Peru - Second Financial Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-7293-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN THE AMOUNT OF US $300 MILLION TO THE REPUBLIC OF PERU FOR A SECOND FINANCIAL SECTOR ADJUSTMENT LOAN June 5, 1999 Finance, Private Sector and Infrastructure Department Country Department for Bolivia, Paraguay and Peru 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 AND EXCHANGE RATE (As of May 31, 1999) Currency IJnit = New Sol ("soles"): SI. IJS$1.00 = S/. 3.35 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS AFP Administradora Privada de Fondos de Pensiones BCR Banco Central de Reserva del Peru CAS Country Assistance Strategy COFIDE Corporaci6n Financiera de Desarrollo CONASEV Comisi6n Nacional de Empresas y Valores CV Cedula Viva EFF Extended Financing Facility FCR Fondo Consolidado de Reservas Previsionales FONAHPU Fondo Nacional de Ahorro Puiblico FSAL Financial Sector Adjustment Loan GDP Gross Domestic Product IDB Inter-American Development Bank IFIs International Financial Institutions IMF International Monetary Fund IPSS Instituto Peruano de Seguro Social MEF Ministerio de Economia y Finanzas MLT Medium and Long Term ONP Oficina de Normalizaci6n Previsional SAFP Superintendencia de Administradoras Privadas de Fondos de Pensiones SAL Structural Adjustment Loan SBS Superindentencia de Bancos y Seguros SECAL Sector Adjustment Loan SNP Sistema Nacional de Pensiones SPP Sistema Privado de Pensiones SUTNAT Superintendencia Nacional de Tributaci6n Vice President: Shahid Javed Burki Country Director: Isabel Guerrero Sector Director Danny Leipziger Task Team Leader: Ernesto May Co-Task Managers: Fred Levy John Pollner  FOR OFFICLAL USE ONLY REPUBLIC OF PERU FINANCIAL SECTOR ADJUSTMENT LOAN II LOAN SUMMARY Borrower: The Republic of Peru Implementing Agency: Ministry of the Economy and Finance Beneficiaries: Financial sector regulatory agencies (banking, securities, pensions), the banking industry, pension fund affiliates, pension fund institutions, and the Treasury of Peru. Poverty: A social protection component is included under the loan to ensure protection of key social programs during the adjustment period, and to have in place contingency programs for the temporary provision of employment to vulnerable groups. The latter would be triggered by changes in pre-specified indicators linked to adverse economic developments. Amount: US $300 million, to be disbursed in two tranches of US $175 million for first tranche and $125 million for second tranche (before applying front-end fee). Terms: LIBOR-based US Dollar loan with a grace period of 5 years, a final maturity of 17 years, and level repayment of principal, at the Bank's standard variable interest rate. Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days after Loan signing. Front-end Fee: 1 percent of the loan amount payable upon effectiveness. Schedule of Disbursements: First tranche to be disbursed upon effectiveness. All conditionality to be met before Board presentation except for standard effectiveness conditions. Second tranche estimated to be disbursed nine months after first tranche release, after meeting second tranche conditionality. Economic Rate of Return: Not applicable. Project Identification No.: PE-PE-65596. 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.  REPUBLIC OF PERU FINANCIAL SECTOR ADJUSTMENT LOAN II TABLE OF CONTENTS Loan Summary ...................................................... .i PART I. Recent Economic Developments and Prospects ....................................................... 1 A. Economic Context ....................................................... 1 B. Recent Economic Developments ......................................................2 C. Economic Prospects and Financing Requirements .......................................................4 PART II. Financial Sector Context and the Reform Program ....................................................... 5 A. Overview .......................................................5 B. The Banking Sector .......................................................6 C. The Capital Market ...................................................... 14 D. The Pension System ...................................................... 19 E. Social Protection for the Poor and Contingency Plan ...................................................... 25 PART III. THE PROPOSED LOAN ...................................................... 27 A. Loan Description: Objective and Rationale for Bank Involvement ........................................ 27 B. Tranche Conditionality ....................................................... 29 C. Disbursement and Auditing ...................................................... 33 D. Environmental Aspects ...................................................... 33 E. Program Objective Categories ...................................................... 34 F. Benefits and Risks ...................................................... 34 PART IV. RECOMMENDATION ...................................................... 35 Annex 1: Policy Matrix ....................................................... 36 Annex 2: Letter of Sectoral Development Policy ...................................................... 39 Annex 3: Timetable of Key Processing Events ...................................................... 49 Annex 4a: Peru - Status of World Bank Operations ...................................................... 50 Annex 4b: Peru - Statement of IFC's Committed and Disbursed Portfolio . ..................................... 51 Annex 5: List of Protected Basic Social Spending ...................................................... 52 Annex 6: Table of Macroeconomic Indicators ...................................................... 54 Annex 7: Peru at a Glance ...................................................... 56 Bank staff and consultants who worked on the FSAL II included: Ernesto May (Task Team Leader, LCC6C); Fred Levy and John Pollner (Co-Task Managers, FSD & LCSFP); Augusto de la Torre (LCSFP); Gabriella Ferencz (FSD); Fred Truslow (Cons.); Clemente Del Valle (CMD); and Genaro Alarcon (LEG). The Financial Sector reform program was developed based on the findings from a Rapid Financial Sector Assessment conducted in December 1998, task managed by Fred Levy (Advisor, FSD), and which included the following team: Jose Antonio Alepuz (LEGPS); Fred Truslow (Cons.); Clemente Del Valle (CMD); Patrick Conroy (CMD); Eriko Togo (CMD); Michael Ballhausen (FSD); Gabriella Ferencz (FSD); Santiago Herrera (LCSPR); and Hunt Howell (IDB). Additional key inputs were received by Augusto de la Torre (LCSFP); P.S. Srinivas (LCSFP); Norman Hicks (LCSPR); Judy Baker (LCSPR), and John Shilling (FSPEU). Peer reviewers for the FSAL II were Diana McNaughton (FSD) and Alberto Musalem (CMD).  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN II TO THE REPUBLIC OF PERU 1. I submit for your approval the following Report and Recommendation on a proposed Financial Sector Adjustment Loan II (FSAL II) to the Republic of Peru in the amount of US $300 million. The Loan would be LIBOR-based, US Dollar denominated, with a grace period of five years, a final maturity of seventeen years, and level repayment of principal at the Bank's standard variable interest rate. PART I. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS A. Economic Context 2. As a result of decades of mismanagement of economic and social policies, Peru entered the 1 990s with falling per capita incomes, hyperinflation, and one of the worst income distributions in Latin America. By the time of the change in Government in mid- 1990, per capita income was below that of 1966; prices had risen by a factor of 27 million over three decades, including almost 7,700 percent in 1990 itself; tax collections had fallen to less than 5 percent of GDP; the country was in default on most of its external debt; and political violence was claiming 3,000 lives per year. The immediate priorities of the new Government that took office in July 1990 were to reestablish the authority of the state, to bring inflation under control, to restore the functioning of the market system, and to provide minimum protection to the most disadvantaged groups from the expected heavy social costs of the necessary adjustment process. 3. Among the stringent monetary and fiscal measures adopted were the establishment of the full independence of the central bank, the prohibition of central bank credit to the public sector, the elimination of credit subsidies, and drastic reductions in the deficits of the state enterprises. As a result, the combined public sector deficit was reduced from 7.5 percent of GDP in 1990 to zero by early 1997. Deficits in the interim were fully financed by external funds, including from the IFIs, with which relations were reestablished. Structural reforms included the elimination of controls on prices, interest rates, and foreign exchange transactions; the reduction of tariffs, removal of administrative trade barriers, and liquidation of state marketing agencies; and the strengthening of private property rights and a far-reaching program of privatization. Financial sector reforms included the liquidation of the public development banks, the privatization of state-owned commercial banks, the elimination of state interventions in the allocation of credit, the strengthening of bank and capital markets regulation and supervision, the opening of the financial system to private pension funds, and first steps toward covering the unfunded liabilities of the public pension system. The negotiation of debt reduction and restructuring agreements with the Paris Club and commercial bank creditors completed Peru's reintegration into the international financial system. 4. Stabilization, structural reforrn, and the restoration of public order achieved the hoped-for results. Incomes grew an average 5.3 percent per year between 1990-1997, while inflation  -2- decelerated rapidly, falling to 6.5 percernt by 1997. Increasing price stability encouraged the remonetization of the economy in both soles and US dollars, and interest rates declined. Reflecting the improving public sector accounts, domestic savings rose steadily from less than 12 percent of GDP in 1990 to more almost 19 percent in 1998. Investment, spurred largely by the private sector, rose from under 16 percent to more than 24 percent of GDP over the same period. Peru moved from being a net exporter of capital to becoming an attractive recipient. Net capital inflows averaged US$2.8 billion per year during 1991-1996, of which 60 percent was long-term. The net international reserves of the central bank rose from around US$300 million at the beginning of 1990 to about US$10 billion by end-1998, providing an important cushion in face of the high degree of dollarization of the economy and the openness of the capital account. B. Recent Economic Developments 5. After a strong economic performance in 1997, marked by rapid growth, falling inflation, a primary fiscal surplus, large foreign investment, and a high but declining current account deficit in the balance of payments, the Peruvian economy was hit with successive shocks in late 1997 and 1998. The Asian financial crisis hurt Peru's export markets, with sharp declines in the prices of major mineral and agricultural exports; the El Nino phenomenon directly affected fisheries and agricultural crop production and washed out infrastructure; and the Russian financial crisis resulted in an abrupt tightening of access to external credit lines by private borrowers and the banking system. As summarized in Table 1, the cumulative macroeconomic impacts of these shocks in 1998 included a sharp fall in growth and a deteriorating current account. Fiscal management remained tight, however, and inflation continued to decline. The real effective exchange rate depreciated an estimated 11.6 percent over the course of the year. Table 1: Macroeconomic Impact of External Shocks 1997 1998 Growth of GDP (%) 7.2 0.7 Inflation - CPI (%) 6.5 6.0 Combined public sector balance (% of GDP) 0.1 (0.5) Public sector primary balance (% of GDP) 1.8 1.3 Current account deficit, % of GDP (5.2) (6.0) Money and Credit - Annual % change Broad Money 22.7 4.5 Total Credit to Private Sector 36.9 13.7 Real effective exchange rate:'( )' depreciation 3.1 (11.6) m_ :  - 3 - 6. External Environment. The combination of the Asian crisis, which caused steep price declines for Peru's major minerals and agricultural export products, and the El Nino phenomenon which affected production particularly of Peru's important fisheries sector, had a profound impact on the real economy. The export volume of fish products in 1998 decreased by 68 percent compared to the level registered in 1997. Despite higher prices, the export value of fish products decreased from US$1.4 billion (22.5 percent of total exports) in 1997 to US$634 million in 1998. The value of Peru's major agricultural exports, principally cotton, sugar, and coffee, were similarly down 23 percent over the period. Falling world prices also impacted negatively on the value of Peru's metals exports (which accounted for 40 percent of total exports in 1997). Export prices overall were down 17 percent over the period. Import prices, led by petroleum, also declined The terms of trade deteriorated by an estimated 13.4 percent for the year. 7. Falling external demand and the loss of output from El Nifno thus resulted in a sharp slowdown in the growth of the economy with GDP estimated to have risen only 0.7 percent during 1998, as compared to a growth rate of 7.2 percent in 1997. All sectors of the economy were affected. The rate of inflation, as measured by the consumer price index, continued to decline to reach 6 percent for the year. The prices of tradeable goods rose relative to non- tradeables, reflecting exchange rate movement and weakening domestic demand. The El Nifbo shock was transitory, and the most vulnerable sectors, fisheries and agriculture, have started to rebound in 1999. Overall recovery in 1999 highly dependent on the growth of the world economy, which is likely to be slow and continues to be inhibited by uncertainties in international financial markets. 8. Monetary and Financial Developments. The third major external shock affecting the Peruvian economy in 1998 was the Russian debt default, which added to the nervousness of international lenders extending credits to emerging market economies. This was further exacerbated by growing fears of devaluation and recession in Brazil. The response was a sharp fall in external credit lines, intermediated principally through the Peruvian banking system. The net short-term external liabilities of the financial system (excluding the central bank) had increased continuously at an average rate of US$269 million annually during 1992-1996. During 1997, this stock almost doubled, from US$1.7 billion to US$3.3 billion. Net short-term external liabilities of the financial banking sector reached a peak of US$4.3 billion in September 1998, but by end December had fallen to US $3.3 billion.2 9. The sudden reduction of external credit lines, combined with deteriorating loan performance and increased provisioning requirements under the December 1996 banking law, resulted in a sharp contraction of bank liquidity and credit, and higher interest rates. Commercial bank credit outstanding to the private sector in dollars, after growing 11 percent through the first nine months of 1998, contracted 1.8 percent in October-December. Nominal credit outstanding to the private sector in soles contracted 3.3 percent during the third quarter, before government policy measures allowed a 9.2 percent expansion to ease the squeeze during the fourth quarter. In general, the Peruvian economy and financial system have shown resiliency in adjusting to the series of heavy external shocks. A number of points of vulnerability, however, have been identified. The proposed loan would support strengthening of the government's capacity to manage external shocks while fortifying key institutional and regulatory functions to enhance the 2 The impact of the cut of short-term credit lines through the banking system was exacerbated by a parallel reduction in the level of direct external credit to Peruvian enterprises.  