all IFMs and Completed. negotiations with Paris Club. continue negotiations with all other Restore access to international creditors aiming for the full capital markets. restoration of service. Monetary Policv Creation of monetary base mainly to finance Non-reversal of policy. Completed. the quasi-fiscal deficit and increase foreign Gradual achievement of price reserves of the Central Bank. stability. Credit Miarkets Interest rates allowed to be matket determined. Interest rates will be allowed to Completed. continue to be established by market Efficient allocation of credit. forces. Market Alocation Mechanisms All price and wage controls lifted. Maintain market determination of Completed. prices and private sector wages. Efficient resource allocation. Fiscal Balance Consolidated Public Sector Operational Deficit Adopt measures and an Completed. reduced to 6.5% of GDP in 1990 and an implementation schedule satisfactory Control of inflation. expected 3.6% in 1991. to the Borrower and the Bank aiming NFPS primary deficit reduced to 1% of GDP for a level of Tax Revenues for the in 1990 and expected to reach a 0.4% surplus Central Administration of about 9.0% in 1991. of GDP. The primary deficit of the NFPS will not be larger than 0.6% of GDP (Jan.91-Dec.92) and there will be no domestic financing of the Consolidated Public Sector Balance, defined as the deficit of the primary balance added to the quasi-fiscal deficit, plus interest payment on internal and external debt. Deficit Financina Internal financing of the CPS reduced to 3.3% Central Bank creation of domestic Completed. in 1990 and expected to reach 0.5 % for 1991. credit consistent with IMF targets. Control inflation. Inflation reduced to 230% between August 1990-1991.  - 32 - Annex 2: STRUCTURAL ADJUSTMENT LOKN: POLICY MATRIX ISSUES AND OBJECTIVES ACCOMPLISHNIENTS FROM MMI-1990 CONDITIONS OF LOAN SIGNING STATUS TO BOARD PRESENTATION Macroeconomic Indicators Expected 1991 values: Performance indicators for 1992 Actual performance (NOT CONDITIONALITIES): for first three quarters of 1992: These indicators should not be Central Administration Tax Revenue: 7.6% of Central Administration Tax Revenue interpreted as individual targets to GDP; about 9.0% of GDP: 9.1% of GDP. be met for loan compliance, but rather as the Bank's guidelines to Primary surplus of the non-financial public Primary deficit of the non-financial Surplus: 0. I% of evaluate macroeconomic sector: 0.4% of GDP: public sector no larger than 0.6% of GDP. performance. GDP; Rate of increase in monetary base: 320%. Rate of increase in monetary base less than or equal to 40%: 37.8% Stock of Central Bank of other monetary liabilities in Soles always 2.5%. less than 10% of monetary base. FISCAL ISSUES Drastic increase in price of public sector goods By October 31. 1992, the Completed. Tax Regime and services and frequent price adjustments Government and the Bank will jointly allow sharp recovery in tax revenues. review taxes on exports, and bank Simplification of tax system. Simplification of tax regime. New regime current account debits and interest to Increase tax revenues and reduce based upon taxes on income, wealth, value assess the prospects of phasing them highly distortionary taxes. added, and selective consumption imports. out within a specific timetable. Elimination of most exemptions. Reduction of some marginal tax rates. Simplification of tariff regime and reduction of tariff rates to three categories. Enactment of Legislative Decree 666 regulating VAT and selective excise taxes (September 11, 1991). Supreme Decree enacted to interpret the regulations created in Legislative Decree 666. by establishing procedures for their application (Supreme Decree 269-91-EF, November21, 1991, .  - 33 - Annex 2: STRUCTURAL ADJUSTMEN'T LOAN: POLICI' MATRIX ISSt ES AND OBJECTIVES ACCOMIPLISHNMENTS FRONI MID-1990 CONDITIONS OF LOAN SIGNING STATU'S TO BOARD PRESENTATION Tax Administration POLIC} CHANGES BETVEEN MARCH The monitoring of large taxpayers Completed 1991 & DECEMBER 1991 will be expanded from 1,200 to 2.50() Reintorce independence of firms. SUNAT (the Peruvian tax collection Diagnosis and design of strategy for structural agency) and improve its efficiency as reform to be implemented with the support of By March 31, 1992, SUNAT will Completed. measured by number of taxpayers Intemational Technical Assistance. complete the process of personnel and level of tax revenues. selection at the national level. Legislative Decree 639 (March 18, 1991): Provides the legal framework for the By June 30. 1992, the new Completed. reorganization of personnel and the acquisition infrastructure of computer of basic (local) equipment. information systems will be installed in Region I (primary taxpayers). Implementation of the program of voluntary resignation through incentives. The process of implementation of a Completed. new registration system for Personnel evaluation and selection with tax-payers will continue to be carried examinations in Lima. out on a priority basis. Definition of the organizational structure and Changes in the tax code, satisfactory Completed. structure of appointments to posts in the to the Borrower and to the Bank, will National Service Corps (Intendencias) and the be introduced to allow for greater Regional Service Corps I & 11 efficiency in the tracking of infringements. Legislative Decree 641 (June 26, 1991): Simplifies system of sanctioning so as to allow for implementation of moderate sanctions on a massive scale. Legislative Decree 673 (Sept. 24, 1991): Labor law which affects employees of the new SUNAT tax administration and made to correspond to Law 4916 (Private Sector Labor Law). Revise-and-purge process of the primary taxpayers' registry in existence and tax regime grants first priority to the VAT. Creation of a division for taxpayer account sanctioning and/or termination at SUNAT, charged with administering account closures and developing sanctioning systems for the Regional Service Corps (Superintendency Resolution 326-91 -EF/SUNAT, November 6. 1991). SUNAT increased the number of primary taxpayers to 2,220 on December 6, 1991.  -34 - Annex 2: STRUCTURAL ADJUSTMEN'T LOAN: POLICY NIATRIX ISSUES AND OBJECTIVES ACCONIPLISHMENTS FROM MID-1990 CONDITIONS OF LOAN SIGNING STAI't'S TO BOARD PRESENTATION Government Expenditure Tight controls upon public sector wages. No further actinn rcquired and Ouasi-Fiscal Deficit Reduction of public sector employment through incentives (Supreme Decrees 004-91-PCM & Increase the efficiency of 041-91-EF& Supreme Resolution 544-91- provision of public goods. INAPII). Introduction of a CMC (Cash Reduction of administrative Management Comminee), which spends only discretionality. its available cash (Supreme Decree 227-90-EF, Dec. 10, 1990 & General Public Sector Budget Law, December, 1991). Postponement of public investments. Limits to Banco Agrario subsidized credit. Elimination of subsidized credit to exporters. A draft law which incorporates agreement on substantive objectives satisfactory to the Borrower and the Bank was enacted, establishing the basis for reform of the Peruvian public sector, redefining the scope of government activities, and reforming personnel policies, including the tenure system (Supreme Decree 166-91-PCM, October 1991). SOCIAL SECTOR ISSUES Social Emergency Program (SEP) initiated to The Govemment will develop, by Completed. provide emergency food assistance and January 31, 1992, a poverty Poverty AUeviation medicines, mainly through NGOs, for 5 alleviation strategy and months (8/90-12/90). implementation schedule, both Develop well-targeted social acceptable to the Bank, outlining safety net mechanisms and With UNICEF assistance, a Plan of Action for policies, and identifying priority provide the context for individual Child Welfare was prepared and endorsed by programs and target groups. The social programs and projects. the Government in June 1991. It diagnoses Government will adopt this strategy problems and sets goals in the area of health, by December 31, 1992. education, water and sanitation, nutrition, employment, and the problems of children in difficult circumstances. In August 1991, a temporary National Social Compensation and Development Fund (FONCODES) was created (Legislative Decree 657, August 15, 1991) to finance employment- generating projects benefitting the population in extreme poverty. FONCODES's statute was approved through Supreme Decree 163-91 - PCM, October 20, 1991. Health and Nutrition The Ministry of Health defined short-term The Government will develop profiles Completed (two objectives for 1991: reduce mortality for priority projects in primary health profiles). Improve the provision of low-cost associated with high-prevalence illness; expand and nutfition acceptable to the Bank primary care to the poor. health coverage in poor areas: rehabilitate by April 30, 1992. social infrastructure; and upgrade the capacity of professional staff.  - 35 - Annex 2: STRUCTIJItAL ADkJUST'MENT LOAN: POLICY MATRIX ISSUES AND OBJECTIVES ACCOMPLISHMENTS FROM MID-1990 CONDITIONS OF LOAN SIGNING STATUS TO BOARD PRESENTATION Improve the cost effectiveness and Generalized food subsidies were abolished and The Government will prepare a Completed. impact of nutrition assistance to the monopoly positions of ECASA and ENCI national nutrition policy acceptable to the poor. were eliminated (Supreme Decree 066-91 -EF y the Bank, based on a review of Supreme Decree 067-91-EF, March 27, 1991). existing food assistance programs, and will recommend reforms necessary to improve cost effectiveness by April 30. 1992. The Government will initiate the first stage of these refortns in food assistance programs, including streamlining the role of public agencies, by June 30. 1992. Education The Ministry of Education defined broad short- The Government will develop profiles Completed (three term objectives for 1991 (to expand the for priority projects in pre-primary profiles). Increase internal efficiency of coverage and quality of primary education and and primary education acceptable to education and improve the quality link technical training to the job market) and the Bank by April 30, 1992. and coverage of pre-primary and medium-term priorities (to improve the quality primary education, of education, universalize education for 6-14 year old children, and upgrade the quality of teachers.) The Ministry of Education initiated an emergency program to feed schoolchildren one meal a day and use the school as a locus to introduce tuberculosis detection and improved health practices. PRIVATIZATION ISSUES The Govemment announced its intention to The Government will establish the Completed. Privatization of State reduce SEA and issued, on March 12, 1991, a institutional framework defined in Entrepreneurial Activity (SEA) Supreme Decree (No. 041-91-EF) authorizing Decree 674 by June 30. 1992. the privatization of 23 companies. Improve efficiency in allocation of resources through development The Government issued the Law for the of the private sector, avoiding the Promotion of Private Sector Investment in possibility of fiscal drain. State Enterprises, which called for (i) the creation of a commission, COPRI, to be responsible for the design and control of privatization, thus centralizing the decision making process, and (ii) the creation of Special Committees to implement the privatization of either one company or several within a sector (Legislative Decree 674, September 27, 1991). The Government issued a law providing a legal framework for foreign investment, through guarantees on the stability of the fiscal regime (Legislative Decree 662, September 2, 1991). The Government issued a Legislative Decree which establishes rights, guarantees, and obligations applicable to national and foreign investors (Legislative Decree 757, November 13, 1991). The Government issued Legislative Decree 674 which defines the legal and institutional framework for privatization (September 27, 1991).  - 36 - Annex 2: STRUCTURAL ADJUSTMENT LOAN: POLICY MATRIX ISSUES AND OBJECTIVES ACCOMPLISHMEN'TS FRONI MID-1990 CONDITIONS OF LOAN SIGNING STATUS TO BOARI) PRESENTATION SEA Privatization in Bankine The Government abolished the Financial The Government will develop an Completed. System Nationalization Law and included overall action plan and Banco Popular del Peru in the list of 23 implementation schedule acceptable companies to be privatized (DS no.041-91-EF). to the Borrower and the Bank for The Govemment decided to restructure public divestiture in the sector bv June 30. commercial banks with a new Banking Law in 1992. April 1991 (General Law for Banking, Financial, and Savings Institutions: Legislative Decree 637). The Government sold its 15 % share of Sogewiese Leasing on June 10. 1991. SEA Privatization in Fisheries The Government eliminated state monopoly of The Government will develop a Completed. fishmeal production in March 1991 and began policy framework for the sector and a a partial sale of the assets of Pescaperu. firm-by-firm divestiture strategy acceptable to the Borrower and the The Govemment issued a Law for the Bank, including an action plan and Promotion of Private Investment in the fishery implementation schedule for sector, prohibiting monopolistic practices and Flopesca, Pescaperu, Epsep, and authorizing the Ministry of Fisheries to grant CERPER by June 30. 1992. concessions to the private sector (Legislative Decree 750, November 13, 1991). SEA Privatization in Minine The Govemment sold its 19% stake in Minas The Govemment will develop a Completed. Buenaventura on July 19, 1991. policy framework for the sector and a firm-by-firm divestiture strategy The Govemment issued a Law for Private acceptable to the Borrower and the Sector Investment in the Mining Sector which Bank, including an action plan and creates conditions for the development of implementation schedule for Minero private investment (Legislative Decree 708, Peru, Centromin Peru, and Hierro November 14, 1991.). Peru by June 30, 1992 SEA Privatization in Oil and Petroperu increased the contracting-out of The Government will develop a Completed. Gas exploration and development to the private policy framework acceptable to the sector. Borrower and the Bank, including an implementation schedule for private Petroperu monopoly eliminated (Legislative sector participation in exploration, oil Decree 655, August 7 1991). refining, distribution, and gas production and distribution by June 30, 1992. SEA Privatization in Power In February 1991, The Govemment authorized The Govemment will develop a Completed. entrance of private investors to the power policy framework acceptable to the sector; this included participation of Borrower and the Bank, including an autoproducers. co-producers, and implementation schedule for private concessionaires (Law 25304). sector participation in power generation, transmission, and On July 19 1991, The Govemment authorized distribution by June 30. 1992. the sale of its participation in regional power companies (Legislative Decree 649). The Govemment issued a Law for the Promotion of Private Sector Investment in the Power Sector. Private investors will have access to the sector by means of a regime of concessions which will permit the generation and/or distribution and/or commercialization of electric energy (Legislative Decree 693, Novembert6, 1991).  - 37 - Annex 2: STRUCTURAL ADJUSTMENT LOA-N: POLICY NMATRIX ISSUES AND OBJECTIVES ACCOMPLISHMENTS FROM MID1990 CONDITIONS OF LOAN SIGNING STATUS TO BOARD PRESENTATION SEA Privatization in The Govemnment enacted a new The Govemnment will develop a Completed. Telecommnunications Telecommunications Law enabling competition policy framework acceptable to the and private investment (Legislative Decree Borrower and the Bank. including an 702, November 8, 1991 and Legislative Decree implementation schedule promoting 766, November 15, 1991). private sector investment in the telecommunications sector by June The Govemment created the Enterprise for 30 1992 Postal Services of Peru, S.A. (SERPOST) and declared that the incorporation of private investors in SERPOST is of national interest (Legislative Decree 685, November 5, 1991). SEA Privatization in Transport For ports, The Government transferred to the The Government will develop a Completed. private sector all stevedoring work, the loading strategy acceptable to the Borrower and unloading of cargo, and the maintenance of and the Bank, including an container-handling equipment, and issued implementation schedule to promote Supreme Decree 039-91-TC on November 5, private sector investment in railways, 1991, specifying actions to be taken for labor ports, airports, and air transport by reduction in CPV (shipping company). June 30. 1992. The Govemment liberalized urban transportation tariffs (Legislative Decree 651, July 25 1991). The Govermnent liberalized air transpon tariffs, authorized the entrance of new companies, and issued Legislative Decree 648 (July 17 1991), authorizing the privatization of AeroPeru. The Government also transferred part of the activities of CORPAC (airport authority) to the private sector (Legislative Decree 723, November 11 1991). The Govemment authorized the Ministry of Transports to grant concessions to private companies for rehabilitation and maintenance of highways (Legislative Decree 676, October 6 1991). The Govenument declared private sector investment in Enafer to be of national interest, prohibited any form of monopoly and restrictive practices, and authorized the Ministry of Transpon and Communications to grant concessions, through a public bidding process, to the private sector for rehabilitation and maintenance of portions of the railway lines. Tariffs and freights of service operators are market-determined according to supply and demand (Legislative Decree 690, November 6, 1991).  - 38 - Annex 2: STRUCTURAL ADJUSTMENT LOAN: POLICY MATRIX ISSUES AND OBJECTIVES ACCOMPLISHMENTS FROM MID-1990 CONDITIONS OF LOAN SIGNING STATllS TO BOARD PRESENTATION SEA Privatization in Water and Sedapal began bidding process to delegate the The Government will develop a Completed. Seweraze task of billing in part of the city of Lima to an strategy acceptable to the Borrower extemal private firm. and the Bank, including an implementation schedule to promote The Govemment issued a Law for the private sector participation in the Promotion of Private Sector Investment in the sector by June 30, 1992. area of Water/Sanitation, specifically in the activities of exploration of potable water, sewage, waste disposal, recycling of water, and public cleaning (Legislative Decree 697, November7, 1991). The Govemment authorized Senapa and Cortapa to undergo an economic and financial stabilization and an administrative rationalization, including staff reduction and a program of incentives for voluntary retirement (Supreme Decree 171-91-PCM November 7, 1991). SEA Privatization in Industry The Government announced its intention to The Govemment will develop a Completed. reduce SEA by including several industrial divestiture strategy acceptable to the companies on the list of 23 designated for Borrower and the Bank, including an privatization (Supreme Decree 041-91-EF, implementation schedule for the sale March 12 1991). of shares in all companies where the Govemment is a minority The legal and institutional framework shareholder. The Govemment should established by Legislative Decree 674 allows bring to the point of sale at least 6 of for privatization in all sectors of economic these companies. activity. AGRICULTURAL ISSUES Private Sector Development in Enactment of the Agricultural Sector No further action required. Agriculture Investment Promotion Law (Legislative Decree 653, August 1, 1991). Azriculttral Commoditv Natinnal rice-marketing monopoly (ECASA) By September 30, 1992: (i) liquidate Substantially Marketinz abolished (Supreme Decree 066-91-EF, March ECASA; and (ii) implement Supreme Completed. While 27 1991). National input-marketing company Decree 148-90-PCM, authorizing ECASA has already Increased efficiency in trade and (ENCI) downscaled (Supreme Decree 148-90- ENCI's reorganization. ceased its operations. production. Reduction of public PCM & 084-91-PCM, April 17, 1991). laid-off its sector involvement. employees, and Freedom of entry for private sector (Supreme established a Decree 066-91-EF, March 27, 1991). liquidation commission, the process of liquidation is still underway. ENCI is being downsized. To date (6/2194), ENCI's liquidation commission is still in the process of selling the company's assets. Non-reversal of the elimination of State marketing monopolies Completed. established by Supreme Decree 066- 91 -EF.  - 39 - Annex 2: STRUCTURAL ADJUSTMENT LOA.N: POLICY' MIATRIX ISSUES AND OBJECTIVES ACCOM_LISHMENTS FROM NID-1990 CONDITIONS OF LOAN SIGNING ST_ _LS TO BOARD PRESENTATION Land Tenure/Registrv and Restrictions removed: land freely transferable; Maintain all provisions retforming Completed. Titling all regular rights of Peru's civil code extended land tenure, agriculrural labor, and to the agricultural sector; individuals and liberalizing agri-business activirs in Improved resource allocatiotn, corporations permitted to own land; size limit the "Ley de Promoci6n de las improved access to formal of individual agricultural estates increased; Inversiones del Sector Agricola" economy for small landowners. promotion of private investment in (Legislative Decree 653). development of uncultivated land. Speedy mechanism established to guarantee land ownership against expropriation and squatters. Agricultural Credit Elimination of credit subsidies through Banco Non-reversal of policy liberalizing Completed. Agrario (BA). Reduction of Central Bank the use of land as collateral. Improved resource allocation, credit to BA. Abolition of BA's pnvileged improved access to credit for access to collateral of agricultural producers. Maintain legal framework allowing Completed. small producers, and expansion of agricultural-sector access to private access to commercial banks. Liberalization of use of land as collateral. commercial bank credit. Agricultural Water Usage Legislative Decree (No. 653, August 1, 1991: Maintain all provisions on water Completed. Agricultural Sector Investment Promotion Law) usage included in Legislative Decree Promotion of better water usage. provided legal framework allowing transfer of 653. irrigation network to private producer associations. Agricultural Trade Policy Deregulation of all domestic and foreign trade Maintain trade liberalization Completed. of agricultural products and imports. provisions of Legislative Decree 653. Better resource allocation. Removal of anti- agricultural bias. Unified exchange rate eliminated bias against Consolidate macroeconomic agricultural exports and allowed foodstuff stability. imports without exchange rate subsidies. Elimination of exemptions for agricultural imports. Agricultural Pricing Policy Floating exchange rate remained and The Government will not introduce Completed. agricultural credit subsidies abolished. In any new mechanism for price control Maintain efficiency in resource March 1991, specific protective tariffs for of agricultural products and there will allocation. selected agricultural products were introduced. be no reversal in its policy of These were replaced in May 1991, by a abolishing interest rate subsidies. variable surcharge scheme designed to lead to a landed price which would not exceed the previous five-year average international price plus a 15 % tariff. The scheme covers: wheat flour, pasta, corn, sorghum, rice, and sugar. Dried milk continued to receive a fixed surcharge. LABOR ISSUES Probationary EmDloyment Creation of a more flexible probationary Non-reversal of policy. Completed. period. Initial period of three months Improve quality of employee extendable to a total of six months, provided screening and reduce turnover the work requires a training and adaptation costs. period. In the case of managerial and other positions of trust, the period is extendable to one year (Job Promotion Law, Legislative Decree 728, An. 43, November 12, 1991).  - 40 - Annex 2: STRUCTURAL ADJUSTMENT LOAN: POLICY MATRIX ISSUES AND OBJECTIVES ACCOMPLISHMENTS FROM MID-1990 CONDITIONS OF LOAN SIGNING STATB'S TO BOARD PRESENTATION Temworarv Emplovment Supreme Decree 077-90-TR issued, allowing Non-reversal of policy. Completed. longer fixed-term contracts for all sectors and Increase flexibility in labor under most circumstances (few relevant markets and reduce turnover restrictions exist). costs. Tempoiary employment authorized for initiation or increase in work load, changing labor market needs, or for retraining of employees (Legislative Decree 728, arts. 100- 102, November 12, 1991). CTS (ComDensation for Time Firms must now deposit semesterly the full Non-reversal of policy. Completed. and Services Rendered) amount due in special accounts for which financial institutions and firms compete. Improve administration of Worker specifies account to be held in national system. Reduce indexation or foreign currency and interest on these problems. Increase supply of accounts is exempt from income tax. CTS long-term funds to financial funds can be withdrawn by workers under intermediaries. specific circumstances (Legislative Decree 650, luly 24, 1991). SOCIAL SECURITY ISSUES Creation of the framework for a Private Non-reversal of policy and Completed. System of Pensions (SPP), to complement the presentation of an action plan and IPSS (Peruvian Social Security System) IPSS. SPP benefits managed by the implementation schedule, acceptable Administrators of Pension funds (AFP) which to the Borrower and to the Bank, on will initiate activities to partially or totally the partial or complete privatization privatize the system by July 28, 1992 of the system by September 30, (Legislative Decree 724, November 11, 1991). 1992. Administration of Health and Separation of accounts for revenue, but not Complete the separation of all health Completed. Pension Areas expenditures. and pension fund accounts (except administrative expenses) by June 30 Improve financial management. 1992. Collection of Contributions Collection system streamlined. Employers can Non-reversal of policy. Completed. complete form estimating contribution due and Avoid losses from under-reporting make payment at any commercial bank. by contributors. Resource Manayement Fund deposits placed in official and private Non-reversal of policy. Completed. banks. Greater efficiency. Supervision and Control None. The extemal audit of financial Substantially statements, involving income Completed. Determine the administrative and (pension and health) and expenditures In December 1992, financial situation of IPSS. (pension) accounts for 1991 will be the Govemment hired completed by October 31. 1992. the external auditors IPSS, as fund interFnediator, will be through Resolution of subject to periodic independent the Controller's auditing. These audits will include Office No. 345-92- not only financial control but also CG. administrative and operational diagnoses and recommendations. N'SS Revenue Collection Contribution rates to IPSS were not increased. The total contribution rate to IPSS Completed. Collection ceilings and some deductions were will not be increased. Increase revenue and force eliminated. efficiency gains without increasing contribution rates.  - 41 - Annex 2: STRUCTURAL ADJUSTMENT LOAN: POLICY' MIATRIX ISSUES AND OBJECTIVES ACCOMIPLISHMIENTS FROMI MID-1990 CONDITIONS OF LOAN SIGNING STATUS TO BOARD PRESENTATION Phvsical Assets of IPSS Newk rental contracts and sale of properry to Non-re%ersid of polics Completed reflect market prices. Greater efficiency IPSS Personnel No renewal of contracts for temporary Reduce number of employees by an Completed. IPSS personnel. additional 7,000. personnel reduced by Increased efficiency. 7,700 resignations through early retirement more than 18,00(). incentives.  Annex 3 The Structural Adjustment Loan 42 ANNEX 3 THE STRUCTURAL ADJUSTMENT LOAN Historical and Economic Context' 1. An environment of increasing political and economic instability prevailed in Peru over the three decades that ended in 1990. Expansionist policies produced creeping inflation and periodic balance of payment crises, followed by a series of unsuccessful stabilizations. In this period, economic policy varied widely through the different regimes, but concurred, by and large, in an inward-oriented development strategy and an escalating intervention of the State in the economy. The model of import-substitution predominated throughout, characterized by tariff protection and eventual quantitative restrictions to trade. 2. The govermnent deternined key prices and owned important enterprises. The number of state enterprises increased from 29 in 1968 to more than 200 by the end of 1989. Most of these companies operated at a deficit, were state monopolies, and were plagued with political interference. This period was also characterized by economic mismanagement, resulting in hyperinflation, financial repression, multiple exchange rates, stagnation and higher level of absolute poverty. The economy "survived" by substituting the dollar for the domestic currency and enlarging the "informal" sector. 3. By the end of the 1980s, there was hyperinflation, fueled by an expansionist monetary policy and an increase in velocity as people substituted away from the domestic currency. Monetary growth was used primarily to finance government expenditures or transfers, especially to provide tax credit to the agricultural sector and to non-financial public enterprises. 4. To repress inflation, successive governments repeatedly imposed price controls. By the end of 1989, all products were subject to some kind of government regulation. Basic staples and public services were fixed by the Government, but had to be revised periodically to account for inflation. The direct participation of the State in the determination of prices was reinforced by the fact that the government-controlled public enterprises monopolized various areas of activity. 5. Interest rates were constrained by binding ceilings which were significantly below inflation. Lacking indexed financial instruments and faced with significant restrictions See also: World Bank, Peru: Economic and Sector Reforns to Sustain Stabilization and Lay the Foundations for Developmnent, green cover, 10361-PE, February 18, 1992; and World Bank, Peru at the Crossroads: Building a Modem State, Green Cover, 11943-PE, June 30, 1993.  Annex 3 The Structural Adjustmenr Loan 43 on capital mobility, the dollar became first a store of value and unit of account, and then a medium of exchange. By the end of the decade, only petty transactions were made in soles. 6. Exports were subject to compulsory surrender of receipts to the Central Bank, in exchange for domestic currency at one of the multiple sets of government-determined exchange rates. Those were adjusted to compensate for inflation, but with protracted delays. The disparity in exchange rates, which were fixed arbitrarily, generated black markets and rent-seeking activities to gain access to a better rate. In addition, the existence of illegal export activities (drug dealing and smuggling) precipitated the emergence of a parallel "black" exchange rate market. 7. Foreign trade was discouraged because of high tariffs and quantitative restrictions. Imports were severely restricted, with explicit bans on some final products, quantitative restrictions, and licenses, among others. On the other hand, capital goods and industrial inputs not only were permitted, but received preferential treatment. Together they accounted for 79 percent of total imports for the period covering 1988-1990. In order to generate the necessary foreign exchange, exports were encouraged through a promotion scheme based on credit subsidies, but which was inconsistent with the implicit taxation of the required surrender of foreign exchange at one of the appreciated exchange rates. Overall, exports accounted for about 15 percent of GDP for the period covering 1988-1990. The main source of export revenues was mining products, copper in particular. Other traditional exports included oil, fishmeal, coffee, and cotton. In addition, a diversified set of non- traditional export increased its share over time, contributing about US$ 1.0 billion to export earnings. 8. Capital-outflows restrictions to restrain capital flight were consistent with domestic financial repression. Profit remittances, royalty and interest payments were temporarily prohibited. In 1985-90, the Garcia Administration unilaterally announced that its debt service would be limited to only ten percent of exports. Debt service to the multilateral institutions was stopped and large arrears accumulated to these entities. This position forced the IMF to declare Peru as ineligible for funding and the World Bank to declare loans to Peru in iion-accrual. Consequently, Peru was isolated from international capital markets. In 1990, total external debt amounted to more than US$ 20 billion, most of which was in arrears. 9. Capital inflows were welcome but understandably very scarce. The country did not attract direct foreign investment, in part, because of its explicitly adverse legislation. Investors were subject to discriminatory treatment by nationality, had strict regulations for dividend remittances, and had difficulty gaining access to certain activities. 10. Government finances were in a state of collapse and depended heavily on inflationary finance. Tax pressure, measured by the ratio of tax collection to GDP reached its historic low record at about 5 percent in 1990, as a result of an inadequate tax system as  Annex 3 The StructuralAdjustment Loan 44 well as lax administration of the tax collection authority. The tax system was extremely complex, exhibiting numerous taxes, high dispersion of marginal tax rates, and many exemptions. The legislation, besides being complicated and unstable, was plagued with loopholes, and there were no appropriate provisions against inflation to protect from late payments. Indirect tax revenues were low due to controlled prices and poor collection procedures. The tariff system exhibited a high dispersion and resulted in an extremely high average rate which provided protection to the domestic industrial sector. In addition, lack of supervision and control from the tax administration allowed widespread tax evasion. 11. Dwindling government revenues were accompanied by a halt in public investment. However, public employment increased significantly in the period, at wage levels which although low, were subject to periodic indexation. This was possible with Central Bank direct transfers that took the form of credit at no interest. 12. Government regulation of labor and agricultural markets adversely affected the efficient allocation of resources, hampered the development of new working opportunities, and blocked the progress of agriculture. To "protect" workers, the regulations promoted strict labor stability, under which the worker gained tenure after a three-month probationary period. Temporary contracting of personnel was very limited. This regulation increased the (fixed) costs of operating firms and magnified their exposure to fluctuations in demand. The result of the drastic reduction in labor mobility was that the fornal labor market shrank, and the "informal" economy gained momentum. 