health of the financial system and allow the government to maintain a stable macroeconomic policy framework. C. Economic Prospects and Financing Requirements 10. The Bank is closely coordinating its financial sector adjustment program with the IMF which is currently finalizing the arrangements for a new EFF for Peru; and with the IDB which is financing a parallel operation jointly developed with the Bank, covering the banking and capital markets sectors. The IDB is also including related programs in housing finance and financial services for low income sectors, as well as technical assistance funding for some of the structural measures under the joint program. With IMF support, the government's economic program contained the current account deficit and reduced inflation in 1998. The slowdown in output growth was stronger than anticipated and the authorities implemented a restrained monetary policy, with monetary aggregates growing below programmed levels. Although public expenditure was kept in line, tax revenue deteriorated partly as a result of lower than expected economic activity, and the program's targets on net domestic financing of the combined public sector was exceeded. The public sector primary surplus was 1.3 percent of GDP, below the program target of 1.7 percent of GDP. 11. The external current account deficit is estimated to have increased to 6 percent of GDP in 1998, slightly above the program projection of 5.9 percent, reflecting the large drop in export volume and a deterioration in Peru's terms of trade, which were only partially offset by a decline in import volume. The current account is was financed mostly by private inflows (of which about 75 percent were in the form of foreign direct investment and medium-long-term disbursements), and by a small decline in net international reserves. During 1999, the current account deficit is projected at US$ 2.9 billion. Private capital flows are expected to total just US$ 1.3 billion, continuing their decline from US$ 4.9 billion in 1997 and US$ 2.4 billion in 1998. Given the authorities' desire to replenish half of the US$ 1.0 billion in international reserves lost during 1998, a projected financing requirement of US$ 2.1 billion will necessitate increased public sector net external borrowing of about US$ 1.2 billion. 12. The authorities continue to implement a flexible exchange rate policy. Last year, nominal depreciation of the sol amounted to 15.4 percent with respect to the dollar, and by 11.6 percent in real terms. So far in 1999 the sol has depreciated by about 6 percent against the U.S. dollar, in part reflecting uncertainty resulting from developments in Brazil. This has placed increased pressure on the banking system, as a large share of loans denominated in U.S. dollars were extended to borrowers without a steady flow of income in foreign currency.  - 5 - PART Il. FINANCIAL SECTOR CONTEXT AND THE REFORM PROGRAM A. Overview 13. Structural reform has resulted in enormous growth of the financial system since 1990. Total deposits in the banking system increased almost fourfold (in US dollars equivalent) during 1991-1997, as M3 rose from 13 to 24 percent of GDP. Commercial bank credit outstanding to the private sector rose six-fold (also in US dollars equivalent) over the same period, or from less than 5 percent of GDP in 1991 to 19 percent in 1997. The incipient capital market also grew rapidly, stock market capitalization rising from less than US$600 million in 1991 to US$17 billion by the end of 1997, before falling in the wake of the international financial crisis to US$11 billion by end-1998. Although also growing rapidly, the size of the bond market is far smaller, capitalization amounting to US$1.8 billion at the end of 1998, more than five times the level of four years earlier. With virtually no public sector domestic debt, bond issuance has been almost entirely corporate. 14. Despite this rapid growth, the level of financial intermediation in Peru remains well below that of many other emerging market economies. Many new financial institutions have entered the Peruvian financial system during the 1990s, but the system continues to be dominated by the banking sector, the commercial banks accounting for more than 80 percent of the system's assets and loans, more than 90 percent of customer deposits, and almost 75 percent of shareholders' equity. Concentration is also high within the banking sector, although declining in recent years. The four largest of the 25 banks accounted in 1998 for about 62 percent of the assets of the system, 69 percent of deposits, and 60 percent of aggregate equity, ratios well above the average in Latin America.3 The banks, moreover, through their financial groups, dominate other segments of the system as well. In 1998, the three largest bank groups accounted, respectively, for 56 percent of bank assets, 63 percent of bank deposits, 76 percent of the pension funds under private administration, 74 percent of the asset value of mutual funds, and 73 percent of the brokerage of long-term bonds. Such a concentration of market participation and control weakens competition and increases the risk that a crisis in one part of the system can rapidly spread to the rest. 15. Although stabilization increased general confidence in the economy, and a gradual shift occurred after 1993 in favor of domestic-currency assets, the Peruvian financial system remains highly dollarized. There are no reliable data for the volume of dollars held outside the banking system, but it is known to be large. In broad terms, Peruvians hold soles largely for small day- to-day transactions, with most large-ticket items (e.g., mortgage payments, consumer durables and other imports) priced in dollars. Savings are held largely in dollars. More than three-fourths of private deposits in the banking system and bank credits to the private sector were denominated in dollars at the end of 1998. In addition, two-thirds of outstanding private bond issues were denominated in dollars (including bonds denominated in local currency but whose principal was indexed to the exchange rate). 3The year began with 26 banks, but the failure of one small bank in December reduced the number to 25. The four largest banks in order of size are Banco de Crddito, Banco Wiese, Banco Continental, and Interbanc. In February 1999, Sudamneris bought a controlling interest in Banco Wiese and merged it with its previously owned Banco de Lima, thus further concentrating the share of the "Big Four" in the sector.  - 6 - 16. As a consequence of strict fiscal discipline and the reopening of Peru's access to external financing, including from the IFIs, the Peruvian financial system is marked by the virtual absence of public debt from the domestic market. Government debt is thus mostly external. Public sector MLT debt (including central bank obligations) totaled some US$19 billion as of December 1998, equivalent to 33 percent of GDP and almost 340 percent of export earnings in 1998. Debt service in 1998 absorbed about 29 percent of export earnings. At the same time, a significant proportion of government revenue is also denominated in, or effectively indexed to foreign currency. The policy against borrowing internally has itself been an important element of Peru's impressive fiscal performance. The absence of a reliable benchmark yield curve, however, typically provided by public debt, may be an inhibiting factor in the growth of Peru's domestic capital market, with the result that large private sector borrowers, too, must go to the external market to meet their financing needs. 17. The major source of funds to the Peruvian capital markets, accounting for over 40 percent of daily investments in the securities tradLed on the Lima Stock Exchange, is the private pension system, consisting of five private pension fund administrators (AFPs), now managing the individual accounts of some 1.9 million workers and totaling more than US$2 billion. Unlike the other actors in the financial system, the AFPs are largely invested in sol-denominated instruments. Moreover, despite their potential importance as suppliers of long-term funds to the market, AFP investments are predominantly short-term, responding both to regulatory constraints and to the absence of adequate long-term instruments in the domestic market. B. The Banking Sector Background 18. As noted above, Peru's financial system is dominated by the conmmercial banks. The Banking Law of 1991 as well as the 1996 Banking Law, prohibited the state from engaging in first-tier banking activities. The then-existing state development banks, with the exception of the Corporaci6n Financiera de Desarrollo (COFIDE), were closed; the Banco de la Naci6n was downsized and restricted to its role as fiscal agent for the government, and COFIDE was redefined as a strictly second-tier lending institution. Two previously nationalized commercial banks, the third and fourth most important banks in the system in terms of asset size, were re- privatized. With the liberalization of the system, foreign investment in the sector has grown rapidly, through both the entry of new banks and the purchase of shares of existing banks, and exceeded 40 percent of the system's total equity by end-1998. Nearly half the banks in the system are now more than 40-percent foreign-owned and controlled, with significant foreign participations in several other banks as well. 19. The Peruvian banking system experienced very rapid loan growth over the past several years: commercial bank credit outstanding to the private sector rising 75 percent in 1994, 46 percent in 1995, 50 percent in 1996, and 33 percent in 1997. Although consistent with the rapid improvement of the macroeconomy and the attendant reintermediation of the economy, at the micro level banks' credit risk managemernt capacities are likely to have been significantly strained by such rapid portfolio growth. 20. The sharp improvement in Peru's access to external capital, that resulted from completion of a debt restructuring agreement with the commercial banks and the country's rapidly improving economic prospects, was reflected in a strong growth in external short-term credit  - 7 - lines intermediated through the banking system. These credit lines financed almost 44 percent of the increase in bank lending to the private sector in 1997 and reached almost 24 percent of total banking liabilities. Long-term external credit to the banking system financed an additional 5 percent of incremental credit to the private sector in 1997. In contrast, domestic foreign currency deposits (net of required reserves) accounted for only 15 percent of credit expansion in 1997, compared to 47 percent in 1996. 21. The availability of credit was thus becoming increasingly dependent on sustained access to external credit lines. The growth and degree of dollarization of bank lending operations was not matched on the deposit side, so that the loans-to-deposits ratio for foreign-currency operations diverged sharply from that of domestic-currency operations. The overall increase in the ratio of loans to deposits was reflected in a significant reduction in banking system "headroom", particularly in foreign currency. Bank reserves in foreign currency exceeded required reserves by only 0.4 percent by mid-1998, while actual sol reserves exceeded required reserves by only 5.2 percent. The stage was thus being set for the credit crunch that resulted from the reduction of access to the external lines in the third quarter of 1998. The reduction of the mandatory reserve requirement on foreign currency deposits (see para. 29) partially ameliorated some of the repayment pressures following the withdrawal of short term external credit. 22. The impacts of external shocks on the real economy were reflected in bank loan performance (Table 2). The quality of commercial bank loan portfolios had improved steadily through the middle of the 1990s but leveled off in 1997 and deteriorated significantly in 1998. By end-1998, the ratio of problem loans (defined as past due loans plus rescheduled loans) to gross loans reached 10.5 percent, as compared to 7.9 percent at the end of 1996. As a result of higher provisioning requirements and a rapid growth in provisions over the period, the ratio of provisions to problem loans increased by 3.5% during 1998. Nevertheless, the level of problem loans not covered by provisions rose sharply in relation to bank equity. Table 2: Quality of Commercial Bank Loan Portfolios, 1993-1998 (e.o.p., SI. mn.) 1993 1994 1995 1996 1997 1998 (1) Gross loans 7,059 12,214 18,075 27,151 36,250 44,550 (2) Problem loans 1,136 1,445 1,616 2,155 2,898 4,690 Rescheduled loans 479 601 745 738 1,061 1,589 Overdue loans 657 844 871 1,417 1,837 3,101 Less than 4 mos. (106) (188) (214) (378) (428) (982) Over 4 mos. ( 77) ( 90) ( 96) (223) (297) (440) Under litigation (474) (566) (561) (816) (1,112) (1,679) (3) Loan loss provisions 498 649 793 1,219 1,664 2,855 (4) Equity 1,396 2,084 2,798 3,966 5,083 6,029 Ratios (%): (2)/(1) 16.1 11.8 8.9 7.9 8.0 10.5 (3)/(2) 43.9 44.9 49.1 56.6 57.4 60.9 [(2)-(3)]/(4) 45.7 38.2 29.4 23.6 24.3 30.4 Source: Superintendency of Banks and Insurance  - 8 - 23. The restoration of confidence in Peru, as evidenced, inter alia, by the remonetization of the economy, massive capital inflow, and the entry of new competitors, both foreign and domestic, into the financial sector, brought with it a significant initial decline in interest rates and financial spreads (Table 3). Nevertheless, rates remained high in nominal terms and in real terms, as inflation declined even faster. High spreads in the banking system reflect a combination of the inefficiencies inherited from the past, the strong growth of credit demand that accompanied financial liberalization, risk perceptions, and the high reserve requirements on foreign currency deposits. Table 3: Average Interest Rates ona Commercial Bank Loans and Deposits, 1995-98 Local Currency MONTH/YEAR Loan rates Deposit Spreads Inflation rates Dec. 1993 173.8 (84.2) 44.1 (-3.0) 129.7 (87.2) 48.6 Dec. 1995 33.5 (20.8) 9.9 (-0.5) 23.6 (21.3) 10.5 Dec. 1996 30.6 (19.4) 10.5 (1.0) 20.1 (18.4) 9.4 Dec. 1997 30.4 (21.4) 9.9 (2.3) 20.5 (19.1) 7.4 Dec. 1998 37.1 (29.3) 12.6 (6.2) 24.5 (23.1) 6.0 U.S. Dollars MONTH/YEAR Loan Rates Deposit rates Spreads Dec. 1993 Dec. 1995 17.2 6.2 11.0 Dec. 1996 16.8 5.7 11.1 Dec. 1997 15.6 5.2 10.4 Dec. 1998 16.8 5.4 11.4 Note: Interest rates are annualized weighted average rates for the indicated month; inflation is the average increase in the consumer price index during the year; the numbers in parentheses are the indicated nominal interest rates deflated by the price index. 24. Rates and spreads rose sharply in the third quarter of 1998 as a consequence of the tightening liquidity, rising spreads on and reduction of foreign financial inflows, and the deterioration of bank portfolios. Higher real interest rates raised credit risk in the system, leading to further increases in provisions and further credit tightening. The expected asymmetrical impact of credit tightening on medium and small-sized enterprises, which normally pay interest rates well above the average rates shown above, was exacerbated by the return to reliance on the banking system of large enterprises no longer able to borrow abroad directly. 25. Bank earnings have been severely impacted by the externally generated crises and by increased loan loss provisioning. As a consequence of the deterioration of portfolio quality and more stringent provisioning requirements, loan loss provisions in 1998 consumed almost 49 percent of net interest income, as compared to only 25 percent in 1996. The return on assets for the sector fell dramatically during 1997-98, decreasing from 1.6 percent in 1996, to 1.2 percent in 1997, and to 0.7 percent in 1998. This low level of earnings, together with decreased access to sources of liquidity and flight to quality among depositors, has increased the vulnerability of  - 9 - some institutions to external shocks and to continuing poor economic conditions at home. Liquidity has been doubly impacted by the decrease in cash flow from loan portfolios and by reduced access to external lines of credit. The current economic environment and expected increases in non-performing loans and higher provisions, will continue to negatively impact the banking sector in 1999. With world economic growth rates not expected to recover quickly, the improvement of portfolio quality is likely to be slow. 26. In late November 1998, a small bank (Banco Republica) accounting for around 1 percent of the assets of the banking system, was intervened by the Superintendency of Banks and Insurance (SBS) for having fallen out of compliance with several regulatory criteria, including individual lending limits, following which access to central bank credit was halted. At the same time, efforts were proceeding to complete the sale of a medium-sized bank (Banco Latino), which accounted for about 4 percent of system assets, and which was also approaching intervention trigger points. In December 1998, COFIDE announced it would make a US$60 million dollar equity investment in that bank, thus becoming the principal stockholder pending its resale to private investors. 27. Monetary Policy Instruments. Since 1990, the central bank has exerted strict monetary control while shifting from direct to indirect, mostly market-based tools of monetary management. The most actively used instruments of monetary policy have been the central bank's purchases and sales of foreign exchange and open-market operations, for which it issues its own short-term (7-21 day) debt obligations, in the absence of sol-denominated public debt instruments or comparable private sector securities. With the accelerating inflow of foreign capital after 1993, the BCR managed the trade-off between upward pressures on the exchange rate and excessive domestic monetary expansion by purchasing dollars and mopping up domestic liquidity through the auction sale of central bank certificates of deposit (CDs). The BCR became a net repurchaser of its CDs during 1998, with the slowing of capital inflow, the depreciation of the sol, and the tightening of domestic credit. Given the recent shocks and the consequent weakening of the financial sector, the monetary authorities may now have less room to maneuver in managing the trade-off between credit tightening and a stable exchange rate. 28. The central bank imposes a significantly higher marginal reserve requirement on foreign currency deposits than on domestic currency deposits. In mid-1998, the marginal reserve requirement on dollar deposits stood at 45 percent, partially remunerated, while the reserve requirement on sol deposits was fixed at 7 percent, remunerating only excess reserves. The high reserve requirement on foreign currency deposits was intended to reduce the likelihood of a currency crisis in the context of Peru's open capital account, and to cushion the impact on the macroeconomy and financial sector of sudden fluctuations in capital flows. Toward these ends, the policy served Peru well. The implicit tax on foreign currency deposits has been less successful, however, in encouraging a more rapid de-dollarization of the econormy. Moreover, it led the banks to prefer the contracting of external credit lines, which were not subject to a reserve requirement or other form of taxation, rather than more vigorous mobilization of deposits, and also motivated the more creditworthy enterprises to seek credit directly from the international financial market. Indeed, large bank customers were encouraged to place their deposits in offshore bank accounts, for repatriation via credit lines to avoid the reserve requirement. Consequently, as noted above, these credit lines grew rapidly in 1996 and 1997. As demonstrated by the reaction of international lenders to the Russian crisis, the magnitude reached by the external short-term liabilities of the commercial banks and their borrowers significantly increased foreign exchange risk in the economy and its vulnerability to liquidity crisis.  - 10- 29. Managing Bank Liquidity. During the second semester of 1998, in order to inject liquidity into the system, the marginal reserve requirement on foreign currency deposits was lowered in successive steps from the initial level of 45 percent to 20 percent by the end of the year. At the same time, a prudential regulation was irntroduced requiring that banks maintain a 20-percent liquidity ratio against all short-term liabilities, including external short-term credit lines. In this way, the incentives to banks in choosing between these two sources of funds have now been effectively balanced. 30. Other measures were also taken in the last half of 1998 to alleviate liquidity pressures affecting both banks and enterprises. To counter the decline in sol-denominated deposits, public sector institutions were directed to convert dollar deposits, as they matured, into local currency. To ease the credit squeeze on small and medium-sized enterprises, the government increased COFIDE funds available for on-lending in soles through the banking system by S/. 320 million, financed by external lines of credit and by the transfer of public sector deposits in Banco de la Naci6n. An emergency decree also authorized Banco de la Naci6n to make deposits in banks requiring liquidity support, effectively giving it temporary lender-of-last-resort responsibility. To maintain depositor confidence, the ceiling on deposit insurance on personal accounts was retroactively raised more than five-fold (from about US$ 4,000 equivalent to US$20,000) following the Banco Repuiblica intervention. In addition, a US $150 million public bond exchange was offered for the restructuring of bank debt (since then raised to US $300 million).4 To be eligible for the bond exchange, banks must agree to augment capital, including the reinvestment of profits, make no additional loans to related enterprises, and ensure that existing related loans are adequately secured. The amount of bonds exchanged cannot exceed the bank's capital, and provisions on the exchanged portfolio cannot be reduced. In addition, under a recently announced program, COFIDE will make available up to US$1 billion of funding through the commercial banks, enabling enterprises to refinance existing debt at longer maturities. Loans will be at market terms, and will be subject to COFIDE's normal prudential limits for individual banks, and the participating banks will bear the full credit risk. 31. Bank Regulation and Supervision. Bank supervision and regulation, which is well advanced in Peru, is the responsibility of the Superintendency of Banks and Insurance (SBS). The SBS is also responsible for the consolidated supervision of financial groups. The banking law and regulations were substantially strengthened in 1996. In general terms, the body of laws and regulations governing the banking sector, including those for loan classification and provisioning, is adequate and in conformbity with international standards for bank supervision (Table 4), and capital adequacy requirements exceed current Basle Committee guidelines. In August 1997, the SBS raised the minimum ratio of regulatory capital to risk-weighted assets to 9.09 percent (from the previous required level of 8.0 percent), allowing the banks until the end of 1999 to meet the new requirement. While standards are high, further determination as to whether they are consistently and uniformly applied, is needed. SBS continues to evolve towards a more risk-based approach in its oversight function and has steadily upgraded its processes, procedures, and staffing. Off-site supervision is a continuous process based on the monthly Teports submitted by the individual banks. Normally, comprehensive on-site 4The bonds, which are negotiable in the secondary market, are denominated in dollars and remunerated at the average interest rate on dollar bank deposits, mature at the end of 2003, and are to be amortized in equal installments over five years. The exchanged portfolio, which must be classified in the top three of the five ratings categories, will continue to be managed by the bank on a fiduciary basis, also paying a return equal to the average interest rate on dollar deposits.  - II - examinations are conducted once a year for each bank, but special "surprise" examinations may be conducted at any time in response to specific concerns as they arise. Particular attention is given to the assessment of credit, liquidity, and market risks, information systems, and internal controls. Table 4: Provisioning Requirements by Level of Loan Classification (%) Classification Without preferred With preferred Guarantee Guarantee 5 Pass / Normal 1 1 Special Mention 5 2.5 Sub-standard / deficient 25 12.5 Doubtful 60 30 Loss 100 50 The Government Reform Agenda in the Banking Sector 32. As noted above, banking law and regulation in Peru have been substantially strengthened and modernized since 1990. Nevertheless, recent difficulties in the financial sector have made evident several aspects of the banking sector's legal and regulatory framework that required attention. The government reform agenda includes a number of measures that have been taken or are being prepared for implementation to further strengthen the financial system. These measures, which are closely interrelated, include: (i) the enforcement of early and prompt effective actions to prevent anticipated deterioration in a bank's performance from leading to a situation requiring formal intervention; (ii) improving the systemic management of liquidity and access to the central bank's discount facility; (iii) implementing the legal and policy framework for failed bank resolution; and (iv) strengthening the consolidated supervision of financial groups. 33. Early Corrective Action. The SBS's authority and willingness to force timely and effective corrective actions well in advance of the triggering of enhanced surveillance or formal intervention procedures, by which time a bank may already be at the brink of insolvency, is crucial for public confidence and to reduce the likelihood and severity of bank failures. Peru's banking law endows SBS with substantial powers to enforce corrective actions, which in its judgment are necessary to avoid the future deterioration of bank performance. The SBS also has wide authority to sanction banks, their managers, and owners for infractions of bank prudential regulations and failures to adhere to its orders. To anchor the reform program in the banking sector, important modifications to the banking law were enacted in May 1999, after intensive discussions with the Bank and within the government. These changes enable SBS to more effectively utilize its authority to anticipate banking problems before they are manifested in deteriorating financial performance and to move more expeditiously (through, inter alia, cease and desist orders) to mitigate emerging bank problems. The law also protects the supervisory process by providing that the enforcement actions implemented by SBS cannot be halted by lawsuits. To further strengthen the efficiency and consistency with which it carries out its responsibilities, SBS is preparing new directives and guidelines for the supervisory staff, setting Preferred guarantees are defined as those that (i) are rapidly convertible into cash without significant cost; (ii) have adequate legal documentation; (iii) have no prior claims against them; and (iv) whose value is continuously updated.  - 12- out the methodologies for risk management analysis and the instruments and sanctions available to the supervisors for correcting unsafe practices. It has also contracted an international consultant to carry out an in-depth evaluation of its supervision procedures, to make recommendations for improvement, and to provide on-the-job training to its bank examiners. 34. An additional important step needed to assure strong and effective supervision, consistent with international practice and considered a Basle Core Principle, is to extend to supervisory staff legal protections against civil suits ifor actions taken during the conduct of their duties. Currently, the Superintendent and Vice-Superintendents enjoy a degree of legal protection under the banking law, but an effort to extend that protection under the recent modifications to the law was not adopted by the Congress. Other mechanisms, including an insurance plan, are now being explored. 35. Management of Bank Liquidity and Intensive Supervision. The rigidity of the formal process previously defined by the banking law, in which a bank, after having exceeded defined prudential limits, would be placed under enhanced surveillance ("vigilancia"), had severe consequences. In particular, the regime provided few tools for rehabilitation of the bank, may have come too late in any event for rehabilitation to have been a feasible alternative, contained no mechanism for sustaining the value of the failed bank's good assets, and did not provide adequate bank restructuring tools and orderly mechanisms for dealing with the systemic risks of contagion. The new legal framework clarifies SBS's powers to enforce changes in bank behaviors during the 'intensive supervision' stage prior to enhanced surveillance, when the rehabilitation of banks which are solvent and salvageable remains a viable option. In the new legal framework, greater flexibility is provided for the use of the central bank discount facility as a means of temporary liquidity support. Under the old law, any bank that utilized the facility for a cumulative total of 90 days out of any 360 days was automatically thrown into enhanced surveillance, after which it was prohibited from any further access to the discount window. Under the new law, banks that present an acceptable plan to solve their liquidity problems can access the BCR's discount facility for up to 90 out of 180 days without triggering enhanced surveillance. 36. Enhanced Surveillance and Bank Resolution. The recent modifications to the banking law also define a more orderly and efficient process for enhanced surveillance and, if necessary, the treatment of insolvent banks during the subsequent resolution ("intervenci6n") stage. The triggers for putting a bank under the enhanced surveillance regime are more sharply defined, to include, inter alia, the reduction of the capital adequacy ratio below the required minimum, as well as a reduction of more than 40 percent in the bank's capital. The SBS is given added authority to remove managers and directors deemed responsible for the deterioration and to insist on an immnediate infusion of new capital. The period allowed a bank for improving its situation to avoid liquidation is shortened. In the event that a bank is unable to comply with the commitments for rehabilitation made to the SBS during the enhanced surveillance stage, or its capital decline exceeds 50 percent, its operations are suspended. The bank is effectively taken over by the SBS, and a process of resolution is begun, under which the authorities have the legal power to separate, according to specified rules, a so-called "good" bank from the balance sheet of the failing bank. The assets and liabilities of the "good" bank can then be quickly and efficiently transferred to one or several existing (and sound) private banks, with market-based techniques available to facilitate the rapid transfer of assets whose value is uncertain and difficult to determine without lengthy due diligence. The residual "bad" bank's license will be revoked, and it will proceed into the traditional (udicial or extrajudicial) liquidation process. Under carefully  - 13 - defined "exceptional circumstances" involving systemic risks of contagion, the Deposit Insurance Fund is empowered to participate with its own resources in the rehabilitation of an otherwise failed bank during the enhanced surveillance stage. 37. The key principle underlying this bank resolution framework is to minimize costs to depositors and to the State, while optimizing asset value under more efficient bank restructuring and/or liquidation procedures. The formalization of this type of procedure enables the authorities to close nonviable banks, while avoiding unnecessary destabilization of the financial system and the economy, and better preserving assets relative to their liquidation value. This resolution framework improves overall incentives in the banking system, by removing concerns regarding contagion risk that tend to inhibit authorities from closing nonviable banks when traditional liquidation is the only option. The procedures adopted also minimize the risk of losses to the Deposit Insurance Fund. 38. Coordination Among Regulatory Agencies. Overlaying the process, will be the increased coordination among supervisory institutions. As described earlier, ownership in the financial sector is heavily concentrated in a handful of bank groups, which operate mutual funds, pension funds, insurance companies, and brokerage houses. In addition to ownership concentration, the banks are also the principal issuers in the bond market, with bank obligations accounting for 61 percent of market capitalization in October 1998. At the same time, pension funds and mutual funds are major investors in the bonds issued by these banks. Besides possibly constraining intrasectoral competition, the ability to move assets around within a financial group provide managers with ample opportunities to avoid or stretch prudential regulations. Such a concentration of market participation and control poses significant systemic risk for the financial sector as a whole. 