13. Also to "protect" workers against health, accident, old-age and layoff risks the regulatory framework enacted mandatory health and pension insurance with the National Social Security Institute (IPSS) and mandatory severance payments for laid-off workers under the "Provision for Social Benefits". This latter scheme can also be understood as a mandatory savings program that the company managed on behalf of the worker. Both the pension plan and the severance provision behaved as unfunded schemes, one managed by IPSS and the other by the company itself. 14. Furthermore, the severance provision provided an additional income tax shield as changes in the nominal provision were charged to labor costs and could be deducted from taxable income. Nevertheless, the scheme put the company under financial pressure as, in the macroeconomic scenario depicted above, it did not have the means of accumulating in real terms (or at least was not efficient in doing so) the resources needed to meet severance payments when they were to mature, and not all could manage to get subsidized financing. 15. The Social Security system became unviable. Its management was deplorable, employment increased five-fold, and the accounting system was unauditable. The collection system was slow and inefficient. The Institution had become, by the end of the 1980s, one of the most important real estate owners in the country, but rental fees charged were far below market levels. Besides, the pension plan, which became a benefit-defined pay-as-you  Annex 3 The StructuralAdjustmenr Loan 45 go system, became financially unviable, at the given contribution rate and level of evasion. with the aging of the population structure of the country, aggravated by the practice of granting pensions with only five years of contributions. Firms considered contribution to Social Security as taxes to finance the government, and avoided depositing funds withheld from employees. 16. Finally, the regulatory framework prohibited private ownership of land for commercial purposes, with minor exceptions, and prohibited using land as collateral for credit. As a result, farmers were rejected for commercial credits and had to resort to subsidized credit from the state development bank (which in turn received its funding from the Central Bank). In addition, agricultural exports received one of the lowest exchange rates available, and Peruvian staples in the domestic market had to compete with foodstuffs imported at preferential exchange rates by the state import monopoly. The Adjustment Program The Government's Economic Program 17. The present Administration implemented, shortly after assuming office in late July 1990, the first stage of a bold stabilization-cum-structural reform program, with the purpose of achieving macroeconomic stability and reintegrating the country into the international financial community. In March 1991, additional reforms were implemented in trade, financial, and labor markets. 18. The measures adopted implied a drastic change with the past. The new Administration shifted from a multiple-exchange crawling peg to a unified floating exchange rate system. Compulsory surrender of export receipts and all controls on current- and capital-accounts transactions were abolished. In addition, most price controls were eliminated, including a defacto elimination of interest rates ceilings. 19. Monetary expansion was limited mainly to purchases of foreign currency by the Central Bank to accumulate foreign reserves. Central-Bank financing of the central government was explicitly prohibited. A cash management committee managed State finances on a cash basis only. In order to sustain this situation, the Government undertook further fiscal reforms aimed at increasing tax revenues and improving government expenditure management. 20. To increase tax revenues, the Government redefined the Peruvian tax system and reorganized the tax administration authority, SUNAT, and the customs bureau, SUNAD. The new system was based on five types of taxes covering income of individuals and corporations, wealth of firms and individuals, value-added, selective consumption (excise), and import duties.  Annex 3 The StrucruralAdjustment Loan 46 21. Based on the premise that collections were low because of tax evasion and numerous exemptions, not necessarily because of low marginal tax rates, most exemptions were eliminated. In addition, the income tax rate on firrns was reduced from 35 to 30 percent, the tax on net equity of corporations was unified at two percent, and the highest bracket of personal income tax rate was reduced from 45 to 37 percent. For corporations, the Government instituted a minimum income tax, set at two percent of total assets net of depreciation, of which the two percent net equity tax could be deducted. Selective consumption (excise) tax rates -- except fuel and gas oil taxes-- were reduced to three with a maximum of 50 percent. Fuel and gas excise taxes remain one of the most important taxes, accounting for about 15 percent of government revenues. Rates are set above 80 percent, and the tax base (fuel prices) is constantly adjusted for inflation to avoid its erosion in real terms. Finally, import tariffs were initially reduced to a three-tier -- and later to a two-tier -- system, with rates set at 15 percent and 25 percent. 22. However, the value added tax rate was increased from 14 percent to 16 percent, temporary taxes of 10 percent on exports, (of one percent on net wealth and insured assets) were imposed, and emergency taxes on current-account debits and the excise tax on interests were instituted. Through the process, numerous taxes were eliminated. At different stages of the program, including the temporary taxes of 10 percent on exports and of one percent on net wealth and insured assets. Prior to the SAL Board presentation, an emergency tax on current-account debits and the excise tax on interests were being maintained, but were eliminated immediately after?. 23. The approach to strengthen SUNAT was to improve the quality of the personnel and equipment employed at tax collection. To achieve this, SUNAT laid off redundant personnel, and increased its salary scales to attract more qualified professionals. To fund the program, SUNAT was endowed with a budget of up to two percent of total tax revenues. 24. On the government expenditure side, public sector wages were under strict control and a sweeping reduction in personnel took place. Wage increases had to be approved by the central government, after wage indexation was eliminated. 25. Finally, to consolidate the process of economic stabilization, the Government agreed to a Rights Accumulation Program (RAP) with the IMF in September 1991, setting several macroeconomic targets to be achieved during the performance period between January and December 1992 that complemented the efforts made by the Govermnent on its own. Changes in the Legal and Regulatory Framework 26. Together with the stabilization program and policy reforms, a process of drastic deregulation was developed. The Government abrogated all monopolistic and  Annex 3 The StructuralAdjustmenr Loan 47 restrictive practices throughout the economy, including the monopoly rights of 12 public firms. 27. In the financial sector, the Government passed a new banking law which promotes universal banking, accompanied by stronger prudential regulations. This legislation abolished the nationalization of the banking system passed by the previous Government. The law allowed financial intermediation to take place in US dollars. However, dollar- denominated accounts were subject to higher marginal reserve requirements. It also created a limited deposit insurance scheme to reduce the possibilities of runs during banking crises. In addition, other insurance premiums were allowed to be market determined, and insurance monopolies were abolished. 28. Air transport activities were opened to private capital, without regard to nationality, but without committing to an open skies policy. Foreign shipping firms were given access to the domestic market, and the port loading/unloading monopoly was abolished. Finally, the commission in charge of setting transport tariff policy was dismissed. 29. The Government started an extensive privatization program in all sectors of the economy. To attract foreign investors, the Government permitted dividend and royalties remittances, eliminated any kind of discrimination on local investors, and announced a program of immigration for foreigners who bring in funds for investment. In this manner, Peruvian treatment of foreign investment became one of the most open in the world. 30. To improve the efficiency of labor markets, the tenure law was made more flexible, expanding provisions for layoffs and increasing the probationary period from three up to six months. In the case of managerial and other positions of trust, this period is now extendable to one year. Also, regulations for contracting foreign workers were simplified. In addition, the Government allowed fixed-term contracts for all sectors and, under most circumstances, with few exemptions. Companies were allowed to hire workers temporarily for new or increased work loads, changing labor market needs, or retraining of employees. 31. Finally, the severance savings scheme was completely reformed from a pay-as- you-go company-managed scheme to a fully-funded financial institution-managed one, under the name of Compensation for Time and Services Rendered (CTS). The severance-cum- unemployment saving scheme has become a source of long-term funds to financial intermediaries. Under the new program, firms must deposit the full amount due every semester in a special account of the financial institution designated by the worker. The currency denomination of this account (national or foreign) is also chosen by the worker. Interest received on these accounts is exempt from income tax. Even though the nature of the scheme is one of mandatory savings to cover the worker from an unexpected lay-off, workers can withdraw their CTS funds under some circumstances.  Annex 3 The Structural Adjustment Loan 48 32. In 1991, the Government enacted the Agricultural Sector Investment Promotion Law, which wiped out the Agrarian Reform Law of 1969. The new legislation redefined the framework in which trade, price settlement, and credit practices related to agriculture should take place. It determined a major role for the private sector in the development of agriculture. 33. All rights under Peru's Civil Code were extended to the agricultural sector. Moreover, individuals and corporations were free to own land, relaxing size-limit restrictions for individual agricultural estates. Thus land can now be freely traded and leased to any individual or legal entity, whether Peruvian or foreign, with some minor exceptions. Property rights were also defined on water usage for agricultural purposes, by modifying the legal framework to allow the transfer of irrigation networks to private producers' associations. To guarantee land ownership against expropriation and third-party claims, the Administration simplified the registry and titling mechanism for rural property, although the new system remains to be implemented. 34. All domestic and foreign trade in agricultural inputs and products was deregulated and state participation in foodstuff trading was severely reduced. ECASA, the national rice-marketing monopoly, was declared to be in the process of liquidation. ENCI's grain and fertilizer import monopoly was removed, and ENCI began a process of reorganization to make it self-financed. Moreover, the company scheduled its privatization for 1994. Also, the procedures for verifying the quality of agricultural products and medicines were considerably relaxed, allowing for certificates to be issued by private laboratories. 35. The Government also removed price controls on agricultural products. The price support scheme adopted for some selected staples was replaced in May 1991, by a variable surcharge scheme designed to lead to a landed price equivalent to the previous five- year average international price plus the correspondent 15 percent tariff. The staples covered are dried milk, wheat and wheat-derived products, corn, sorghum, rice, and sugar. 36. Finally, the Government abolished directed credit policies, including those directed at agriculture, and modified the legal framework to allow the use of land as collateral, to facilitate access to private commercial bank credit to the agricultural-sector. Farmers were allowed to mortgage their land holdings in excess of five hectares. In addition, the Government abolished the privileged access to the collateral of agricultural producers that Banco Agrario (BA) used to enjoy. In the new environment of fiscal discipline, subsidized credit from Banco Agrario was eliminated.  Annex 3 The Structural Adjustment Loan 49 Preparation and Design of the SAL 37. The Bank's operations in Peru were suspended in 1987, when the Board declared the country in non-accrual status, after the Government of Peri was six months overdue in payments. The last loan to the Republic of Peru was granted in 1984. 38. The Structural Adjustment Loan (SAL) was the second of three policy loans within the Bank's new approach to debt workout problems with Peri, as a country with protracted arrears. Arrears clearance permitted the Bank to restart large lending operations in Pern consistent with its long-term objectives for the country. 39. However, even before arrears clearance, the Bank channeled resources for a major program of technical assistance for project preparation and implementation. The financial resources were obtained through the Japanese Grant Facility and a grant from the German Company for Technical Cooperation (GTZ). 40. To evaluate the major structural reforms under the Fujimori Administration, several missions visited Peri beginning in October 1990. The first mission prepared a report entitled Perui: Sector Reform and Investment Review, while the second mission prepared the report Peru: Economic Reforms to Sustain Stabilization and Lay the Foundations for Development. Several background papers on labor, agriculture, privatization, social security, social sectors, and macroeconomic issues were also written during that period in preparation for the SAL. Program Description and Objectives 41. Long-Term Objectives. The long-term objectives of the Bank's strategy in Peru are to help the Peruvian governments lay the foundations for growth, improve the efficiency of resource allocation, and improve the situation of the poor. 42. A most important element to foster growth is to promote investment by expanding the stock of capital, thereby incorporating technological progress. The market allocation of investment generates productivity gains and also improves the situation of the poor. Appropriate means of attracting investment, besides profitable opportunities, are to strengthen property rights, promote law and order, and establish a sound macroeconomic policy. 43. To improve the efficiency of resources, the Bank supports the role of market mechanisms, in keeping with regional and worldwide trends. Consistent with this is the gradual reduction in the direct participation of the state in productive activity and a redefinition of the role of the state in the economy.  Annex 3 The Struc rural A djus rmen t L oan 50 44. In the social area, the long-term goal is to provide the means for upward social mobility through public investment in education and health and through a competitive environment. These means should enable the poor to respond to income-eaming opportunities arising from structural market-oriented changes. 45. Loan Objectives. The SAL was part of the Bank's debt workout program in Peru, as a country with protracted arrears. As such, the immediate objectives of the loan were to: (a) resume large scale lending operations in Peru, reversing the country's non- accrual status; and (b) support policies to foster growth and alleviate poverty in Peru through the liberalization and deregulation of key markets, in particular, labor, capital and agricultural markets. 46. Reforms in the labor market aspired to enhance labor mobility and improve the scheme of forced-savings for retirement. Reforms in social security aimed at a better management of the corresponding institution and a better allocation of pension savings through an alternative private system, which would have direct impact in the development of Peruvian capital markets. Finally, reforns in agriculture had the objective of eliminating price distortions and legal and regulatory restrictions to credit and trade. 47. The process of privatization was intended to reduce the direct participation of the government in productive activities, thus improving resource allocation in the future while providing a respite from fiscal problems in the present. 48. Finally, the loan assisted the Government to formulate a poverty-alleviation strategy, which outlines policies, target groups, priority programs, and the role of various organizations involved. It also assisted in preparing profiles of priority social projects and established the basis for imnproved food-assistance programs and a national nutrition policy. The strategy recognizes that poverty alleviation calls for revitalization of the economy through stabilization and liberalization, increased and more efficient social spending, and close coordination with community representatives. 49. Program Description. The Structural Adjustment Loan (SAL) supported a set of reformns in macroeconomic and fiscal policy, agriculture, and social security. In addition, it included a social sector component and fostered the divestiture of government-owned enterprises through a broad program of privatization. 50. In these areas, the Governmnent agreed with the Bank on a set of 45 sectoral conditions (Annex 2). Twenty-four of these aimed to prevent reversal of policies implemented prior to loan presentation to the Board. The other 21 were conditions for further reform. 