39. The Banking Law empowers SBS to supervise financial groups on a consolidated basis. Many of the nonbank financial institutions, however, are under the supervisory authority of the National Companies and Securities Commission (CONASEV) or the Superintendency for Private Pension Funds (SAFP), whose functions are discussed below. This division of responsibility is not necessarily undesirable, and similar institutional arrangements have been adopted in many countries. However, the freedom of financial conglomeration permitted in Peru requires an intensive coordination and timely exchange of information among the supervisory agencies, as well as intensive staff training and effort to monitor and evaluate the risks inherent in group operations. In the past, coordination depended largely on informal, interpersonal relationships. To assure adequate supervision, the government, under its reform program, is strengthening and formalizing the coordination and information-sharing among the regulatory agencies by creating working committees and inter-institutional agreements among the SBS, CONASEV, and the SAFP, to complement existing mechanisms for coordinating crisis management and macroeconomic policies more generally.  -14- C. The Capital Market Background 40. As described above, Peru's capital market has experienced rapid growth during the 1990s in response to the more stable, revitalized economy; the liberalization of the financial system; the appearance and rapid expansion of long-term contractual savings (pension funds and insurance); and the substantial modernization of the legal and regulatory framework governing its operations. With no public sector domestic debt, bond issues are entirely corporate and concentrated in a handful of market participants. At the end of the decade, the capital market remains small and, in many respects, pocirly developed: lacking liquidity and transparency, attracting few participants, and offering little competition to the dominant banking sector. In addition to the implications for the mobilization of savings and the efficiency of their use, the small size of the domestic capital market reduces the access of small and medium-sized enterprises to investment financing and forces large corporate borrowers to go to the external market for the bulk of their financing, assuming substantial foreign exchange risk in the process. 41. Market Instruments and Participanrts. The principal capital market intermnediaries as well as the primary buyers of capital markets instruments (i.e., the mutual funds, insurance funds, and pension funds) are fully or partially owned by commercial banks. At the same time, more than half of the bonds outstanding were issuecl by financial institutions. Major issuers of securities, including the banks themselves, may also be members of the same economic groups. The principal institutional investors in Peru are the banks, the private pension funds (AFPs), the insurance companies, and the mutual fund administrators. Overall, these institutions buy more than 95 percent of the available fixed-income securities, the AFPs alone accounting for almost half, and the mutual funds for another 30 percent. The insurance companies, which buy about 9 percent of the bonds issued, are only beginning to gain importance. The small size and illiquidity of the markets, combined with the internal nature of many of its transactions and the lack of a benchmark yield curve, make asset valuation difficult for issuers, buyers and dealers alike, they reduce transparency, competition and allocative efficiency, and complicate financial sector supervision. The 300 equities listed on the Lima Stock Exchange in 1998 were of two kinds: capital shares and labor shares (Table 5). The latter are non-voting shares created during the military government in 1970 as a form of profit-sharing and redistribution of ownership, a rationale that was largely unrealized. Of total issues, only 70 to 80 are actively traded, and only 42 have an annual turnover of more than 80 percent of the shares outstanding. The vast majority of transactions are concentrated in the labor shares of the largest companies. The low frequency of trading for most stocks is explained, in part, by the large number of shares that are listed only to comply with legal obligations. Financial sector enterprises, for example, are required to list their shares, even though many are closely held. In general, the liquidity of traded shares is very low, leading to high volatility of share prices.  - 15 - Table 5: Stock Market Capitalization by Sector and Types of Shares, 1993-1998 (Millions of US dollars) 1993 1994 1995 1996 1997 1998 Capital shares: AFPs 58 68 164 245 146 171 Banks and finance 1,176 2,243 2,099 2,411 2,593 1,882 companies Industrials 837 1,512 2,001 2,205 3,059 2,439 Mining 281 521 765 1,105 1,452 902 Insurance 337 424 380 357 397 323 Agricultural 0 0 0 0 440 236 Utilities 1.344 1,666 3,706 4,465 5,185 3,284 Other 140 211 358 411 656 679 Labor shares: Industrials 640 894 756 653 774 460 Mining 267 617 580 686 688 463 Other 0 2 1 1 1 7 Shares issued abroad 0 0 885 1,300 1,977 1,288 Total 5,084 8,162 11,701 13,842 17,383 12,139 Source: Lima Stock Exchange. 42. The money market is minimally developed, and there is very little short-term paper present in the market. The largest volume of short-term instruments are the Certificate of Deposit (CDs) issued by the central bank, ranging from 1 to 12 weeks in maturity. These, however, are auctioned in the primary market and do not trade in the secondary market. Inasmuch as they are used to implement short-term monetary policies, central bank CDs do not represent a stable source of supply of securities to the market. To compensate for the lack of short-term instruments, a market for liquid repurchase agreements (repos) has also developed, in which securities lending and borrowing take place for periods ranging from 7 to 30 days. 43. Regulatory Functions. The regulatory agency for Peru's capital market is the National Commission for Companies and Securitites (CONASEV). Under the 1992 law that established it in its present form, CONASEV's responsibilities go well beyond that of market regulation. Among CONASEV's specific functions under the law are: (i) to study, promote, and regulate the securities market and to control the natural and legal persons who participate in it; (ii) to assure market transparency, proper price formation, and investor protection; (iii) to investigate and act upon accusations of wrongdoing; (iv) to maintain the Public Registry of Companies and Securities; (v) to prepare and distribute securities market data; (vi) to supervise the management and accounting of companies organized under the General Law of Corporations, foreign enterprises, and cooperatives; (vii) to oversee the activities of auditing firms; and (viii) to control consultant services. 44. Stock Brokerage Firms. There were 28 stock brokerage firms in Peru at the end of 1998, a number that had declined sharply over the course of the year in the context of a declining market and tightening capital requirements imposed by the regulators. Of the eight largest firms, six were linked to the largest banks in the country, and the top six brokers accounted for 60 percent of total commissions. Half of the brokerage firms suffered losses during the year, and  - 16- the total commissions collected by all firms failed to cover their collective operational costs. Their weak financial situation implies significant counterpart risk for investors and limited ability on the part of the firms to assume the risks of proprietary trading and market-making activities. 45. The Mutual Fund Industry and Asset Valuation Issues. Peru's mutual fund industry was growing rapidly until recent economic developments and events specific to the industry precipitated a sharp reduction in overall asset values. Funds under administration grew from US $140 million at end-1996 to about US $700 million in mid-1998, before falling back to US $400 million in late 1998, following the international financial crisis. After the Russian crisis in August 1998, banks raised interest rates, as external lines of credit were cut and liquidity in the system was squeezed. As corporate investors, in particular, sold fund shares for needed liquidity, they discovered that the value of their principal had eroded. This situation attracted considerable negative press coverage and led to a significant deterioration of confidence in the market. A lack of investor sophistication, combined with marketing efforts that had implied guaranteed investment principal and returns, precipitated intervention by CONASEV. This intervention culminated in changes being made to the regulations governing asset valuation methodology. As previously prescribed by CONASEV, bonds with a turnover of less than 20 percent per year had been valued at original acquisition cost, while more frequently traded issues were valued at market prices. The new regulations stipulated that the assets must be marked to market, giving discretion to the individual fund managers regarding the method and periodicity of asset valuation. This episode highlighted the difficulties of establishing asset values in an underdeveloped and illiquid secondary market. 46. Private Pension Funds. The private pension fund administrators (AFPs), now responsible for the investment of some US$2 billion of contractual savings, are the largest single source of demand for capital market instruments and account for a large proportion of market turnover. Nevertheless, the shortage of investment instruments, high administrative costs, and restrictive regulation have combined to limit both the fulfillment of their potential role as a stable source of long-term funds and the returns to their affiliates. These issues are further discussed in Section D below. 47. Rating Agencies. The law requires that any security offered to the public must be rated by at least two rating agencies. Doubts have been raised about conflicts of interest and the quality of ratings. Given the small size of the Peruvian market, it is questionable whether the existence of the four rating agencies currently operating is justified. Only about 100 companies are currently rated, and there is little evidence of investor demand for the agencies' output. Issuers of securities and large investors often employ their own credit analysts to perform the same function. The raison d 'etre and credibility of the rating agencies might be enhanced, if they took a longer-term view of business development and made a greater investment in identifying and analyzing new entrants to the market, such as medium-sized companies. 48. Clearing House Arrangements. The "Instituci6n de Compensaci6n y Liquidaci6n de Valores" (CAVALI) is the clearing house for securities transacted at the stock exchange, and for other transactions occurring outside the exchange. Transactions are settled three days after the trade date, at which point shares are debited and credited to participant accounts via a book entry system. All monetary settlement occurs at one medium-sized bank. The consequent settlement concentration risk needs to be rectified by spreading settlement across multiple institutions of the requisite financial strength and management capacity to minimize systemic risk. CAVALI  - 17- currently does not provide a central guarantee of settlement (i.e., it does not assume the role of settlement counter-party to the seller and buyer). CAVALI is considering modifying this arrangement. Removing counter-party risk through the provision of a guarantee, would contribute to market efficiency and overall liquidity. The Government Reform Agenda for the Capital Markets 49. Capital market development is an integral component of effectively managing economic risks. The small size and fragility of Peru's bond and equity markets have left enterprises with little option but to seek external credit, thus increasing their own vulnerability to exchange risk and to the volatility of international capital flows. The development of the domestic capital market would enable them to effectively manage risk through the matching of currency and maturity between assets and liabilities. Development of such markets in Peru is thus not only a question of improving the efficiency of resource mobilization and investment in the economy, but also one of reducing the economy's vulnerability to external shocks. With the rapid past growth and projected future growth of the pension system as well as other contractual savings institutions, the constraint is no longer a shortage of investible funds, but rather the lack of appropriate instruments, infrastructure, and efficient intermediaries. To address these issues, the government will take a number of mutually complementary measures, which include: (i) establishing an interagency working committee to examine, in consultation with the private sector, existing regulatory and other impediments to, and recommend strategies for capital market development; (ii) clarifying the regulatory mandate and work program of CONASEV to focus primarily on the securities market, taking into account its accompanying responsibility for promoting market development; and (iii) establishing an interagency working committee to develop a government debt management policy, including options for government participation in the capital markets consistent with a sound framework for asset, liability, and risk management. 50. Capital Market Development Program. Development of the capital market requires breaking out of the "vicious circle" of a small, illiquid market that results in high risks and lack of transparency for investors, high costs and poor investment incentives for intermediaries, and high entry costs and limited options for borrowers, all of which combine to keep the market small and illiquid. Complicating this "vicious circle" in Peru are high financial sector concentration-with the consequent internal, noncompetitive nature of many of its transactions-- and the lack of a benchmark yield curve typically provided by public debt issues, which makes asset valuation difficult for issuers, buyers, and dealers alike. As part of the reform agenda, the government has recently established an inter-agency working committee to identify factors impeding domestic capital market development. The committee is comprised of all the financial sector regulatory agencies, MEF and BCR. This committee will conduct a study and issue recommendations for implementation of policies and instrumentalities to develop the domestic debt market and the creation of a pricing benchmark for establishing a yield curve, including the potential roles of the government, COFIDE, and private corporations in the development of primary and secondary markets in fixed income securities. Private sector participants in the market as well as external consultants, will support the work of the committee. 51. Regulatory Functions. CONASEV has made significant strides in modernizing and strengthening the legal and regulatory regime for the capital market, and improving its own efficiency. A number of issues remain, however. The first concerns the unduly broad scope of CONASEV's current functions, many of which are of little relevance to, and distract its attention  - 18- from its core responsibilities. As part of the reform program, CONASEV has begun implementing a series of measures to streamline its organization sharpen its focus, and further such measures will be incorporated into amendments to its organic law. A review will also be undertaken of CONASEV's resource requirements and necessary measures taken to assure adequate funding in view of the loss of fees from its budget due to functions dropped., CONASEV also needs to further develop analytical methods for asset valuation, market oversight, and to upgrade its market monitoring and supervisory tools. As noted in Section B, formal coordination and information-sharing will be strengthened with other regulatory bodies, in order to better manage the risks of a financial crisis spreading across the financial system. At the same time, CONASEV will seek to balance its statutory responsibility to both "promote and regulate" the capital market. Toward that end, it will establish more formal internal processes to identify capital market promotion strategies and to assure that the impact of its regulatory decisions on market development are taken fully into consideration. In a number of these areas, CONASEV will benefit from technical assistance financed by the Inter-American Development Bank. 52. Government Debt Management. The government itself could potentially be a key player in promoting the development of a benchlmark yield curve. Moreover, even if the budget itself might not carry a significant direct foreign exchange risk (a large proportion of revenues-e.g., customs duties--are effectively indexed to the exchange rate), there is a strong argument for the government to diversify the currency of its debt in terms of its own debt management objectives. The high currency risks assumed by the private sector, for lack of domestic debt alternatives, also represents significant indirect risk to the Treasury. For all these reasons, a gradual shift of the currency composition of the government debt is an option to be explored (although it could entail somewhat higher debt-servicing costs in the short term, given higher domestic interest rates). As part of its reform program, therefore, the government will take steps to strengthen its debt management capacity and to create an analytically based debt strategy, dealing with, among other factors, the indicated trade-offs between cost and risk exposure and the development of sound asset/liability management policies. This work will take place under the aegis of ajoint MEF and BCR working committee to be created as part of the reform program with technical support coordinated in the Public Credit ]Directorate of MEF.  - 19- D. The Pension System Background - The Private Pension System 53. The private pension system (SPP) has, since it started operations in mid-1993, become the principal source of retirement security for Peruvian employees in the formal sector and the most important source of domestic investment capital for the Peruvian financial system. Some 1.9 million contributing employees (affiliates) are now enrolled compared to under 1 million in the competing public national system (SNP). By the end of 1998, contributions to the private pension funds reached 100 million soles a month despite a recession, and the value of the pension funds under administration reached 5.5 billion soles (US$1.8 billion at the then prevailing exchange rate). AFPs accounted in 1998 for about 40 percent of the daily investments in securities on the Lima Securities Exchange (up to 90 percent for fixed income securities) and about one-seventh of national savings. 54. The SPP was designed along the lines of the Chilean model, under which private administrators (AFPs) receive contributions from, and are paid commissions by affiliates who have individual retirement accounts in funds independently managed by the AFPs. Pension benefits for each affiliate are funded solely from the assets and earnings of their retirement accounts and an insurance policy paid by the affiliate covering death and disability before retirement. The government, in the case of Peru, provides no guarantee or minimum pension. The SPP is regulated strictly by the Superintendency of AFPs (SAFP), an independent public agency. Peru's relatively small middle class and capital market constrain the growth of, and increase risks to the system, which also faces continued competition from the open national system. The original eight AFPs have been reduced by mergers to five, three of which have just reached break-even operation, while the other two remain in weak financial condition. Planned changes include actions to reduce high costs, improve collections, reduce systemic risks, and expand the reach and flexibility of the system. 55. Characteristics of the Private System. AFPs collect monthly pension contributions from employers equal to 8 percent of affiliate salaries, plus a commission determined by the AFP equal to 2.3 - 2.5 percent of salary, and a death and disability insurance premiurn negotiated by the AFP with an insurance company equal to 1.3 - 1.4 percent of salary." As in Chile and elsewhere, commissions are front-loaded and make up about 22 percent of total monthly payments by affiliates for retirement benefits, excluding insurance. Commissions are charged for each contribution as it is made. Because commission payments are set as a percentage of salaries (instead of as a percentage of funds under administration, as is customary for mutual funds), commissions decline over time as a percentage of total invested funds. For an affiliate with 10 years of participation, the effective annual rate is equivalent to about 4.3 percent of funds invested; after 20 years, the rate drops to slightly over 2 percent, and after 40 years to just under 1 percent. The effective rate would be even lower if the affiliate ceased to contribute for some period before retirement. In the early years, front-loaded commissions generate a negative return for the affiliate. Thus, despite a cumulative 5 percent positive real annual return on portfolio investment since inception, the value of SPP retirement funds after 5 years of operation is about 12 percent less than the aggregate contributions and commissions paid in by affiliates. " Health insurance premiums are paid separately to the Institute of Social Security (IPSS).  - 20 - 56. AFPs might be expected to reduce commissions gradually over time in response to competitive pressures. There is, however, little inclination in the present oligopolistic structure of the industry to compete on price, particularly since two of the AFPs are not yet profitable.'2 To mandate commission reductions would be contrary to the notion of a private, competitive system and would likely shrink the already low number of AFPs. In order to facilitate commission reductions, the regulatory authorities are considering restoring to AFPs the authority, removed in late 1996, to charge a combination of fixed commissions and commissions calculated as a percentage of funds under administration, while taking steps to reduce operating costs. 57. Market Limitations on Investments and Systemic Risks. Despite their potential importance as suppliers of long-term funds to the market, AFP investments are largely short-term in nature. This short-term concentration of their portfolios responds to constraints and incentives imposed by the regulatory framework as well as to the absence of adequate long-term instruments in the domestic market. Unlike other actors in the system, AFP investments are largely sol-denominated. This investmernt pattern leaves AFP affiliates vulnerable to systemic risks. At the same time, the large sums now being invested by the AFPs and their concentration in sol-denominated short-term assets make them a potential source of volatility in the financial system as a whole. 58. Financial Condition of AFPs. Front-loaded commissions have been important in financing the start-up of the SPP. At the end of 1997, the year in which the AFPs in aggregate achieved a break-even level of operations, cumulative commissions paid into the system (766 million soles) were twice aggregate AFP capital contributions (378 million soles). Had the AFPs charged commissions of 2 percent of fund balances, more comparable to local mutual fund practices, they would have received only about 170 million soles. As indicated by the following table, these substantial cash flows have permitted the AFPs to depreciate or arnortize the bulk of their fixed assets and start-up costs in their first 5 years of operation while attaining some profitability. System liabilities have declined in the last two years, and profits have risen substantially. Table 6. AFP Financial Results (S/. millions) |~~~~~~~~~ i AFPs (combined results for system) 1997 1998 (to Sept.) Cumulative capital contributions'3 378 382 Fixed assets and intangibles 347 383 Less: Depreciation and amortization 254 310 Unamortized fixed assets & intangibles 93 73 Required reserves and investments 48 59 Excess of liabilities over current assets 50 10 Net profit (annualized for 1998) 14 35 Source: SAFP, Boletin Informativo Mensual. 59. Operating Costs of AFPs. Sales costs account for more than 50 percent of AFP operating costs. AFPs do not make detailed or complete cost breakdowns public, but have estimated that 30-40 percent of their costs are for the sales force and 8-10 percent for publicity and promotion. 12 The Herfindahl-Hirschman (HH) index for Peru's AFPs rose from about 1,950 in 1996 to 2,271 in September 1998, indicating a high degree of concentration (substantially highet than the HH for the region of 1,373). 13 Estimated from year end capital in annual financial statements.  - 21 - Estimates of collection costs averaged 5 percent; supervision fees paid the SAFP - 4 percent; and intermediation costs including brokerage fees, 3 percent. It is evident from the above that reducing expenditures on sales forces offers the best opportunity for cost reduction. An important factor in generating the high sales costs is the front-loaded commission system that concentrates AFP profit opportunities in the higher-income affiliates. These affiliates are in short supply, and AFPs compete vigorously amongst themselves, paying fees to sales agents of as much as 15 percent of salary (i.e., half a year's anticipated commissions) to attract such affiliates. Background - The Public Pension System 60. The Oficina de Normalizaci6n Previsional (ONP) was created in 1992 to administer the defined-benefit, pay-as-you-go National Pension System (SNP). Steps taken in 1996-97 to reform these systems were supported by a World Bank Pension Reform Adjustment Loan (PRAL), approved in 1997. The principal objectives of these steps were to improve the terms of the SPP relative to the SNP, so that the former would be more attractive to new affiliates; close the Cedula Viva (CV), a state-funded pension system for government employees, and identify its beneficiaries and costs; establish a framework to fund future government obligations to the pension system by creating the Fondo Consolidado de Reservas Previsionales (FCR), and make an initial deposit to the FCR to fund the Bonos de Reconocimiento (Recognition Bonds), which were created to endow and permit transferability of the accumulated benefits of workers in the SNP to the SPP. 61. The Instituto Peruano de Seguro Social (IPSS) recently renamed ESSALUD, administered both the national retirement and the health insurance systems prior to the creation of the ONP, and afterwards continued to administer the health system and collect contributions for both systems. IPSS, however, never developed a system for identifying enrollees in the health or retirement systems; it simply collected contributions from employers based on their payrolls, and transferred the monies to the State. ONP thus does not know who or how many people are contributing to the SNP. It cannot project future pension obligations, because it does not have the ages, marital status, or number of children of affiliates. The now closed Cedula Viva (CV) system has about 50,000 active affiliates, and 260,000 retired pensioners, whose pensions are paid by the over 800 state entities to which they belong. New affiliations to the CV are prohibited, and the ONP is completing a program started under the PRAL to register all enrollees and eliminate unauthorized persons from its rolls. As of late 1998, registration had been completed, and 80 percent of the registrants had been cross-checked against employment records to confirm the accuracy of inscriptions. 62. Characteristics of the SNP. The SNP presently contains about 1 million active affiliates, and 340,000 retired pensioners. It distributes about 1.3 billion soles annually in retirement benefits, of which 60 percent are covered by contributions from active affiliates, and the remainder from the public treasury. New enrollment is permitted, despite the establishment of the SPP. The closing of the SNP to new entrants was considered when the SPP was started and again at the time of the 1996-97 reforms, but was rejected. Continuation of the SNP commands considerable political support. In contrast to the SPP, the SNP is a defined-benefit, pay-as-you- go system; that is, the government commits to pay each affiliate a pension benefit determined by years of service and pay and not necessarily corresponding to the contributions received from the affiliate. The lack of a direct linkage between contributions and benefits results in a loss of control over costs and less attention given to the collection of contributions. In addition, because  - 22 - obligations to current pensioners are paid from current contributions, funds are not accumulated to cover future costs. 63. Funding Arrangements for the Public System and Government Pensions. The Fondo Consolidado de Reservas Previsionales i(FCR) was established in April 1996 to fund government pension obligations. The decree establishing the regulatory regime for the FCR allows it to: (i) invest funds in the domestic market or abroad, (ii) subcontract one or more administrators to manage the investment portfolio, and (iii) invest no more than 5 percent of the funds in government debt instruments. The funds of the FCR are declared to be exempt from embargo or attachment, and may be used only for payment of pension obligations. It is administered by five directors: the Finance Minister, the General Manager of the BCR, the Head of the ONP, and two private citizens chosen by the President of the Republic. 64. The FCR presently administers: (a) US$ 1.06 billion derived from the allocation of privatization proceeds in March 1997 arid held to fund Recognition Bonds; (b) US$ 180 million contributed to fund particular pension obligations in connection with the Entel, Electrolima and other privatizations; (c) US$ 600 million whose earnings are allocated to the "Fondo Nacional de Ahorro Publico" (FONAHPU); and (d), US$ 350 million (plus US$100 million in real estate) transferred from the IPSS and also applied to the FONAHPU. The FONAHPU was created in July 1998, to supplement in equal amounts, each year's pension payments to SNP and CV retirees with pensions of less than 1,000 soles per month. It is to be funded with up to US$ 1.3 billion from proceeds of the sale of state interests in companies to be privatized. Of this amount, about US$70 million has been funded to date. Until the rest is funded, FONAHPU will be supported as indicated above, by earnings on US$ 950 million of the FCR. Most funds in the FCR are presently invested by the BCR in short- term, international, fixed-income securities in the same manner as BCR reserves. The Government Reform Agenda for the Pension Sector Private System 65. The reform program for the SPP seeks to: (a) improve the collection of contributions due, (b) expand investment options available for AFPs to permit better returns and risk management, and (c) significantly reduce AFP operating costs. In combination, these measures will achieve a more satisfactory return to affiliates, attract new entrants to the SPP, enhance savings, reduce systemic risks, and enhance the pension system's contribution as a provider of stable, long-term funds to the economy. 66. Collections. According to the SAFP, of the 1.9 million affiliates enrolled in the private SPP in September 1998, 420,000 (22 percent) had never contributed, and an additional 650,000 (34 percent) did not contribute during the preceding month. The amount in arrears is estimated at 10-20 percent of scheduled collections, plus fines and interest. In some cases the arrears to the SPP result from employers erroneously continuing to send payments to the SNP for employees who have migrated to the private system. In addition, however, many employers traditionally ignored or avoided their obligations to contribute to the public pension system, and have continued this pattern of nonpayment for SPP affiliates. In many cases, private sector employers defer pension payments, in effect using the SPP as a source of credit. Perhaps a third or more of the arrearages are owed by the public sector, which generally is immune from judicial debt collection and attachment of accounts. AFPs are thus ill-equipped to deal with wide-spread  - 23 - collection problems. Because the SAFP has not taken the lead in collection efforts, each AFP has had to deal with each employer (averaging 40,000 per AFP), involving costly efforts. 