51. Macroeconomic Policy. The macroeconomic policy component stressed market determination of prices, exchange rates, private sector wages, and interest rates. In  Annex 3 The Structura/ Adjustment Loan 51 addition, it limited monetary base expansion to IMF targets, and restricted its growth to the financing of the quasi-fiscal deficit and foreign exchange purchases by the Central Bank. Also, it supported a unified floating exchange rate system and accepted the use of foreign currencies in the local financial system. All foreign exchange surrender requirements were explicitly prohibited. 52. Finally, there were quantitative "performance indicators" related to tax revenues, and government deficit and financing: tax revenues were to reach about 9 per cent of GDP, the primary deficit of the non-financial public sector would not be larger than 0.6 percent of GDP, and the consolidated public sector balance would not be financed domestically. 53. Fiscal Policy. The fiscal policy component stressed the need to reduce tax evasion to improve tax collection, strengthening the tax administration authority, SUNAT. The conditions envisaged the installation of new computerized information systems, as well as the selection of new personnel at a national level. SUNAT also committed itself to expand from 1,200 to 2,500 the list of large taxpayers monitored. 54. The Government agreed to introduce changes in the tax code to allow for greater efficiency in the tracking of infringements. Finally, in order to simplify the tax structure, the Government pledged to assess the phasing out of taxes on exports, bank current-account debits, and interest paid. 55. Labor. The changes in labor legislation supported by the SAL took place prior to loan design. The conditionality was intended to prevent policy reversals in this area. In particular, the longer probationary period, the extended fixed-term contracts, and the authorization for temporary employment to accommodate work load increases, changes in market needs, or retraining of employees were to be maintained. Moreover, the reform of CTS from an unfunded provision for severance payment to a fully-funded one was to be preserved. Every semester, the company was to deposit in a worker's bank account the equivalent of a yearly wage. 56. Social Security. In the area of social security, the Government adopted the decision to establish the legal framework for the partial or complete privatization of the pension system. The SAL conditionality required improved management of the national social security institution, IPSS. This entity agreed to an action plan to significantly reduce personnel, improve its accounting system, separate health and pension fund accounts, and present an independent audit of its financial statements by the end of 1992. Furthermore, the plan envisaged the streamlining of the collection system, aimed at increasing revenues for the institution without resorting to raising the social security contribution rate. Finally, IPSS committed to deposit its reserves (funds) in public and private banks, and to issue new rental contracts or sell its real estate investment.  Annex 3 The Structural Adjustment Loan 52 57. Agriculture. The SAL conditions for agriculture were intended to preserve the changes introduced in the legal, regulatory and judicial framework that governs the sector. In particular, policies related to the use of land as collateral, the liberalization of trade, the elimination of price controls, the abolition of interest rate subsidies, and the reforms in land tenure strengthening property rights were to be maintained. 58. Further, state marketing monopolies were to be dismantled. ECASA, the state rice marketing entity, was to be totally liquidated and, ENCI, formerly the state foodstuffs and fertilizer import monopoly, was to be downsized, reorganized and lose its market monopoly. 59. Privatization. The Government promised to launch the privatization process following the regulatory framework defined prior to loan presentation. The conditionality was expressed in terms of action plans, implementation schedules, policy frameworks and divestiture strategies. This component required a Government commitment to undertake complete divestiture in the banking, fishery, and mining sectors. Furthermore, it required private participation in public utilities (power generation, water supply and sewerage), public services (transportation), and even in politically sensitive activities (oil exploration, refining and distribution; and telecommunications). 60. Social Sector. In the social sector, the Government was to delineate a poverty alleviation strategy, a national nutrition policy, and profiles for priority projects in primary health and nutrition, and pre-primary and primary education. The poverty alleviation strategy, with its corresponding implementation schedule, was to outline policies and identify priority programs and target groups. The Government was to adopt the strategy by the end of the performance period. The national nutrition policy was to improve existing food assistance programs, enhancing cost effectiveness. The Government was to implement this policy during the performance period. 61. Role of the Bank and IMF. The Bank's new approach to support debt workout programs in countries with protracted arrears required, among other things, the adoption of an IMF stabilization program and a Bank-supported adjustment program. 62. The IMF recognized the efforts of Peruvian authorities and agreed with the Government of Peru on a Rights Accumulation Program (RAP) which prescribed fiscal and monetary discipline during the performance period (January-December 1992). Furthermore, the macroeconomic component of the SAL reinforced the goals set in the IMF RAP, and supported additional policy decisions.  Annex 3 The Srructural Adjustment Loan 53 Program Results Macroeconomic and Fiscal Policv 63. All the goals set in the SAL were achieved. In macroeconomic policy, the Government maintained its commitment to strict fiscal discipline and to the market determination of key prices, including wages, as well as the exchange and interest rates. With no foreign exchange surrender requirements, all external transactions were convertible to a single exchange rate. 64. Monetary growth was limited to financing the quasi-fiscal deficit and increasing foreign reserves of Central Bank, at rates consistent with IMF targets. The net international reserves of the entire financial system increased US$500 million from US$2,425 million by the end of December 1992 to US$2,925 million by the end of 1993. 65. Drastic changes in tax legislation reduced to five the number of taxes collected by the central government, allowed for inflation adjustments to account for collection lags, and eliminated many exemptions and loopholes. Moreover, the Government introduced a new tax code allowing more efficiency in tracking infringements, and stricter penalties (inclu- ding prison terms) for certain infractions. The modification of statutory rates increased the share of the value added tax in total collections, reducing the level of more distorting taxes (the levies on exports). Bank current account debits (turnover of bank deposits) and interests on loans were eliminated. 66. Moreover, the institutional framework for the implementation of the law was improved, providing the basis for better tax enforcement. The tax administration institution, SUNAT, reorganized its personnel and modernized its monitoring tools in order to improve its quality and effectiveness. SUNAT completed a process of personnel selection and evaluation at the national level to attract capable professionals and reduce redundant positions. Moreover, the institution had installed a new computer information system, which allowed it to expand from 1,200 to 2,500 the number of large taxpayers monitored. 67. In 1992, the central govermnent's tax revenue reached a level of about 9 percent of GDP, up five percentage points since the new Administration took office. However, the level of tax collection is still low, both relative to a sample of 15 countries in Latin America with analogous levels of per capita income (14.8 percent), and to historical experience. 68. The level of government expenditures was in line with tax collection revenues. In 1992, the deficit of the consolidated non-financial public sector (NFPS) was negligible. This was the result both of deliberate policy and lack of access to credit from the Central Bank, the domestic financial sector, or international markets. Shortage of funds, given the relatively low level of government revenues, forced the Administration to postpone public  Annex 3 The Structural Adjustment Loan 54 sector investment. Over the period, the Government observed tight discipline on public sector wages and accomplished a reduction in the number of employees through voluntary retirement. However, the Government managed to resume debt servicing to all international financial institutions and began negotiations with its Paris Club creditors aimed at the full restoration of service. 69. Consistent with this persistently lower level of government deficit, the performance of the main macroeconomic variables has improved. In particular, inflation has abated from its hyperinflationary levels, domestic real interest rates both in nuevo sol- and-dollar denominated operations have dwindled from their elevated post-stabilization levels, and the real exchange rate depreciated somewhat during 1993, enhancing the competitiveness of exports. However, macroeconomic stability is still fragile, and inflation and real interest rates are very high relative to international standards. 70. Inflation at the end of the "performance period" was at an annual rate of about 60 percent, and continues to decline. It does not appear to have reached a floor. In April 1994, inflation was at about 1.5 percent. The real exchange rate, as measured by the ratio of an external price index (adjusted for devaluation) and the domestic consumer price index, was about 40 percent of the level prevailing on average in 1985, even after depreciating about 10 percent in 1992. On the other hand, despite the high level of capital mobility, real interest rates were higher in Peru than abroad, both on dollar-denominated and on nuevo sol- denominated accounts. Furthermore, the spread between interest rates on loans and interest rates on deposits was high, even after accounting for inflation, reserve requirements and other taxation. It should be pointed out, however, that real interest rates and spreads were consistently higher for domestic currency-denominated loans than for dollar- denominated ones. 71. In the financial system, the amount of demand deposits grew, but at a very slow pace. A bank run on deposits in the months of April and May of 1992, after the closing of Congress, was reversed in the following months. The market has continued to prefer dollar deposits, albeit at a decreasing rate. The participation of dollar denominated accounts in total deposits increased from about 60 percent at end-1990 to almost 80 percent at end-1992. As a result, loans granted were also increasingly denominated in dollars. 72. During 1992 and subsequently, the quality of the portfolio of the banking system, measured as a percentage of non-performing loans, deteriorated significantly. In some financial institutions, the level of insolvency reached such a degree that the Superinten- dency of Banks had to order their liquidation. The grade of uncertainty in the stability of the banking system redirected deposits to the most solvent institutions, increasing the degree of concentration in the industry. As of the end of 1992, four institutions received more than 70 percent of all the deposits in the banking system.  Annex 3 The Structural Adjustment Loan 55 Labor Markets 73. Given the magnitude and scope of the structural change, the Peruvian economy needed a more flexible labor market to permit a more efficient reallocation of labor. Among the reforms supported by the SAL, the labor stability law was relaxed, expanding conditions for layoffs and increasing the probationary period in specific cases. In addition, new labor contracts were allowed on a fixed-term basis (up to three years), allowing for fluctuations in temporary employment to adjust for new market conditions. Finally, the Compensation for Time and Services Rendered (CTS) became a fully-funded severance-cum-retirement mandatory savings, managed by financial institutions. This change has improved labor mobility, because it provided workers with guaranteed savings available in case of severance while they search for a new job. 74. The Government also redefined the framework for collective negotiations and the rules that govern a strike. Previously, most collective labor negotiations were agreed by industrial sector, instead of company by company. Given the hyperinflationary scenario, labor agreements usually included indexation clauses. Strikes were decided in assemblies without a quorum, and there were no periodic votes to decide on the continuation of the strike. With the changes, workers are free to organize in unions, but the law requires a minimum number of 20 members per company. Moreover, collective labor negotiations can now be agreed on a company by company basis. However, if firms and workers assent, the scope could be broadened to an industry basis. Even though inflation remains high, periodic indexation has been ruled out in most collective agreements, allowing fluctuation in real wages to reflect market conditions. On the other hand, strikes now require a quorum: more than half of the workers have to decide in an assembly, in a direct, secret, individual and universal vote, to start a strike in order for it to be valid, and this has to be certified by a notary public. 75. Even though minimum wages were required by the old Constitution, the Go- vernment has set them at non-binding levels. In addition, new legislation now requires a board of employers, employees and government representatives to set the different minimum wages, taking into consideration the sector, cost of living, and type of occupation. 76. Finally, a significant gap still exists between the cost of labor for firms and take-home wages for workers, the difference being compensation for time of service, social security contributions, and a tax to the National Housing Fund. The first of these is not a tax, but a forced savings scheme. The second is a mandatory health and old-age insurance scheme which has been significantly improved (see below). The last used to be a housing lottery, but is currently an earmarked tax used for the construction of basic infrastructure in low-income urban areas.  Annex 3 The Structural Adjustmenr Loan 56 Social Security 77. In the area of social security, the Government redefined the nature of the mandatory saving for retirement. The National Pension System (SNP), currently managed by the Peruvian Social Security Institution (IPSS), has been revised, and new financial intermediaries will be allowed to compete for the administration of the mandatory pension levy. Furthennore, a new law expanding private sector participation in the administration of mandatory health insurance has been passed, but has not been implemented yet. 78. The National Pension System was legally defined in 1973 as a benefit pension scheme, where the initial retirement income was estimated on the bases of a formula which took into consideration years of contribution, number of family members, and average wage in the prior 12 months. Later, the legal framework required the pension, thus defined, to be indexed to inflation every three months to maintain its purchasing power. 79. This system assumed the obligations from prior mandatory pension programs. However, the number of workers close to retirement age who had contributed to the system was small relative to the number of workers being levied. Thus, the system generated, up to 1988, significant cash surpluses and could comply with the benefit formula mandated in the law. This formula was extremely generous relative to other legislations in the world. 80. Given the important cash surpluses, and the nature of the pension scheme, the administration of the program should have built significant reserves from the amount levied on workers and firms. However, this was not possible, basically because the government took those funds in exchange for bonds yielding negative interest rates. 81. Having virtually no reserves, the system collapsed to a pay-as-you go plan, where benefits were, defacto, estimated on the basis of the available resources. Moreover, the transition to an effective pay-as-you-go system was accelerated by giving access to a partial pension with only five years of contribution. With the outbreak of hyperinflation, indexation was abandoned, and retirement income dropped significantly in real terms. 82. The prospects for the system were bleak, with projected reductions in the ratios of contributors to beneficiaries to account both for the natural maturity of the system (tending toward the age structure in Peru) and the observed long-term trend in the aging of the population. This raised questions about its financial feasibility at the given contribution rate and level of evasion. In addition, a deficient administration of the pension plan was characterized by redundant personnel, an inefficient collection system, and financial mismanagement that was concealed by an obscure, unauditable accounting system. 