67. As part of the reform program, a new law and accompanying regulations have established a program for conciliation of accumulated pension debts and payment over three years. The SAFP and AFPs are authorized to settle collection disputes with employers participating in the program and to bring criminal charges against delinquent employers. The SAFP is empowered to inspect employer records or delegate this function to others, impose personal responsibility on officers of the employer for failure to pay pension obligations, and impose fines. The proposed law with its complementary regulations, as well as a Supreme Decree requiring public sector employers to participate in the program, will be enacted in June 1999. The program to improve collections from public and private sector employers will involve three main components. First, payments currently being erroneously made to the SNP for public sector employees that have elected to affiliate with the SPP will be redirected to the latter. This involves (i) cross-checking between ONP's individual accounts database (to be ready in September) and the SAFP's database of delinquent affiliates to identify the problems; and (ii) instructions by ONP to the corresponding employers to correct their records and properly direct payments to the AFPs. Second, the amount of contributions owed to public sector employees for payments misdirected in the past to SNP will be determined, and corresponding compensation made. Third, the full compliance of private sector employers with their pension obligations to the SPP will be vigorously pursued. 68. Reforming Investment Regulations. The investment options open to AFPs are, appropriately, regulated by the SAFP. Under current limits, they may invest only in rated issues, no AFP can take more than 25 percent of a new debt issue, and no more than 5 percent can be invested in securitization issues or in Peruvian "Brady bonds". At the same time, AFP portfolio choices are severely limited by the relatively small supply and diversity of debt and equity instruments available in the domestic market. These constraints reduce AFPs' ability to diversify risks. Under the law, AFPs are permitted to invest up to 10 percent of their portfolios outside of Peru in categories of instruments approved by the BCR. Under the reform program, the BCR will authorize limited categories of foreign investments but will retain control over the amounts to be invested, below the 10 percent allowed by law, allowing the proportion to increase as macroeconomic conditions permit. In addition, a complete assessment will be carried out of current pension investment regulations, with a view to expanding domestic investment opportunities consistent with prudential adequacy and responsiveness to evolving market opportunities. 69. In addition, to reduce systemic risk, the current requirement that the funds each achieve a positive real return on their investments over the three-year period ending June 1999, and over a five-year period thereafter, will be removed. This requirement increases systemic risk, inasmuch as a steep market downturn could force AFPs either to fund reserves equal to market losses or to liquidate their positions, thereby contributing to the market fall. A requirement that an AFP's investment returns not fall below 25 percent of the average for all AFPs will remain in effect. 70. Reduction of Costs. All the stakeholders in the SPP, including the AFPs themselves, agree on the need to reduce the system's high operating costs. Thus, a time-bound study is being 14 An immediate reallocation of AFP investments to the external market, however, may not be desirable in the present macroeconomic environment, and BCR will retain its authority to regulate portfolio limits in this regard.  - 24 - carried out under the reform program to identify the sources of these costs, including, inter alia, sales/marketing costs, transfer-inducement costs, regulatory costs, and insurance premiums, and to take action to reduce them. Possibilities for introducing more varied and lower-cost pension products to better meet the needs of existing affiliates and to attract new affiliates to the SPP will also be studied. Public System 71. Under the reform program, the government will carry out steps to improve the management of the SNP and modify its structure to promote greater discipline in its operation, including: (a) improved collections of contributions due from public and private sector employers; (b) institutionalization of mechanisms to determine liabilities under the SNP and CV, and project government pension obligations and future pension reserves, (c) further progress toward reducing the future fiscal costs of SNP obligations through the implementation of a long- term investment program for the FCR mranaged by investment administrators, (d) establishment of a budget strategy for the next three years, for controlling and covering future budgetary transfers for pension obligations; and (e' additional measures to encourage migration from the SNP to the SPP, including authorization for the issuance of additional Recognition Bonds or other mechanisms to provide the transferability of affilitates' accumulated contributions from the public to the private system. 72. Improving Collections. As part of the government's reform agenda, the ONP has entered into a contract with the SUNAT, the NatLional Tax Superintendency, to administer the collection of pension obligations, including the declaration and payment of contributions, registration of contributors, establishment and maintenance of individual contributor accounts, enforcement of compliance, and handling complaints. In addition to improving system administration, this arrangement will generate vital information concerning affiliates. This will allow the ONP to project future pension obligations and to identify public and private employers who are not making required contributions to the SNP and to bring them current. 73. Improved Financial Management of the SNP. Utilizing the information on characteristics of SNP and CV affiliates and their accoumts, a study will be undertaken to project the government's future pension obligations, and the resources needed to cover projected unfunded obligations. Based on cost and contribution projections being developed by ONP and SUNAT, the government will define a strategy control and fund pension costs to the budget over a rolling 3-year period. This will be coupled with the employment of investment administrators and the implementation of a long-term investment program for the funds deposited in the FCR for the exclusive backing of the Recognition Bonds in order to improve investment returns on these funds and reduce the government's unfunded liabilities. 74. Incentives for Transfer to the Private System. Improvements to the private system outlined above will help to make the SP]P more attractive to workers. In addition, as part of the reform program, the government will study alternatives for controlling SNP costs, including the establishment of individual accounts. Under the program, the government will also authorize the issue of additional Recognition Bonds o:r other instruments, to make accumulated pension benefits already accrued under the SNP, more portable and attractive for transfer to the SPP.  - 25 - E. Social Protection for the Poor and Contingency Plan 75. If a significant economic downturn were to affect Peru during the period covered by the program, it is clear from experiences of other countries that the poorest families would be severely affected. These effects could be felt by households through declining real incomes, as a result of falling labor demand and resulting increases in unemployment, underemployment, and/or lower real wages. At the same time, households are likely to face the effects of decline in public spending leading to a loss in essential services such as health, education, and nutrition, and an increase in social problems such as a rise in crime and violence."5 Households which would likely be more vulnerable to economic shocks are those with less diversified household income, those working in the informal economy where employment is more unstable, and those lacking access to private or public safety nets. Both rural and urban households would be affected, with vulnerable subgroups including children and the indigenous population.'6 To protect those households most affected by a potential economic downturn in Peru, the Government will undertake two new initiatives under the program. First, spending levels have been agreed for basic social programs that will be maintained during 1999 and 2000, despite any reductions in overall government spending induced by a potential crisis and necessary fiscal adjustments. Second, a contingency plan for providing social protection has been developed that would implement key employment generation programs targeted to the most vulnerable segments of the population in the event of a crisis. 76. Protecting spending for key social programs. As part of this operation, the government has agreed with the Bank on a list of high priority social programs that will be protected from budget cuts in 1999 and 2000 in the advent of a crisis (see Annex 5). The list of protected programs, selected in consultation with the Bank, includes programs that are effective in reducing poverty, are well targeted to the poor, and are likely to experience increased utilization during a crisis. Spending on these programs represents approximately 14 percent of the total budget. Monitoring of Government allocations for these programs will be carried out through monthly reports of budget distributions and expenditures. 77. Contingency Social Protection Plan. A contingency plan for providing social protection in the advent of a crisis has also been developed. The plan may be refined in the coming months through further consultation to better respond to the particular needs of a crisis. The plan would provide assistance to the affected population through an expansion of existing programs to provide employment. The implementation of the contingency plan would be triggered with quantifiable changes in the following indicators: terms of trade, tax collections, and poverty levels. The level of changes in these indicators, based on economic performance data over time, are an 18 percent decline in terms of trade from the same three month period in the previous year, a 12 percent drop in three consecutive months in collected current revenues from the same period in the previous year, or an increase of 3 percentage points in the poverty rate from the same period during the previous year17. 78. If economic performance deteriorates and results in a significant change in any of three indicators exceeding the levels above, this would necessitate the implementation of the 5 See for example, Atinc, T. M., and M. Walton, "Social Consequences of the East Asian Financial Crisis", The World Bank September 1998. 16 Based on information from the World Bank Poverty Assessment, 1998. '7 The terms of trade and tax data are collected monthly; the poverty data collected quarterly. The poverty rate is based on the percentage of population unable to consume a basket of basic goods and non-food items.  - 26 - contingency plan. The plan includes provisions for the expansion of three existing programs which would provide temporary employment for those who have been identified as vulnerable in both urban and rural areas, depending on the nature of the crisis. Program expansion levels would be based on need, with a minimum spending level of S/. 30 million creating between 40,000 and 250,000 person months of employment, depending on the program. The programs include the construction of rural roads (Caminos Rurales), the financing of community based social and economic infrastructure and productive activities through FONCODES, and a food- for-work program which currently provides assistance for small rural community works (PRONAA). Participation in the programs under the contingency plan would be limited to one member per family for a period of up to six months, depending on the program, with benefits equivalent to a value lower than the local market wage. Expansion of the programs would be targeted to selected geographic areas based on need. Further targeting would be carried out through self-selection given the low wage levels and labor intensive nature of the work. 79. The rural roads program (Caminos Rurales) finances the construction, rehabilitation and maintenance of rural roads and key links connecting to the primary road system in selected poor areas of the country. The program is operated by the Ministry of Transport, Communications, Housing and Construction and is financed by the World Bank and the Inter-American Development Bank. Currently, the program operates mainly in the Sierra, and in some areas of the Ceja de Selva. These investments help alleviate rural poverty and raise living standards of rural communities through increased access to basic social and economic and income-generating activities, and through the direct generation of employment. While employment generation is not a long term objective, the type of work carried out is labor intensive, drawing on the local labor force. Expansion of this program under the contingency plan would be targeted to those areas most affected by a crisis, with temporary employment limited to two and a half months per beneficiary, at a wage rate of S/. 360 per month. 80. FONCODES, the Government's social investment fund, finances community-based subprojects in social and economic infrastructure, productive activities, as well a series of special projects that include the production and distribution of school uniforms, shoes, school breakfasts and school furniture through urban microenterprises. FONCODES operates out of the Ministry of the Presidency with financing (on the first component only) from the World Bank and Inter- American Development Bank. Subprojects are identified and executed by community groups, in cooperation with NGOs, local governments and line ministries. Under the contingency plan, the Government would identify, within the rmenu of FONCODES projects, those which would be most appropriate for generating urban employment in a cost-effective manner. Employment would be limited for a period of maximum four months per beneficiary, with wages set below local market rates. 81. The food for work program under PRONAA currently operates in poor rural areas. PRONAA provides food rations as payment for labor in the construction of small-scale community works. Projects are demand driven, with the community or local NGOs providing the materials, and community members providing the labor. The food rations provided by PRONAA are 2 kilos of food per beneficiary, per day of work which is equivalent to 50-70 percent of the daily recommended family caloric allowance. The value of this transfer is approximately S/. 107 per month. Under the contingency plan, expansion of this program would be in both rural and urban areas, with the same food ration as exists, and employment generation limited to six months per beneficiary.  - 27 - PART III. THE PROPOSED LOAN A. Loan Description: Objective and Rationale for Bank Involvement 82. Loan Objective. The objective of the loan is to strengthen the government's capacity to manage the impact of future economic shocks on the financial system, promote the longer-term development and resiliency of the system, and enhance its contribution to the overall growth and stability of the economy. Toward these objectives, the loan will support implementation of a modernized bank resolution framework coupled with improved surveillance and prompt corrective actions, and finer-tuned rules for providing liquidity support to healthy banks. In addition, the loan will support reforms aimed at more systematic coordination of prudential supervision and crisis management across the banking, capital markets, and pension sectors. In the capital markets area, measures will be supported to deepen the securities markets, including the design of an institutional framework for government debt management and its role in the development of the long-teii fixed-income securities market, as well as to better focus the mandate of the regulatory authorities. The loan will also support second generation reforms in the pension sector to improve benefits and expand options to affiliates and enhance the pension sector's role in mobilizing and channeling a growing long-term savings base to productive investments in the economy. In this context, the loan will support reforms in the private pension system aimed at eliminating arrears in employer-funded contributions, improving the scope of safe and better yielding investment instruments for pension funds, rationalizing the industry's operating cost structure, and broadening the range of pension products available to workers. For the public pension system, measures will be implemented to improve system administration, control costs, and strengthen fiscal management and funding practices. 83. A key aspect of the proposed program will be to ensure, that, if economic conditions deteriorate on account of external factors while the financial sector reform effort is underway, measures will be taken to protect social programs for the poor. In this regard, and based on the experience with the South East Asian crisis, the government and the Bank consider it prudent to build in the requisite protections during the period of financial sector adjustment. In order to protect the gains attained in poverty reduction and to mitigate any adverse impact of an economic downturn on the poor, the government has designed a safety net program that consists of two elements: First, the protection of high-priority social programs identified by the government include those that are targeted to the poor and are essential for provision of basic education, rural development, nutrition and basic health. The protected programs cover about 14 percent of the government's total budget for 1999. In addition, the government has identified emergency employment measures that will be put in place if an economic downturn occurs. This contingency plan will permit the expansion of existing programs presently being operated. A set of indicators has been developed along with a set of critical trigger points - these indicators will be monitored under the program to determine when it would become appropriate to implement the contingency plan. 84. Loan Amount and Tranching. The amount of the FSAL II will be US $300 million, to be disbursed in two tranches. The first tranche of US $175 million will be available upon effectiveness. The date of release for the second tranche of US $125 million, is estimated to be nine months after effectiveness.  - 28 - Rationale for Bank Involvement and Strategy 85. Relation to Country Assistance Strategy. The Bank has supported earlier financial sector reforms in Peru with adjustment loans for both banking (FSAL I) and pension sector reform (PRAL). In the most recent CAS discussion on July 22, 1997 (Report No. 1 6796-PE dated June 26, 1997), the consideration of another adjustment loan for the financial sector, with particular emphasis on second-stage pension reforms "if justified by program content and financial requirements" was recommended and included in the lending program. The objective of poverty reduction in Peru is supported by this operation through conditionalities to protect and maintain basic social programs and key services throughout the program, and provide safety net contingency funds in the event of economic downturns. This loan, therefore, not only supports the implementation of the CAS but is critical to attaining its objectives. 86. Timing and Level of Financial Support. The Peruvian economy has been hard hit by a series of externally generated shocks over the past year and a half, which, despite a solid track record of good economic management and a vigorous growth rate of 7.2 percent in 1997, have severely slowed economic growth, widened the current account deficit, reduced capital inflows, and threatened the sustainability of anti-poverty efforts. The main transmission mechanisms of these shocks were a deterioration of Peru's terms-of-trade, coupled with a decrease in the volumes of main exports and a US $2.4 billion reduction in private capital flows from US$ 4.9 billion in 1997 to US$ 2.4 billion in 1998 and a projected US$ 1.3 billion in 1999. 87. At the same time, while the financial sector has proven itself resilient, vulnerabilities owed to weaknesses in its bank resolution framework and the shallowness of its capital markets, not so evident during the previous high-growth period, have become more apparent. The proposed lending operation has been designed and will be carried out in close coordination with parallel adjustment lending from the IDB and a new EFF program supported by the IMF. The combined programs of the IMF, IDB and World Bank will boost public sector borrowing, partially offsetting the projected reduction in net private capital inflows while avoiding a decline in the level of international reserves over the medium term. During 1999, a projected further reduction of US $1.2 billion in private flows, and a requirement to replenish international reserves following a US $1.0 billion decline in the previous year, will require net public borrowing of US$ 1.2 billion (of which the Bank and IDB will provide US$ 500 million). Table 7: External F'inancing Requirements ($US billions) 1998 1999 (est.) 2000 (proj.) Current Account Balance (3.8) (2.9) (3.0) Financing: Private Capital Flows 2.4 1.3 2.6 Privatization Proceeds 0.1 0.8 0.9 IBRD/IDB Disbursements 0.0 0.5 0.2 Other Public Disbursements 0.8 1.3 0.5 Repayments (0.9) (0.8) (0.8) Debt Relief 0.4 0.1 Int. Reserves (-) = increase 1.0 (0.4) (0.5) 88. Under the program, real GDP growth is expected to be around 3 percent in 1999, while the external current account deficit would be reduced to around 5 percent of GDP. Prudent fiscal and monetary policy will allow gross domestic investment to start recovering, after an  - 29 - anticipated decline in 1999 owing to the high interest rates and worsened expectations. The loan, by supporting implementation of more robust regulatory, supervisory and institutional mechanisms for the financial system will complement Peru's macroeconomic program and the strengthening of its external accounts, particularly in the context of the currently unsettled international financial markets. B. Tranche Conditionality Conditions for Board Presentation / First Tranche 89. Prior to Board Presentation: The Government will have (i) taken the necessary steps to maintain a sound macroeconomic framework; (ii) agreed to implement an overall medium term economic reform program as indicated in the Letter of Development Policy (Annex 2); and (iii) carried out the following specific regulatory and institutional reform actions in the areas of banking sector, capital markets, and pension systems (see Annex 1): I. Banking Sector Reform a. Banking law modifications and complementary regulations (Supreme Decree on "Reglamento de Seguro de Dep6sitos", SBS regulations on "Regimenes Especiales, Disoluci6n, y Liquidaci6n", and FSD Statute) enacted to incorporate new procedures for timely and efficient resolution of failed banks. b. Regulatory directive of the Superintendency of Banks and Insurance issued to set out policies for prompt corrective and cease and desist orders for prevention of banking problems. c. Terms of reference agreed to with Bank for external adviser to carry out a project to improve diagnostic and forecasting methodologies, enhance and integrate on-site and off- site supervision, and upgrade the technical capacity of SBS. d. Consistent with the recent amendments to the banking law, time limits on commercial bank access to the BCR discount facility extended. e. Evidence of incorporation of SAFP officials into inter-agency working groups among SBS, CONASEV and SAFP, covering consolidated supervision, risk management standards, asset valuation and risk identification issues. II. Capital Markets Reform a. Inter-agency working committee including MEF, BCR, SBS, CONASEV, SAFP, and COFIDE constituted via issuance of Ministerial Resolution and supporting terms of reference, to review current impediments to the development of the domestic debt market, and to evaluate the possible role of the government, COFIDE and private corporations as participants in spurring the development of such market. b. Terms of reference and funding approved for a review of CONASEV's strategy and its mandate to balance its functions of capital market regulation and promotion.  - 30 - c. Working committee including MEF's Public Credit Director and Public Treasury Director, and a BCR representative, established via issuance of a Ministerial Resolution and supporting terms of reference, to develop a policy and institutional framework, and strategy for instituting a systematic approach to government debt management; and terms of reference for the committee's technical coordinator established. III. Pension System Reform Private System a. Legislation enacted and complementary regulations issued authorizing settlement and extended payment program, and granting SAFP access to personnel records of employers in arrears, with the aim to eliminate public and private sector arrears of employer contributions to the private pension system. b. Supreme decree issued requiring public sector employers to participate in extended payment program. c. Foreign investment instrument categories suitable for AFPs investments approved by the Central Bank, with AFP portfolio limits for foreign investments set at a minimum of 1%. d. Terms of reference established, a consultant satisfactory to the Bank identified, and studies initiated to identify mechanisms to reduce AFP operations costs, permit additional investment options to affiliates, an,d attract more workers to the SPP. Public System e. Schedules set and implementation of work program begun to prepare ONP projections of future SNP and CV pension obligations including numbers of SNP and CV retirees and active SNP affiliates, and to prepare the carrying out of collection activities under the SUNAT/ONP contract. f. Terms of reference and selection procedure established for the qualification and selection of an investment consultant for the long term investment program of the FCR, and letters of invitation issued to pre-qualified investment consultants. g. Statement issued by Board of Directors of the FCR, confirming that the assets (and earnings thereon) in the fund established for the coverage of Recognition Bonds, are inviolable and can only be used for that purpose. h. Private and public system affiliation procedures equalized by ONP to encourage migration from the SNP to SPP.  - 31 - IV. Protection of Social Programs and Vulnerable Populations a. Agreed budget allocations for key priority social programs (Annex 5) for the second half of 1999 effected under corresponding monthly allocations for the relevant executing agencies. b. Contingency Social Protection Plan defined and approved for the expansion of emergency employment generation to be enacted in the event of an economic downturn (triggered by changes in pre-specified agreed indicators). Conditions for Second Tranche Release 90. In addition to continuous adherence to the commitments for Board presentation and first tranche release, the Government will maintain a sound macroeconomic policy framework and carry out the following specific actions prior to release of the second tranche (see Annex 1 for more details): V. Financial Sector Reform a. Operational procedures of SBS adopted for the implementation of the reformed banking resolution mechanism, and incorporated into the body of SBS existing policies and procedures. b. Action plan incorporating methods and techniques into the ongoing supervisory process of SBS based on recommendations drawn from the project carried out with the assistance of the external adviser, documented and adopted. c. Verification of improvements in: bank supervision, including prompt corrective actions and enforcement, improvements in off-site and on-site supervisory processes, and application of new bank resolution tools if needed. d. Formal inter-agency agreement among SBS, CONASEV and SAFP is in effect to ensure systematic information sharing, promote consistency in norms across financial sub-sectors, enhance the financial sector policy dialogue, and facilitate the consolidated supervision of financial conglomerates. Work plan established to address specific issues identified under the agreement. e. Budgetary autonomy granted to the Superintendency of Banks and Insurance under the Budget Law for the year 2000. VI. Capital Markets Reform a. An action plan has been approved and adopted for implementation, based on recommendations of the review in II.a above. b. The draft law, satisfactory to the Bank, including modifications to rationalize the functions of CONASEV, define its funding sources, and improve its capital markets regulatory capabilities, is presented to Congress.  - 32 - c. An action plan to improve the balance between CONASEV's regulatory and market promotion functions adopted for implementation. d. Review under II.c. above completed, and based on the recommendations of the committee, an action plan adopted for the implementation of a policy and institutional debt management framework. VII. Pension System Reform Private System a. All contributions by public sector employers for their employees affiliated to the SPP and listed under the ONP individual accounts database, that are being erroneously redirected to the SNP by public entities, are redirected to the SPP. b. Notification and instructions to submit debt reconciliation and employee payroll data, given to 100% of non contributing public sector employers of SPP affiliates, matched/identified by the ONP/SUNAT database. Employee payroll and related debt reconciliation data covering at least 7,500 such affiliates, has been submitted by employers to SAFP for the AFPs. c. Reconciliation process completed for, and collections begun or authorized, with respect to all delinquent private sector employees enrolled in the extended payment program. At least 200 inspections of delinquent private employers have been carried out by SAFP prior to August 31, 1999, and at least 100 inspections per month completed thereafter, with priority given to delinquent employers with more than 50 employees. d. A program is authorized by BCR. to increase the current 1% portfolio limits on foreign investment by AFPs. Under this program, an additional 1% of portfolio will be allowed to be invested abroad for every US$ 20 million of reserves reached above the net international reserves target for December 31, 1999, up to a limit of 5%. e. SAFP regulations modified and enacted, to (a) expand AFPs' domestic investment opportunities consistent with prudential standards and evolving market opportunities, and (b) eliminate the requirement that AFPs demonstrate a positive real rate of return. f. Plan, satisfactory to the Bank, adopted to implement measures to reduce AFP operating costs, open broader investment options to affiliates, and attract new affiliates to the SPP. Public System g. Individual accounts database created, permitting identification and enumeration of public pension system affiliates, and providing necessary information to project future obligations of SNP. h. Investment administrator(s) selected for the long term investment program implemented for FCR, and report submitted on investment allocations and execution strategy.  - 33 - 1. Investment of at least US$220 million equivalent of the FCR fund, under the new investment strategy. Study funded under terms of reference satisfactory to the Bank, and analysis initiated to project future obligations of and required government contributions to the SNP and CV. k. ONP to issue report providing ten year projections of government SNP & CV pension obligations, future pension reserves, and required budget funding for such. 1. Government to establish a strategy to control and cover future budget transfers for pension obligations, over the next 3 years. m. Adoption of a mechanism to effect the transferability to the SPP, via the offer of Recognition Bonds or some other mechanism, of workers' accumulated contributions to the SNP as of the date of transfer, thereby enabling workers to move from the SNP to the SPP without financial loss. VIII Social Sector - Protection of Vulnerable Population and Contingency Plan a. Presentation of evidence, satisfactory to the Bank, that the 1999 monthly budget allocations for the priority social programs (Annex 5) were maintained at an aggregate level equivalent to at least S/. 