83. The Government decided to reform the nature of the pension system in Peru. The new legal framework will allow workers to choose between joining a pension system managed by the State and one handled privately. A massive transfer of workers to the new  Annex 3 The Structural Adjusrment Loan 57 system is expected, since the benefits of the former have been reduced significantly and are decided arbitrarily. The pension provided by the private system will depend on the amount of contributions of the individual during his working life, and the evolution of the real interest rate over the period; thus it is a fully-funded scheme instead of pay-as-you-go. This system promotes competition because the worker can choose the intermediating institution to manage its funds, whereas the other scheme acted on a monopoly basis. Finally, financial institutions in charge of managing the funds are private instead of State-owned institutions. 84. In summary, the modification may significantly increase the saving rate and improve income distribution. It also eliminated all favorable discriminatory treatment for some pressure groups and changed the legal requirement for pension indexation to periodic rises to account for inflation depending on the financial resource available to the managing institution. 85. The National Pension system has been operating on a pay-as-you-go basis. Consequently, a massive transfer of contributors to the alternative system will significantly affect the system's finances. Because of this, the Government has offered to guarantee, over the transition period, the pensions of retired workers. In the meantime, the Government inproved the administration, accounting and financial management of the social security institution (IPSS). 86. The reforms imply a partial privatization of the administration of the social security institution, as many of its former duties have been delegated to the private sector. Consistent with this reduced scope of work, the Government has trimmed redundant personnel from a level of 45,000 to 22,000 across the nation. Agriculture 87. This sector is one of the most important sources of employment in the country. Agricultural and livestock activities absorb 35 percent of the economically active population, but contribute only about 12 percent of GDP and 8 percent of exports. Nevertheless, the level of production is enough to provide a significant amount of the food consumed by Peruvians. The balance is provided by imports. Imports are especially important when the economy suffers from adverse supply shocks, such as the El Nifio current phenomenon which repeats itself about every 10 years. 88. Agricultural production is widely diversified. The most important staples in volume, are rice, maize, potatoes, coffee, cotton and sugar. The latter three have traditionally provided most of the foreign revenue generated by agriculture. The abrupt topography and difficult geography of the country mean that croplands are broadly scattered and segmented. This inhibits large-scale operations and increases transportation costs. In addition, farmers have to face the problem of cultivating land in sloped areas, for which they  Annex 3 The Structura/ Adjustment Loan 58 have developed their own technology. Pasture area is relatively small, restricting large-scale animal raising activities in the country. 89. Despite Peru's sizable territory, agricultural land is relatively scarce. Only 2.9 percent of the land mass of the country can be used for agriculture, most of it to be found in the highlands. However, this resource has not been appropriately managed through time, and much of it has been severely damaged or completely wasted for agricultural purposes. Salinization is a prevalent problem in the coastal region, while soil erosion is a major issue in the highlands. Deforestation and overgrazing affect large agricultural and animal raising areas through the country. Furthermore, lack of official concern for the environment has contributed to land degradation and ecological disruption. 90. Land is subject to a high degree of climatic uncertainty, exhibiting a high variance of temperature and availability of water and energy. This environmental factor increases the risks associated with the activity in the country. A large number of rural farmers, who are close to a subsistence level, take this as given and adjust their behavior by following risk-averse practices and diversifying their production, even though on a small scale. Over the years, farmers have arranged risk-pooling agreements to reduce their individual exposure. 91. Water availability depends on the precipitation in the mountains, either directly or indirectly. Most of the agriculture in the coast takes place in the scattered river valleys located along the large desert strip. In this region, farmers depend on irrigation systems which gather the seasonal rise in the level of the rivers during the rainfall period, while agriculture in the highlands depends directly on the amount of rainfall. In the 1970s, the Governrnent developed very important irrigation projects which have proved to be badly designed and managed. Despite the high cost of these projects, which aimed at providing water supply for agriculture, successive governments set water charges at levels so low that they were not worth collecting. Cheap water tariffs promoted the overuse and waste of water. 92. Urban centers are the natural markets for agriculture. However, local peasants face competition from imports. Protection is now limited to tariff barriers and, for some staples, a temporary surcharge scheme. Nevertheless, these may not compensate the higher road transportation costs that domestic production has to bear to reach the market. This reflects many factors, among them a government budget that depends on fuel taxes, the deterioration of the road network and infrastructure in general, and the environment of political violence that has prevailed in the country. Rural insecurity caused by terrorism and drug trafficking activities have increased both the costs of production and distribution. 93. Finally, the amount of investment in agriculture is extremely low. The level of under-capitalization can be explained, in part, by the mistakes contained in the Agrarian  Annex 3 The Structural Adiustment Loan 59 Reform Law passed in 1969. This law denied full property rights to the beneficiaries of the reform and threatened them permanently with expropriation. 94. In August 1991, the Government instituted a new Agricultural Investment Promotion Law which abolished most of the negative aspec.s of the earlier Agrarian Reform Law. The new policy framework is based on strengthened property rights and lower tariffs for agriculture inputs. The basis of agricultural progress is to be well-defined property rights for land and water usage, under which land may be owned, leased, mortgaged (if in excess of five hectares), and traded without restriction by or to any individual or legal entity, whether Peruvian or foreign. 95. Nevertheless, a vast array of farmners, are not yet covered by the law, and thus lack a proof of their property rights. Urgent reorganization of the rural registration system needs to be achieved since most of the land has not yet been registered. Once titling and registration of rural properties is undertaken peasants will be able to use their land as collateral for credit. (Peasant communities -- "comunidades campesinas" -- do not have this freedom, though their freedom to dispose of their land has increased under the new 1993 Constitution.) 96. State participation in agriculture is being cut drastically. The State has refrained from setting price controls, providing inflationary credit subsidies, or supporting privileged access to collateral. In foodstuff trading the role of the State has been substantially reduced. ECASA, the national rice-marketing monopoly, has already ceased operations and is completing the process of liquidation. The monopoly on imported grains and fertilizers that ENCI formerly had was removed, and the company has begun a process of reorganization. 97. To temporarily provide funds for agriculture, the central government budget has allocated limited amounts for credit since Banco Agrario is no longer a source of credit and commercial credit to agriculture has remained low. Unfortunately, the improved economic framework for agriculture has not been reflected in greater production, because of bad climatic conditions. In this scenario, banks, which face a difficult financial situation, have not been willing to increase their risk by lending to clients that are unknown to them. Faster procedures to call on guarantees and swifter solutions for legal disputes must be implemented if banks are to increase their stake in agriculture. Privatization 98. The bold privatization program of the Fujimori Administration aims at divestiture of about 224 companies. The State will concentrate on providing basic infrastructure, health, education, justice, and public goods.  Annex 3 The Structrural Adjustment Loan 60 99. The legal and institutional framework for privatization was defined in Legislative Decree 674 of September 1991, as amended in December 1992. This decree created an executive agency in charge of the privatization program, the Commission for the Promotion of Private Investment (COPRI). This inter-ministerial commission is directly supervised by the President. For the privatization of each public company, COPRI nominates a Special Committee (CEPRI) which draws up the plan and conditions of sale on a case by case basis. Each CEPRI monitors the privatization by overseeing consultants contracted under competitive bidding to carry out the technical and financial studies. 100. As part of the effort to promote investment, the Government has transformed foreign investment legislation into one of the most liberal in the world. Foreign investors now have the same rights and obligations as Peruvians. Foreign investors may organize themselves into any corporate form provided for in corporate law, including joint ventures with domestic investors. There are no restriction on any form of capita] remittance, whether dividend, interest, or royalty payments. For the transfers, investors need only channel the resources through the banking system without needing any type of approval from the government. Finally, Peru acceded to the Multilateral Investment Guarantee Agreement (MIGA) in December 1991. In addition, the country has become a member of the Internatio- nal Center for the Settlement of Investment Disputes (ICSID) and has signed bilateral agreements to protect investments with Switzerland, Thailand, and recently with the United States (through the Overseas Private Investment Corporation). 101. From May 1992 to April 1994, 33 companies have been privatized. This process has accrued US$ 2.07 billion in revenues and has helped the Government balance its budget. Of particular note was the privatization of Empresa Nacional de Telecomunicaciones - Entel/Companiia Peruana de Telefonos - CPT - Telecommunications. On February 28, 1994, a control package of 35% of Entel and CPT--including a capital increase in CPT--, was auctioned to a consortium led by Telefonica Internacional (Spain), for a total of US$2 billion. Out of this amount, the State will receive US$1.39 billion, while US$0.61 billion will be the additional capital in CPT. Up to 10% of Entel's shares will be offered to Entel's workers and the remaining shares will eventually be offered in the market. All the remaining mayor companies will be privatized by early 1995. These include the two mayor electricity companies (ELECTROLIMA and ELECTROPERU), the national oil company (PETROPERU), the water and sewerage company (SEDAPAL) and the remaining mining companies (CENTROMIN and MINEROPERU). Social Sector Issues 102. A large segment of the Peruvian population suffers from chronic poverty, defined as a level of consumption below that represented by a basic food basket. There are serious problems in health, nutrition, sanitation, and education. Under the new economic policy, the government will promote wealth-generating activities rather than redistribution of income. The new economic strategy is intended to improve real wages. Crucial in this  Annex 3 The Structural Adjustmenr Loan 61 effort is the process of labor market deregulation and the elimination of the regressive inflation tax. 103. In addition, the Government will concentrate on the provision, rehabilitation, and expansion of basic social infrastructure and essential public services: health, water and sanitation and education services. In order to do so, the Government will have to improve its administrative capacity and reform key institutions, as duplication of functions remains in key areas like health provision. 104. However, as a short-term response to critical poverty, the Government has designed a poverty alleviation strategy establishing a minimum safety net for the most vulnerable groups in society. It began with outlining policies in health, nutrition, education, and employment, identifying vulnerable sectors, priority programs, and the institutional framework for the implementation of social programs. Identification of target groups implies a significant change in policy relative to the prevalent generalized food subsidies of the past. 105. One of the principal safety-net schemes in the program is FONCODES, the National Fund for Social Compensation and Development, created in August 1991. It finances small labor-intensive projects for the rehabilitation of social and economic infrastructure and for the provision of basic social services, identified by the poorer local communities. After its formative period during 1992, there have been notable improvements in its efficiency and management. To fund the program it relies on both internal and external resources. Health 106. The most common health problems in Peru, and among the main known causes of mortality, are pollution-related respiratory illnesses and water-borne diseases such as diarrhea. Diarrheal diseases arise from the use of contaminated water and lack of access to a public sewerage service. The precariousness of the sanitary conditions of the country explains the degree of prevalence of water-borne diseases and the speed with which the cholera epidemic spread in the country in 1991. 107. Infant mortality is very high, especially in the rural areas, where it is double the rate of urban areas. Correspondingly, the number of children per mother in rural areas is twice that of mothers in urban areas. Average life expectancy is about 64 years, but after surviving the first two years of life, life expectancy increases to above 70 years old. The most dramatic fact, however, is that more than 80 percent of the infant deaths could be easily avoided with proper care. Moreover, it is estimated that around 40 percent of children under six suffer some sort of nutritional deficiency. 108. There are in Peri almost the same number of public and private hospitals. However, private hospitals have a much lower number of beds per institution. The Ministry  Annex 3 The Structural Adjustment Loan 62 of Health is the main provider of hospital infrastructure in the public sector, followed by thc Social Security Institution, which provides health care to its contributors and their families. Unfortunately, because of lack of funds and mismanagement, public hospitals are significantly limited in their ability to provide health services to the population. There are about than 27,000 physicians, about one for every 3,000 people. The ratio is much lower in Lima: about one for every 436. In general, health care is much better in urban than in rural areas. 109. The Ministry of Health intends to reduce infant mortality, expand health coverage in poor areas, rehabilitate social infrastructure, and upgrade the capacity of professional staff. Concurrently, the Ministry of Education initiated an emergency program to feed schoolchildren one meal a day and use the school as a locus to introduce tuberculosis detection and improved health practices. 110. With UNICEF assistance, a Plan of Action for Child Welfare was prepared by the Government. It sets goals in the area of health, water and sanitation, nutrition, employment, and the problems of children in difficult circumstances. Moreover, the Government prepared a national nutrition policy based on a review of existing food assistance programs, which were reformed to improve cost effectiveness and nutritional impact. In addition, the Government prepared a list of priority projects and project profiles in primary health and nutrition. Education 11. The illiteracy rate is 11 percent, although the underlying distribution exhibits high variance associated with geographical area and sex. For men, the average rate is only 5 percent, while for women it is 18 percent. The illiteracy rate is 5 percent for urban areas and 30 percent for rural areas. In the Andean valleys, a significant portion of the population barely speaks Spanish, Quechua being the main language. Finally, the rate of illiteracy is much lower for younger than older people, reflecting the effort at universal education undertaken by the State in the last decades. 112. About 70 percent of children receive school education, 90 percent of them in public schools. Of the 47,000 schools in the country, about 41,000 are public. The presence of the State at the university level is lower. It manages 33 of the 56 universities in the country. However, public schools perform very poorly. The degree of educational attainment, although improving, remains very low. Repetition rates are about 10.2 percent in primary school and 8.5 percent in secondary school. The attrition rate is currently about 6.2 percent, being somewhat higher in secondary schools. 113. The Government developed a list of priority projects and implementation schedules with the objective to increase internal efficiency of education. The Ministry of Education aims at expanding the coverage and quality of primary education and linking  Annex 3 The Srruc tural A djus tmen t L oan 63 technical training to the job market. Over the medium-term, the objectives are to improve the qualitv of education, universalize education for 6-14 year old children, and upgrade the quality of teachers in the public system. Over time, the investments in human capital achieved through education will be the most valuable tool to emerge from poverty. Overall Evaluation 114. Reforms introduced by the Fujimori Administration in Peru have proven to be the most important changes in the country's economic framework since 1968. The revolution in the structure of the economy encompasses a change in development strategy from an inward-oriented import-substitution system to a market-oriented open economy. The long- run role of the government has been limited to those activities in which it will be most efficient. In particular, the State is abandoning its generalized intervention as producer and planner, and concentrating on providing a stable legal framework for property rights and services for health, education, security and basic infrastructure. 115. The achievements are encouraging. As described in the prior sections, the structural adjustment has pervaded most activities in Peru. In particular, the Government liberalized economic activity throughout the country. It has lifted barriers to trade domestically and abroad, opened activities to the private sector that were once reserved to the state, and, in general, fostered an environment of competition designed to promote a more efficient allocation of resources. In general, the scope of the structural changes in Peru is one of the boldest and most far reaching ever seen in Latin America. The Stabilization Program 116. The stabilization program implemented by the Fujimori Administration can be characterized as orthodox and monetary-based, since it has stopped domestic financing of the fiscal deficit and imposed targets on money base expansions. Liberalization programs have complemented this effort, laying the foundations for growth and increasing confidence in the sustainability of the stabilization. 117. The program was successful in curtailing hyperinflation, but it has not yet abated high inflation. The monthly rate declined from an average of 40 percent per month through mid 1990 to a figure around two percent per month by the enid of 1993. Notwithstanding the large improvement, Peru is still among the high inflation countries. 118. The observed increase in the consumer price index over the period was consistent with the growth of the monetary base, despite the fact that the Central Bank did not finance any budget deficit. This shows that equilibrium in the fiscal accounts is a necessary, but not a sufficient condition to maintain price stability. Inflation is a monetary phenomenon, and there are many reasons why the Central Bank might increase the quantity of money, besides funding the government. For instance, expansion in the money supply  Annex 3 The Structura/ Adjustment Loan 64 may arise from purchases of foreign reserves. direct credit policy, or open market operations of the monetary authority. 119. The expansion of high-powered monev can be explained mainly by Central Bank purchases of foreign exchange with the double objective of increasing international reserves and trving to depreciate the real exchange rate. Some additional intervention of the Central Bank in the exchange rate market was on behalf of the government, acting as an intermediary in acquiring foreign exchange to service debt. The behavior of the Central Bank was consistent with the yearly monetary expansion targets and credit ceilings agreed with the IMF under the Rights Accumulation Program. The Govemrnent and the IMF agreed on a gradualistic attack on inflation. 120. Although not to the standards of developed countries, inflation has been reduced drastically, thus curtailing the depreciation rate of real money balances. This effect should have boosted, cetenis paribus, the demand for domestic currency. On the other hand, the opportunity cost increased with the elimination of repression in the financial system. Market determined interest rates reached levels previously unknown to the country, and dollar deposits in the financial system provided a low risk financial asset that enhanced the possibilities of inter-temporal substitution which for a large majority of the population was previously restricted to the dollar bill.2 121. Since the Fujimori Administration took office, domestic real interest rates have been above both international and historical levels. At the beginning of the stabilization, interest rates in soles and dollars skyrocketed, due to a liquidity effect increasing demand for credit and higher expected growth. 122. High risk also explains the higher real interest rates observed in the economy. Depending on the denomination of the type of asset, deposits reflected: the lack of confidence in the financial system (the risk of expropriation and bankruptcy); the devaluation and inflation tax premium; and the country risk. The latter arises from the frequent historical changes in economic policy and in the legal and regulatory framework that have affected the business environment. 123. The economy suffered a contraction in GDP as a result of the adjustment process to the new set of market prices and external competition. In addition, other supply shocks were also present, such as bad weather and the presence of the El Nino current that affected agriculture and fishing. This also caused a drought in the Andes that reduced production through a lack of electricity. 2 Domestic nominal interest rates in Peru's financial system prior to 1990, did not reflect the cost of holding currency. Because of financial repression, deposits at the financial system were not the best alternative (and therefore the opportunity cost) of holding purchasing power. Hence, people resorted to dollar bills as store of value.  Annex 3 The S truc tura/ A dus trmen r L oan 65 124. Inflation would have been lower if money demand had responded to lower inflation. One of the possible explanations of the sluggish increase in real domestic money balances is that the reduction in monetary growth rate was not perceived to be permanent. Under this hypothesis, the fact that the current inflation rate was lower did not necessarily mean that people expected it remain that way in the future. Drastic policy changes have been common in the country and Peri has had a long experience with surprise unsuccessful stabilization programs. Those came together with periodic drastic once and for all increases that dramatically shrank the real money balances of those who maintained them. 125. Lack of confidence in the government's ability to lower inflation may be explained with the observation that the inflation forecasts published by the government consistently underestimated actual results. Moreover, the implicit expected devaluation rate observed from interest rate differentials suggests that those forecasts were never believed. Currency Substitution 126. Domestic currency has to compete with foreign exchange to provide monetary services to the Peruvians. The economy uses the US dollar a as means of payment for large domestic transactions, a store of value and a unit of account. Petty exchanges are mostly carried out in local currency. Thus, the dollar coexists with the domestic currency, which lost its monopoly as the domestic means of payment with the outbreak of uncontrolled inflation. 127. The explanation of this substitution is that the foreign currency is cheaper and more reliable than the domestic currency. The user cost of domestic currency is still significantly higher than the user cost of dollars, and transaction costs of exchange are very low. The existence of dollarization in the economy may improve net welfare since it increases the number of options available to consumers. 128. Dollarization of transaction services is still the most efficient way that society has to keep its payment system going, in a scenario of still high inflation rates. If dollarization could be prohibited, economic agents would have to resort to another less efficient means, and probably some mutually beneficial exchanges would not take place. 129. The allowance of dollar deposits has reduced significantly the seignorage paid by the Peruvian Economy as a whole. Before dollar deposits were permitted, seignorage was being paid on dollar bills kept for both uses: transaction and store of value purposes. With the introduction of dollar deposits, the dollar "base" has declined accordingly. Indeed, even though banks must hold reserves at the Central Bank, this institution may deposit those resources abroad and earn interest. Thus, the cost of holding dollar deposits to the society for store of value purposes--the loss of seignorage--is about equal only to the bills in circulation.  Annex 3 The Structural Adjustmenr Loan 66 Real Exchange Rate 130. The real exchange rate has been appreciating since 1988, but has appreciated at a much lower rate since the beginning of the stabilization. Nonetheless, there is a strong perception of real exchange rate appreciation, especially when the ratio is compared to prior historic levels. Moreover, there is a prevalent expectation that the real exchange rate will continue to appreciate. This expectation is consistent with domestic real interest rates of dollar denominated deposits being higher than real interest rates abroad. 131. The Central Bank tried to depreciate the exchange rate to promote export-led growth in the country. It seems that it made a small dent in this rate, but at the cost of a sizable inflation tax. 132. With the liberalization of capital markets came an increase in the supply of dollars in the economy. Capital inflows were attracted to the country by the high interest rates, either to earn a high yield or to avoid paying one. In addition, capital inflows financed the remonetization of the economy, which took place to a significant degree in dollar-denominated liquidity. 133. Many factors have affected the real exchange rate since the launching of the stabilization plan. The reduction in tariffs decreased the price of tradable goods, the elimination of subsidies boosted the price of non-tradable goods and, finally, the increase in the price of energy and public services may have affected the price of non-tradable goods more than that of non-tradable goods. It is difficult to assess the final net result of these opposing effects. Sustainability 134. The current Administration remains committed to the structural reforms and current economic policy, and is expected to maintain that position until the end of its term. Furthermore, the Administration signed a three-year Extended Fund Facility Program with the IMF in March 1993 that has defined an economic program for the period, setting targets consistent with greater macroeconomic stability. 135. However, there are some concerns about the sustainability of the economic program beyond this Administration. On the macroeconomic side, the fears are based on the fragile fiscal situation over the medium term unless there is a significant increase in the level of tax revenues. In particular, two factors could affect the current equilibrium. The first is the level of external debt, the servicing of which would be unsustainable at current tax collection rates. Conservative projections forecast that medium- and long-term public debt could reach a level in excess of total exports in 1996. Peru would have to negotiate a reduction in its debt with its creditors, because even if revenues increase enough to cover  Annex 3 The StructuralAdjustment Loan 57 debt service, the opportunity cost is very high since the State needs financial resources to provide for social spending and basic infrastructure. 136. The second factor is related to the redefinition of the social security system. If the introduction of the new system is successful!, the government would assume a significant internal debt on behalf of the current pensioners and contributors (in principle all workers in the formal system) estimated at US$ 1.9 billion, assuming a discount rate of 4%. That debt would have to be paid over the next 50 years, but could be financed over time in order to redistribute the cost of the transition to a better pension system to the future generations who will benefit from it. 137. Over the shorter run, some macroeconomic progress is required to consolidate the stabilization program. In particular, growth must be resumed and inflation reduced. Inflation continued to fall after 1992, while a promising recovery growth began at the end of 1992. The economic situation of the banking system gives rise to concern. A banking crisis would be a serious setback for the stabilization program. 138. The long-term sustainability of the broad structural reforms and macroeconomic improvement implemented by the Fujimori Administration will depend on the political support that they will be able to retain over time. The Government has enjoyed high approval rates, but it must secure political support from the most vulnerable groups. In this sense, the poverty alleviation scheme implemented by the Government is of utmost importance. Conclusions and Lessons from the SAL 139. The Structural Adjustment Loan (SAL) was the second of three policy loans within the Bank's new approach to debt workout problems with Peru, as a country with protracted arrears. Arrears clearance reversed the country's non-accrual status, and has allowed the Bank to restart large lending operations in Peru. 140. The SAL was instrumental in supporting the reforms that will sustain long- term growth. To improve allocation of resources the loan has fostered the development of the private sector by supporting the liberalization and deregulation of key markets and promoting the privatization of state enterprises, thus directly reducing the participation of the government in productive activities. It has been the Government's decision, supported by the SAL, to limit its scope to those activities in which it will be most helpful for society: providing a more stable legal and regulatory framework, social welfare programs, and basic infrastructure. 141. Reforns in the labor market have enhanced labor mobility and improved the system of forced savings for retirement. Those in social security have achieved a better management of the corresponding institution and the introduction of a superior alternative  Annex 3 The Structura/ Adjustment Loan 68 which will foster Peruvian capital markets. Finally, reforms in agriculture have eliminated price distortions and broadened property rights in land, abolishing most legal and regulatory restrictions to credit and trade. 142. In addition to the structural reforms, the Peruvian economy has made a fundamental change in economic policy. This includes a change in development strategy from an inward-oriented import-substitution scheme to a market-oriented open economy. The new Administration shifted from a multiple-exchange crawling peg to a unified floating exchange rate system. Compulsory surrender of export receipts and all controls on current- and capital-accounts transactions were abolished. In addition, most price controls were eliminated, including a defacto elimination of interest rates ceilings. Monetary expansion was limited mainly to purchases of foreign currency by the Central Bank to accumulate foreign reserves. Central-Bank financing of the central government was explicitly prohibited, and a cash management committee managed State finances on a cash basis only. In order to sustain this situation, the Government undertook further fiscal reforms aimed at increasing tax revenues and improving the management of public expenditure. 143. However, macroeconomic stability is still fragile and there is still much to achieve. Inflation and real interest rates are very high relative to international standards. Finally, Peru still has a sizable labor force working in the "informal" sector. 144. The lessons that can be drawn from the structural adjustment loan are related to the stabilization program implemented by the Government. First, in a scenario of lack of credibility and persistent dollarization, an increase in the demand for domestic real balances cannot be expected despite the reduction in the inflation rate. Second, in this framework, the efforts of the Central Bank to depreciate the real exchange rate through direct purchases of foreign exchange will generate inflation. Third, financial intermediation in dollars may reduce the seignorage paid by the economy. Fourth, real interest rates may be higher in the country even though it is open to foreign capital, as a result of a combination of country risk, expropriation risk, expectations of future real exchange depreciation, and the internal level of taxation.  Annex 4 The Trade Policy Reform Loan 69 ANNEX 4 THE TRADE POLICY REFORM LOAN Trade Policv Reform and the Loan 1. In August, 1990 the newly elected Fujimori Government began a fundamental trade reform concurrently with the introduction of a stabilization policy and the initiation of a broad range of economic reforms. The exchange rate was immediately unified and floated, and rationing of foreign exchange largely eliminated. Many non-tariff barriers, most import tariff preferences, and all export subsidies were eliminated in short order. By March 1991, virtually all remaining non-tariff barriers had been eliminated. At this time, a two-rate tariff (15 and 25 percent) was introduced (with a few exceptions for steel products). A system of variable tariff surcharges was introduced for a limited number of agricultural products in an effort to provide greater price stability in the domestic market. In mid-1991 an anti-dumping code was passed. By this time, the Government had eliminated most of the activity of the Instituto de Comercio Exterior (ICE -- the public body that had formerly administered import controls and export subsidies), and begun a program of reforming the customs service. In September, the Government gave the strength of law to many of the decrees that had achieved these policy changes. 2. The early reforms of the new Administration were not part of any clear blueprint for trade reform. They may have responded to informal policy advice from the international financial institutions, but many of them were also a necessary part of the stabilization. A Bank mission at the end of 1990 made specific proposals in the area of foreign trade including: a rapid move to a low and uniform tariff; elimination of export subsidies; and the creation of a safeguard mechanism to adjudicate claims of import injury that balanced producer and consumer interests.' The mission also proposed a detailed plan for the reform of SUNAD, the Customs Superintendency. After this, a Bank trade mission (funded under the joint UNDP-World Bank Trade Expansion Program) arrived just after the February 1991 appointment of a new Economy and Finance Minister. Carlos Boloiia, for whom radical micro-economic reform, particularly in trade, was a top priority. The radical measures the Government took from March onwards were consistent with the mission's recommendations (though not always identical), and reflected a unanimity of views rather than any new conviction on the Government's part.2 ' Economic Reforms to Sustain Stabilization and Lay the Foundations for Development, December 8, 1990, World Bank, mimeo. 2 The mission proposed: an immediate reduction in tariffs to leave only three rates, 15, 20, and 25 percent, and the move to a flat 15 percent tariff within one year; an elimination of controls on second-hand imports of capital goods and motor vehicles; the permanent elimination of the main non-tariff import barriers and further elimination and simplification of remaining technical barriers; the extension of the temporary admission system to cover all exports; the preparation of a plan to reform customs; the de-activation of ICE, the careful introduction of anti-dumping legislation; and the consideration of a scheme to provide internal price stability to selected agricultural products through a variable specific tariff. See also the subsequent report: UNDP-World Bank Trade Expansion Program, Peru: Towards a More Open Economy, Trade Policy Division, Country  Annex 4 The Trade Policy Reform Loan 70 3. The loan was prepared between June and December 1991. Preparing the trade-policy-related part of the loan proved straightforward. No new analytical work was carried out: even if there had been more time for this, the two missions mentioned in paragraph 2 above had laid a solid basis, while the reform was by and large so classical and straightforward that it did not warrant any complex data manipulation to justify or design it. From the beginning, the Bank worked in close cooperation with the lDB, which presented its own Trade Sector Loan to its Board on September 18, 1991. The close cooperation was facilitated by the fact that the IDB loan was managed by a former Bank staff member who had led the December Bank mission mentioned in paragraph 2 and had recently transferred to the IDB. The Bank and IDB agreed on virtually identical conditionality (with the exception that IDB handled the restructuring of two state enterprises, ENCI and ECASA, in its Trade Sector Loan, while the Bank handled this in its SAL). IDB took the lead in designing the project component on customs reform. (IDB also provided a $2.3 million component of a Technical Cooperation project to fund technical assistance for the customs reform.) 4. The Bank -- although quite pleased with the amount and quality of reform already having taken place -- was concerned to agree on conditionality which would require Peru to undertake to maintain all its actual reforms and carry out only a few remaining reforms it had already announced (notably, eliminating a residual 5-percent tariff rate by early 1993), rather than to seek new policy concessions. In this respect, the Bank sought to defend the policy positions already established by the Government and enjoying substantial public support against any future opposition that might arise. Bank-Government negotiations (in December 1991) were straightforward and uneventful. 5. The loan conditions agreed between the Bank and the Government emphasized the maintenance of the reforms achieved between August 1990 and September 1991, rather than new measures to be taken. Of the 22 conditions agreed (see Annex 1), 16 were to maintain existing reforms and six to achieve further changes. The main actions under the Loan can be summarized as follows: (a) the exchange regime: maintain a single freely convertible exchange rate for all transactions; (b) tariffs: maintain a simplified tariff structure which had substantially reduced the level and variance of protection; maintaining the elimination of most special regimes allowing discriminatory preferences on the domestic market; maintaining the agricultural surcharges scheme as it is (i.e. not expanding or changing it), with the possibility of revising it following a study; revising the anti-dumping code (with the help of a study of the issue); (c) non-tariff import barriers: maintain the elimination of formally protective barriers, including prohibitions, minimum-local-content regulations (except on milk), controls on most second-hand imports (notably excluding clothing), and state agricultural import monopolies; reduce or simplify some technical/safety/health controls on imports (with the help of a study of the issue); Economics Department, the World Bank, October 1992.  Annex 4 The Trade Policy Reform Loan 71 (d) export regime: maintain the elimination of fiscal and financiaL export subsidies; improve schemes to allow inports to recover indirect taxes when the fiscal situation permnitted this; maintain the reduction in non-tariff export barriers; (e) trade institutions: carry out a program for customs reform. Implementation of the Reforms 6. The Board document Perui: Final Review of the Bank's Workout Program (R92-226, December 10, 1992) reported that the Government had observed all measures agreed (see Annex 1, reproduced as Annex 1 in this report, for details) and that its commitment to an open trade regime had not wavered during the performance period.' This is still the case. But this is not to say that the trade reform has been entirely without its ups or downs or problems. This section reports on developments in Peruvian trade policy since Board presentation of the Trade Policy Reform Loan (February 1992). 7. Exchange Rate Policy. The Government has maintained a unified, freely convertible exchange rate for all transactions, with no change in the floating-rate regime. 8. Tariff Policy. At the last moment (while the project was actually being negotiated, in December 1991), the Presidents of the Andean Pact (of which Peru is a member) made a commitment, in the Acta de Barahona, to create a customs union. This had tariff implications for Peru in conflict with the loan conditionality initially proposed by the Ministry of Economy and Finance (which represented the Government at negotiations) and acceptable to the Bank. To solve the conflict, the Bank and the Government then agreed on "either/or" conditions for tariff reform, depending on whether the Government opted to maintain the tariff strategy announced in early 1991 (first a two-tier tariff, then a low single rate) or opted to negotiate a common external tariff within the Andean Group (which was likely to be a multi-tier tariff, with higher average rates). 9. In the event, the Government has not agreed a common external tariff with its Andean-Group partners. In a succession of negotiations from the end of 1991 onwards, the Group was unable to find a unanimous position on a common external tariff, largely because the countries were at different stages in the trade-reform process or had different ideas on the optimum speed of trade reform. The Peruvian Government did not wish to be part of a arrangement that would compromise its strategy of radical and rapid trade liberalization. On August 25, 1992, the Commission of the Cartagena Agreement acceded to Peru's request to suspend its commercial obligations until December 31 1993 and permitted Peru to seek I The procedure in this loan, as in other Bank adjustment loans, was to require the fulfillment, without exception in principle, of a list of conditions. Formally, this gives the Bank little flexibility, short of seeking a Board waiver: if one condition remains unmet while 19 are met, the conditionality is deemed not having been fulfilled, even if some of the other 19 are fulfilled beyond expectations. In this Loan, there were undoubtedly some minor cases of backtracking, but on balance conditionality was amply fulfilled. In the Letter of Development Policy, the Government committed itself to prepare studies in three areas (the anti-dumping code, tariff surcharges, and nontariff barriers), to agree with the Bank on further reforms based on these studies, and to implement them.  Annex 4 The Trade Po/icy Reform Loan 72 commercial agreements with its Andean-Group partners. This suspension has since been renewed for 1994. Perul has since signed limited preferential agreements offering zero duties on the most important items in bilateral trade with its Andean-Group partners. These developments (and earlier official speculation that Peru might even leave the Andean Group) now make Peruvian agreement on a common external tariff unlikely, and the Government's tariff policy continues to be to move to a flat 15-percent tariff. This outcome bodes well for maintaining the momentum of Peru's trade reform process. 10. Thus the Goverrnent has kept to the conditionality on tariff structure agreed as the alternative to the Andean Group tariff. In February 1992 the Government officially decided that the 5-percent tariff on steel inputs, established in January 1991, had been superseded by legislation of September 1991. From this latter date, therefore, Peru has had only two tariff rates, 15 and 25 percent.4 In 1992 and 1993, 850 items (13 percent of all tariff items) were removed from the 25-percent rate to the 15-percent rate. 11. Tariff exemptions. Several measures related to tariff exemptions have been introduced. (a) In March 1992, small producers were permitted to pay IGV (the value added tax) under the simplified regime at 5 percent (normally 18 percent). The purpose of this was not to provide a preference for existing tax-payers but to get some tax from firms which normally evaded it. (b) Under the pressure of recession, the Government in 1992 introduced several schemes that now allow many private capital-goods importers to spread their import duty payments over 24 months, with interest payable at a local market rate for deposits. Thus, the loan represents a subsidy to the extent of the spread between deposit and lending rates. In the particular case of private electricity-generating machinery a concession granted in July 1992 amounts to a 24-month interest-free loan (payable over 18 months, with six months' grace). This measure reflected an emergency situation resulting from a drought which reduced the public electricity supply (which is mainly hydroelectric) by one-third after about May 1992. It is noteworthy that, for the first time, the Government has not resorted to a full tariff exemption. There are no domestic producers of large generators, hence the measure has no discriminatory effect. However, these schemes allowing importers to spread out their import duty payments involve a subsidy -- which is close to representing a tariff preference -- and should be discontinued. 12. Agricultural surcharges. The scheme, created in March 1991, provides for a variable surcharge, in addition to the normal 15-percent tariff, based on the average of the previous five years' c.i.f. import price. Much of the revenue from these tariffs provides resources for the Ministry of Agriculture. The Government agreed not to extend the scheme ' In March 1992, a system of tariffs reclassified according to the harmonized system (NANDINA) was introduced. As a result, 27 percent of tariff positions came to enjoy the higher rate (25 percent ad valorem), compared to 18 percent under the previous classification. There is no evidence, however, that if these figures were import-weighted, there would be a rise in protection.  Annex 4 The Trade Policy Reform Loan 73 beyond the 18 products originally specified, to apply and publish an agreed methodology for calculating the surcharge, and to update the surcharge regularly. For two of the 18 products (powdered milk and dehydrated milk fat), a fixed, specific surcharge was permitted. 13. The Governrnent also agreed to undertake a study to evaluate the scheme and, by about September 1992, to implement reforns to the scheme agreed with the Bank. The study was completed in August 1992.5 This study found that, had the scheme been consistently implemented as originally intended, greater price stability would have brought welfare gains, particularly for sugar. But the frequent changes in the rules led instead to welfare losses. Moreover, the presence of close substitutes and apparently imperfect competition in food distribution meant that the surcharges were not translated into increased farm-gate prices. The study recommended the direct provision of budgetary resources to improve farmer welfare, measures to increase competition in distribution, and a flat 10- percent ad valorem tariff surcharge. (This last recommendation presumably reflects the belief that a technically optimal scheme -- with variable rates -- would inevitably lead to, and be frustrated by, rent seeking.) 14. The surcharge has proven the most contentious part of the trade reform process. It has been potentially damaging to the overall thrust of trade reform because it provides the thin end of the wedge for protectionist interests. The revenue from the surcharge has also been used in part to reintroduce discretionary programs of agricultural support. The scheme has been changed on a number of occasions: the number of items covered has been increased and then reduced; the methodology has been changed. All this reflected struggles among agricultural, processing, and importing interests. The current situation is that the scheme, now covering 20 products, has been more or less brought back to its September 1991 situation (with two of the products, maize and sorghum, now reflecting a flat 10-percent surcharge). 15. Given opposition within the Government (mainly from the Ministry of Agriculture) to the flat-10-percent-tariff recommendation, and the view that evolved in the Bank that the scheme should be changed wholesale (preferably eliminated) or not at all, the Bank has accepted the scheme in its present form, but has undertaken to keep the matter under review in its policy dialogue with the Government. If only because the scheme has been so clearly revealed as a vehicle for rent-seeking and a dangerous precedent encouraging creeping protection in other fields, it has revealed itself as thoroughly undesirable, notwithstanding the technical merits that price stabilization schemes could theoretically have. 16. Free-trade zones. Perui has two free-trade zones which process or re-sell imports for the internal market. Imports from these zones into the rest of Peru pay full taxes, except on some goods where a uniform 10 percent duty is charged. The Ministry of Industry is promoting the introduction of twelve industrial free-trade zones, but the Ministry of Economy and Finance is less enthusiastic about this. 5 Javier Escobal and Ariuro Brisceno, El Sisiena de Sobretasas Agricolas en el Peru: Evaluacion y Recomendaciones, GRADE, 28 de Agosto de 1992.  Annex 4 The Trade Policy Reform Loan 74 17. Non-tariff Barriers. The Government has agreed: to ban the use of reference prices and minimum values for protective purposes; not to introduce new non-tariff barriers beyond those existing on July 5, 1991; and to undertake a study which would lead to the implementation, about June 1992, of regulations assuring non-discrimination in health and sanitary regulations and technical standards. (a) Reference prices. Although the use of reference prices for protective purposes had been eliminated, the customs service (SUNAD) continued until 1992 to apply reference prices to imports of steel, Chilean wine, and automobiles. In May 1992 the Government eliminated the use of reference prices for customs valuation, turning instead to reliance for customs purposes on the valuation provided by pre-shipment inspection companies (see below). Since September 1992, SUNAD has used reference prices for imports that fall outside the pre-inspection scheme (principally consignments of less than $2 million). Reference prices do not appear to have been used in a protective manner (and have not, for instance, been deliberately set at above-world prices). (b) Non-tariff barriers. An August 1991 measure prohibited the import of milk inputs, in powder and other forms, for commercial reconstitution or combining. (This measure had been exempted from the provisions of the Bank's Loan.) This measure replaced a de facto non-tariff barrier limiting the share of imported inputs to 30 percent of the dairy industry's inputs, a barrier enforced through a public monopoly of such imports. (The public monopoly no longer has legal standing, but the state enterprise, ENCI, is still the only importer.) Producers of evaporated milk and milk producers agreed in early 1992 to a timetable for increasing the proportion of fresh Peruvian-produced milk in evaporated milk from 70 percent in mid-April 1992 to 100 percent from the beginning of 1994. Since the end of 1991 cotton imports from Brazil and Colombia have been subject to controls on health grounds: the requirement of vacuum-chamber fumigation for such imports in their country of origin has a discriminatory aspect. The Government has not yet been able to solve this problem. In January 1992, a Lima court mandated the suspension of imports of plastic products from Colombia on the grounds of dumping. However, the customs service did not accept the court's authority in this matter and has not applied the measure. * In August 1992 quarantine treatment was required for fruits and vegetables suffering from fruit flies originating from neighboring countries. This was also thought to have a discriminatory aspect. (c) Certification of agricultural imports. There have been halting moves toward the liberalization of procedures in this area. Various ministerial-level decrees have been  Annex 4 The Trade Policy Reform Loan 75 issued to reduce the monopoly that the Ministry of Agriculture has enjoyed in issuing Qualitv Certificates for agro-livestock products. The Ministrv resisted these measures, but progress is being made in establishing agreed procedures to allow certified private firms to issue the certificates. (d) Certification of pharmaceutical imports. Registering with the Registro Sanitario is indispensable for production, import, and trade in pharmaceuticals, cosmetics, and medical goods. There has been a similar halting progress towards partial privatization of the issue of Health and Quality Certificates to that observed in agricultural certification. Health legislation relating to imports is now contained in one law. 18. Bank conditionality required a study on non-tariff barriers related to health, technical, security, and miscellaneous regulations. A study of import procedures for agricultural goods and inputs, completed in March 1992, provides and analyzes an inventory of these measures, and it proposes criteria and measures for non-discriminatory health controls.6 The study criticizes the protectionism of pre-Fujimori measures, but also suggest that health risks may be posed by the extent of liberalization associated with some of the post-Fujimori reforms. The study was originally intended as the basis for Bank-Government agreement on new policy measures to be takeii. However, the complexities of the public- goods problems involved in health and safety controls suggest that thorough-going reforms will require more study. 19. Undoubtedly, non-tariff barriers have now been largely eliminated in Peru, and the most important remaining task is to perfect an efficient system of health and safety controls that addresses public health needs while minimizing the discrimination this causes against imports. In practice the Government has been assiduous in fighting the lingering bureaucracy of some of its ministries. Surveillance of non-tariff barriers is now the responsibility of a new National Institute for the Maintenance of Competition and Defense of Intellectual Property (INDECOPI). INDECOPI continues to be active in studying methods of reducing the discriminatory impact of non-tariff barriers, and may take over accreditation responsibilities for health and quality certification from the Ministries of Agriculture and Health. 20. Anti-dumping code. The Government agreed to undertake a study on further refonn of the existing anti-dumping code to make sure that it did not give unjustified protection to domestic producers and to enact, by around March 1992, appropriate amendments to the code. Prior to Board presentation, expert commentary had been made on the code, both from within the Bank and from outside.7 This commentary fulfilled the loan requirement for a study. The Government then amended the code in March 1992. This 6 Hermogenes Pinedo R., Criterios y Normas de Impornacion: Elimninacion de Barreras No Arancelarias al Comercio Exterior. Inventario y Criterios para Mejorar la Aplicacion de las Normas de Control Sanitario en la Importacion de Productos e Insumos Agrarios, Lima, Marzo 1992. 7 See July 25, 1991, memorandum from Patrick Low to Geoffrey Shepherd and the memorandum of August 28, 1991 from Horlick and Shea (representing a Washington law firm) to Mr. Johnson, IDB.  Annex 4 The Trade Policy Reform Loan 76 amendment follows most of the expert reconunendations, and the revisions reasonabls address the issues of guarding against unjustified protection. 21. INDECOPI has also assumed responsibility for administering the anti-dumping code. The Institute has so far taken a strongly pro-free-trade line in its actions, dismissinc most cases. Out of 24 applications for anti-dumping subsidies from 1991 to the end of 1993, only one saw the imposition of anti-dumping duties. Even the best written anti-dumping codes allow enough discretion to enable them to be used as surrogate instruments of protection. While INDECOPI has so far applied the code in a manner consistent with the Govermnent's free-trade philosophy, the Government needs to be vigilant that this will continue. 22. Export taxes and subsidies. The Government has agreed not to raise existing taxes, extend them to other products, or introduce any fiscal or financial subsidies to exports. It also promised to extend the drawback as and when the fiscal situation permits. 23. The Government has taken various measures to reduce the burden of indirect taxes on exporters through duty-drawback and temporary admission schemes (these are conventionally permitted measures to equalize international competitive conditions, not export subsidies). These measures have somewhat improved the situation, but these schemes are still largely ineffective. It appears that the Government still hesitates for budgetary reasons to move to a clear and transparent drawback system. 24. Customs Reform. The Government agreed to formulate and carry out an Action Plan to restructure the Customs Superintendency (SUNAD) and reform the legal framework for customs. The reform plan was based on principles of: bona fide (through the devolution of duty-assessment functions to private agents and the move to ex-post verification on a sample basis); the reorganization of customs; and strengthening of the Customs School and the computer system. 25. The Government has continued to observe the agreed timetable of actions, and the progress that SUNAD has made in changing its structure and practices is impressive.8 Customs clearance has become more efficient: bureaucracy is less and average processing time faster (it now takes less than a day, on average, to clear customs). Meanwhile, there has been a dramatic increase in revenue collection: from 1990 to 1992 revenues doubled while the value of imports increased by only 40 percent (the services of pre-shipment inspection companies are no doubt also part of the explanation -- see below). But the present reform may not go far enough. There is, for instance, further scope for privatizing customs clearance, leaving a streamlined SUNAD to issue rules and to supervise. The Government has been considering further reform along these lines. 26. Pre-shipment inspection. The Bank had no conditionality in this area. Indeed, the President's Report was equivocal about the benefits of the scheme (para. 90). (In general, the Bank has embraced such schemes more positively than this.) A pre-shipment I See Cooperacion Tecnica a Superintendencia de Aduanas (SUNAD): Supervision de la Tercera Fase: Informe de Mision, IDB, 1993.  Annex 4 The Trade Policy Reform Loan 77 inspection (PSI) scheme, legislated in August 1991, has been working since March 1992. Four companies have been qualified by SUNAD. The inspection fee is 0.5 percent for "commodities" (and not all consignments need an inspection certificate) and one percent for other imports. Consignments of less than $2 million are not subject to PSI. 27. The Government has explained that the PSI scheme is intended to last for no more than one to two years, by which time customs will have a decent valuation data bank (indeed, the main value of PSI is to assist with customs reforn). Few have been caught cheating, but tariff revenues have risen. A Bank study has looked at the Peruvian PSI scheme in the context of a broader research project on the costs and benefits of PSI schemes.9 The study acknowledges the benefit of the scheme as a transitional aid to customs reform by removing the valuation process from customs and giving the service a breathing space to concentrate on other aspects of reform. While costs and benefits are difficult to assess, the net benefit is likely to decrease over time as customs and trade reform reduces the returns to misdeclarations. Thus, according to the study, SUNAD must begin to take over progressively customs valuation responsibilities from the PSI companies. Recent Developments in Foreign Trade 28. There is no doubt that the trade reform measures have fundamentally changed the trade regime that Peruvian producers face. A recent Bank report on Peru, Peru: a Private Sector Assessment, surveyed a range of private firms in Lima to gauge the current business climate and the changes in this since 1990. Of 14 obstacles to growth that firms were surveyed on (pertaining to the tax regime, inflation, bureaucracy, finance, labor regulation, and so on), import and foreign-exchange restrictions and export regulations had been among the severest before the reformns and had become the least severe by 1990. The report characterized the changed climate as follows (paragraph 57). "The trade reform appears to have been one of the great successes of the reform program. From being one of the most severe of the constraints to doing business, it became of much lesser concern. Imports of capital goods have risen substantially since 1990, indicating that restructuring is beginning to occur. Furthermore there is an indication that many firms that were hitherto producing goods in the previously heavily protected environment have stopped manufacturing and have started importing and distributing the same products. For them in particular, trade reform has improved allocative efficiency. Many complained about competition from smugglers, however. With an 18 per cent VAT rate on top of the import duty, incentives for smuggling are substantial and there is a lot of anecdotal evidence that it is still widespread. There have been great efforts on the part of senior officials in the customs administration to make sure that the new rules are being applied. At lower levels, however, customs officials have not welcomed the change in their authority to interpret the rules regarding importation in a way that is less than transparent ....... However, all companies interviewed indicated that problems connected with imports had declined sharply and that there were now few problems with exporting." 9 Geoffrey J. Bannister, The Peruvian Pre-Shipmenr Inspection Program, International Trade Division, World Bank, July 1993.  Annex 4 The Trade Policy Reform Loan 78 29. But this radically changed climate for trade has not yet been translated into a measurably different role for trade in the Peruvian economy. This reflects above all broad developments in the economy. The economy is still in the process of stabilization. From a high point of 43 percent a month on average in 1990, inflation has continued to fall. It has remained below two percent a month for most of the time since September 1993. Real GDP at best stagnated from 1990 through 1992, but began a vigorous recovery from the last quarter of 1992. The overall growth of the economy in 1993 was seven percent. The signs of recovery of confidence in the economy, on the part of local and foreign business, are evident. 30. Since 1990 imports and exports (of goods and non-factor services) have both grown in dollar terms, thus reversing the absolute decline of the 1980s. In recent years exports have grown in line with the growth of the economy as a whole, and there is as yet no clear change in the commodity structure of exports, except for a slow increase in the share of non-traditional exports. In the years 1990-92, terrorism, weather conditions, and the cholera epidemic contributed to a sluggish export performance, especially in mining, fishing, and tourism. Imports grew faster than the economy, until 1992 at least. The structure of imports is changing in two dimensions. First, consistent with the removal of state monopolies and the recent process of privatization, there has been a strong fall in the share of the public sector in imports (though the trend appears to have started before mid-1990). The public sector now accounts for about 16 percent of imports (third quarter of 1993), compared to 45 percent in 1989. Second, since the initial trade reform measures in 1990, the share of consumer goods has grown steadily (from 11 percent of all imports in 1989 to over 20 percent in 1993). Nowhere is this development reflected more dramatically than on the streets. A couple of years ago, most cars on the road looked as if they should be in museums or junkyards. Imports of new and second-hand cars (especially the latter) have since completely changed the picture. 31. The faster growth of imports than exports reflected a large growth in the current-account deficit of the balance of payments, which doubled to $2 billion from 1990 to 1992 (but remained unchanged for 1993, according to preliminary estimates). This deficit was the result of a sharp growth in short-term capital flows following the capital-account liberalization of 1990-91. The earlier period of the reform -- 1990-92 -- coincided with substantial complaints from the private sector about the effect of an overvalued exchange rate on their ability to compete. There are substantial problems in measuring Peru's real exchange rate, prior to 1991 at least. According to the most frequently used measure (that of the Central Bank), the real exchange rate appreciated steadily after the mid-1980s. From 1990 to 1992 it appreciated by 25 percent, but depreciated 16 percent in 1993. 32. Notwithstanding the apparent appreciation, it is difficult to argue that the exchange rate is misaligned: the Central Bank has continued to accumulate reserves in recent years; the current account deficit, though high, is considered sustainable from an indebtedness point of view; the price of non-tradable goods in Peru is probably not excessive by international standards; and the recent productivity gains Peru has enjoyed are a reason for a real appreciation. The appreciation that followed stabilization in Peru is consistent with the experience of other countries eliminating high inflation (for instance Argentina in 1991 and Israel in 1985): the stabilization removes the artificial scarcity of foreign exchange,  Annex 4 The Trade Policy Reform Loan 79 while economic reforms encourage the repatriation of savings. In addition, the. fall in interest rates in world markets has encouraged financial flows to Peru. Conclusions 33. The Trade Policy Reform Loan was based on a sweeping and simple reform program which took place within a broader and supporting program of macro- and microeconomic reforms. The essence of the reform was to move trade policy to a stance approaching neutrality, i.e. where there is minimal policy discrimination between different economic activities, between, firms, or between imports and exports. Peru's trade reform was in general as radical and rapid as that observed in any other country, including Chile and Bolivia. In the very early days of the Government, the Bank's advice was important. From early 1991 onwards, the initiative in design was clearly that of the Governrment. There is no doubt of Peruvian "ownership". 34. The trade reforms have been completely effective in moving trade operations to a more market-oriented system of incentives and greater integration with the world economy. While the Peruvian economy has now begun a strong recovery from decades of stagnation and a subsequent period of recession (induced by the stabilization), it is as yet difficult to identify measurable changes in the structure or level of trade (beyond a rapid growth in imports and some change in their composition), hence to measure the gains from trade reforms. If the economic reforms are maintained, measurable benefits are soon likely to be apparent. 35. Is the reform sustainable? The essence of the conventional wisdom -- which still has much to learn -- on this can perhaps be expressed in the following conclusion from a Bank research project that studied 36 liberalization episodes in 19 countries. ".... for reform to succeed, a small group of factors -- each entirely within the government's control -- appears to really count: The program should be bold and it should start with a bang. Any quantitative restrictions should be rapidly dismantled. Where appropriate, the program should begin with a substantial real depreciation of the currency. And there must be a stable macroeconomic enviromnent. Almost every program that has followed these four simple rules has succeeded. "l0 The Peruvian reform is, by the above criteria, classically sustainable, with the proviso that there was not a "substantial real depreciation". The latter has not apparently occurred in Peru: the perception among economic agents was especially prevalent in 1991-92 that the currency was overvalued. There is no evidence that, under the circumstances, the currency could have been much more depreciated, if only because there was a strong inflow of short- term capital over which the Government did have (and could have) only limited control. On the other hand, a more depreciated currency would undoubtedly have helped in the "political economy" of trade reform by raising the profitability of exporting and thereby more rapidly creating a new political constituency for trade reform. The real exchange rate has '