2.2 billion for the second half of 1999. b. Presentation of evidence, satisfactory to the Bank, that an aggregate amount at least equal to S/. 4.52 billion has been budgeted for the year 2000 for the social programs listed in Annex 5. c. Presentation of evidence, satisfactory to the Bank, that in the event that the pre-specified indicators in the Contingency Social Protection Plan exceed the agreed trigger points as listed in such plan, the Government has enacted the expansion of the Contingency Plan programs in an aggregate level equivalent to at least S/. 30 million. C. Disbursement and Auditing 91. Disbursement arrangements will follow the simplified procedures for SALs/SECALs approved by the Board on February 1, 1996. The Borrower will open an account in the Central Bank of Peru. Once the Bank formally notifies the borrower that a tranche is available for withdrawal, the borrower may submit a withdrawal application so that the proceeds of the tranche are deposited by the Bank in this account to be used in accordance with the Loan Agreement. Although a routine audit of the deposit account will not be required, the Bank reserves the right to conduct one. D. Environmental Aspects 92. The FSAL II has no direct impact on the environment. For the purposes of Operational Directive 4.01, it has an environmental category of C, which does not require an environrnental assessment.  - 34 - E. Program Objective Categories 93. The FSAL II belongs to the category of Economic Management. It supports the Government's economic reform prograrn aimed at improving the environment for sustained and stable economic growth, by ensuring a stable, appropriately capitalized, and well functioning financial system. The FSAL II includes features to protect social programs from budget cuts, and contingency measures targeted exclusively at the poor, in the event that adverse economic circumstances materialize during the course of the program. Implementation of the wider financial sector program will also benefit the population at large by eventually generating improved access to finance and retirement savings. The program thus complements assistance by the Bank and other donors designed to directly support the Government's social development objectives. F. Benefits and Risks 94. Benefits. This proposed adjustment loan would have benefits in a number of areas of the financial system. The modernization of bank supervisory practices and better 'tuned' use of the central bank's discount facility, will enhance banking sector surveillance and reduce the frequency and severity of bank failures. Modernization of the failed bank resolution procedures will reduce potential drains on both the public budget and deposit insurance funds and improve confidence in the financial system by providing a rapid and efficient mechanism for bank exit, which will reduce the likelihood of contagion effects. The increased coordination among regulatory institutions will also strengthen the country's financial management. 95. In the private pensions and capital market areas, the reforms under the program will promote a deeper, more liquid and transparent market, reducing the economy's dependency on, and the foreign exchange risk associated with external financing. Both the anticipated cost reductions mandated by the proposed pension reform, as well as the improved collection mandates and broadening of eligible prudential investment instruments (paralleled by efforts to develop the domestic capital market), will result in more efficient savings intermediation and a corresponding larger savings stock for beneficiaries. Similarly, the rationalization of the public sector pension scheme, and the reforms proposed to ensure better cost control and more orderly funding, and encourage affiliate transfer, will reduce future government outlays and liabilities, and increase the competitiveness of the pension fund industry. 96. Risks. The principal risks to the reform program are political and macroeconomic, and the two are interrelated. Peru will be holding national Presidential and Congressional elections in 2000, and active campaigning can be expected to begin in the second half of 1999. As in all countries, this process can be expected to engender increasing pressures for public expenditure, pressures likely to be intensified if economic growth is slow to recover. Banks, too, could come under increasing public pressure to ease credit requirements despite the portfolio deterioration suffered over the past year. The government's demonstrated track record of sound economic management over the past eight years, and the importance it gives and its responsiveness to the support of the international financial institutions provide a strong presumption of confidence that electoral pressures will not be allowed to pull the macroeconomic program off track. 97. The current outlook is for a gradual acceleration of growth over the course of 1999, as production recovers from El Nifio, the world economy stabilizes, and confidence in international financial markets is restored. Some easing of Peru's access to external capital is already evident,  - 35 - and pressures on the exchange rate, banking liquidity and the domestic interest rate have begun to ease. This outlook, particularly with regard to access to external private capital, could be rapidly reversed, however, if the financial difficulties of Russia, Brazil, or other major countries intensified. A new constriction of liquidity in the economy, coupled with a significant further currency depreciation, would intensify the immediate portfolio problems of the banking system, reduce needed credit to the private sector, and make a number of the specific elements of the reform program-e.g., reduction of arrears to the pension system, strengthening bank loan classification and, thus, provisioning-more difficult to implement. Additional banks could also be forced into the enhanced surveillance or resolution regimes, possibly resulting in the use of seemingly expedient but more costly approaches for restructuring problem banks. There is an important risk, therefore, that progress under the program could be slowed. The financial support of the Bank, IMF, and IDB are an important signal to the international financial community of our continuing confidence in Peru's economic management and creditworthiness and will help to prevent the above scenario from coming to pass. Setting these reforms in motion, moreover, is crucial to building Peru's capacity to manage and mitigate future shocks to the economy and financial system. The govemment's recognition of this necessity and commitment to the direction of reform, as clearly evidenced in understandings reached with its IFI partners and the major steps taken toward release of first tranche funds, gives confidence that the program will be carried out and the expected benefits realized. PART IV. RECOMMENDATION 98. I am satisfied that the proposed Loan would comply with the Articles of Agreement of the Bank, and recommend that the Executive Directors approve it. James D. Wolfensohn President By: Sven Sandstrom Attachments Washington, D.C.  PERU Annex I FINANCIAL SECTOR ADJUSTMENT LOAN II POLICY MATRIX OBJECTIVES FIRST TRANCHE SECOND TRANCHE Macroeconomic Policy Framework Maintenance of a sound Maintenance of an adequate framework of macroeconomic management agreed Maintenance of macroeconomic policy framework endorsed by the Bank. macroeconomic policy with the Bank, covering fiscal, external, exchange, and monetary policies. framework. Banking Legal and Regulatory Framework * Develop and institute sound Enactment of modifications to the banking law, and complementary regulations Operational procedures for the reformed banking resolution mechanism adopted. legal/regulatory institutional satisfactory to the Bank, in effect, in order to establish an effective bank failure Such procedures incorporated into the body of SBS's existing policies and framework for bank failure resolution mechanism. procedures. resolution. * Strengthen bank supervision SBS Directive issued, setting forth policies for prompt corrective, and cease and Policies and procedures incorporated into SBS supervisory practices. to enforce early and prompt desist type actions. corrective actions by banks, as well as cease and desist Terms of reference agreed to with Bank for an external adviser to carry out a Action plan documented and adopted, incorporating methods and techniques into measures. project to: (i) improve diagnostic and forecasting methodologies, (ii) enhance and the ongoing supervisory process, based on the recommendations drawn from the W integrate on-site and off-site supervision and (iii) upgrade the technical capacity project with the extemal adviser. of SBS. Verification of improvements in bank supervision including prompt corrective actions and enforcement, and application of new bank resolution tools if needed. * Make more flexible the Consistent with the modifications to the banking law, the time limits on lender-of-last-resort commercial bank access to the BCR discount facility will be extended. BCR will responsibility of the BCR. continue to exercise its authority to grant or withhold access to the facility based upon assessment of the bank's condition, and to make use of the facility by recurrent banks contingent on the presentation of a plan to reverse liquidity problems. * Strengthen the consolidated Incorporation of SAFP officials into inter-agency (SBS, CONASEV, SAFP) Formal inter-agency agreement between SBS, CONASEV and SAFP in effect to: supervision of financial working groups dealing with (i) consolidated supervision, (ii) standards for risk (i) ensure systematic information sharing, (ii) promote consistency in norms across groups and improve management, and (iii) asset valuation / risk identification issues. sub-sectors of the financial system, (iii) enhance financial sector policy dialogue, information sharing & and (iv) facilitate the (off-site and on-site) consolidated supervision of financial consistency of norms across conglomerates. financial sub-sectors. * Establish budget autonomy Budgetary autonomy for the SBS granted under the Budget Law for the year 2000. for the SBS. Capital Markets Development * Address systemic risk via the A working committee established, including MEF, BCR, CONASEV, SBS, Review has been undertaken and an action plan based on recommendations, has development of primary and SAFP, and COFIDE with agreed terms of reference, to review and make been approved, satisfactory to the Bank, for implementation. secondary markets in fixed recommendations regarding current impediments to the development of the income securities. domestic debt market, including the absence of market benchmarks, and to evaluate the potential roles of government, COFIDE, and private corporations in the development of the domestic debt market. Terms of reference, membership, and work schedule satisfactory to the Bank, established.  PERU Annex I FINANCIAL SECTOR ADJUSTMENT LOAN II POLICY MATRIX OBJECTIVES FIRST TRANCHE SECOND TRANCHE lmprove capital markets Terms of reference and funding approved to initiate a review of CONASEV's The draft Law to improve the efficiency of CONVASEV, rationalize its functions, regulation and promotion, and strategy and mandate to balance its functions of capital markets regulation and define its budget funding sources, and improve its capabilities for capital markets rationalize institutional promotion. regulation; is presented to Congress. supervisory functions towards securities market oversight. An action plan for implementation of recommendations on improving the balance between CONASEV's regulatory and market promotion functions, adopted. * Develop a strategy for A working committee established, including MEF and BCR, to develop a Review has been undertaken and an action plan for a policy and institutional govemment debt policy/institutional framework and time-bound work program for government framework for implementation of a debt management strategy based on the management. debt management. Terms of reference, membership, and work schedule review's recommendations, has been approved, satisfactory to the Bank, for satisfactory to the Bank, established, including the terms of reference for the implementation. technical coordinator of the committee. Pension Reform Private Pension System (SPP) * Improve collections from both Legislation enacted and complemernry regulations issued authorizing extended Redirection to the SPP of pension contributions for all public sector employees in public and private sector payment program and settlement of late contributions and commissions to AFPs, the ONP individual accounts database whose contributions are being erroneously employers. and granting the SAFP access to personnel records of employers in payments directed to the SNP by public entities. Notification given by SAFP, to 100% of arrears, with the aim to eliminate public and private sector arrears of employer non contributing public sector employers of SPP affiliates matched/identified by contributions to the SPP. ONP/SUNAT individual accounts database, to submit debt reconciliation and employee payroll information. For at least 7,500 of such affiliates, employee data for reconciliation of debts has been fully submitted by employers to SAFP/AFPs. Supreme Decree issued requiring public sector employers to participate in the Reconciliation process completed for, and collections begun or authorized, with extended payment program. respect to all delinquent private sector employers enrolled in the extended payment program. SAFP has carried out least 200 inspections of delinquent private employers prior to end-August, 1999, and at least 100 inspections per month thereafter; priority given to delinquent employers with more than 50 employees. * Expand investment options Categories of foreign investments suitable for AFPs (e.g., investment grade A program is authorized by BCR to increase current portfolio limits on foreign and risk management. sovereign debt, index and fixed-income funds of appropriate quality) specified by investments of AFPs. Under the program, additional increments of 1%/o, up to a SAFP and approved by BCR. Portfolio limit for foreign investments of AFPs set limit of 5% of the portfolio will be permitted for investment abroad for every $20 by BCR at a minimum of 1% of their portfolios. million of reserves reached over and above the end-December 1999 net international reserves target. SPP regulations modified via enactment of amendments thereof, with a view to (a) expand domestic investmnent opportunities consistent with prudential standards, and (b) eliminate the requirement that AFPs demonstrate positive real rate of return on pension fund investments while providing the appropriate safeguards. * Increase attractiveness of SPP Terms of reference for SPP studies approved, consultants satisfactory to the Bank Presentation and adoption by the Govemment, of a plan to reduce AFP operating to workers and expand its identified, and studies initiated to identify means of (i) reducing the SPP's high costs, open up wider and lower-cost investment options to affiliates, and attract coverage of the working operating costs (sales costs and insurance premiums); (ii) permnitting workers new affiliates to the SPP. population by reducing SPP additional investment options; and (iii) attracting more workers to the SPP. costs and enhancing competition among pension providers.  PERU Annex I FINANCIAL SECTOR ADJUSTMENT LOAN II POLICY MATRIX OBJECTIVES FIRST TRANCHE SECOND TRANCHE National Pension System (SNP) * Improve accounting, cost Schedules set and implementation of work program begun to prepare (i) ONP Individual accounts database for SNP established, affiliates identified and controls and collections of the projections of future SNP and CV pension obligations and determine numbers of enumerated, and all necessary information provided to properly project future SNP and C0dula Viva SNP and CV retirees and SNP active affiliates; and (ii) the carrying out of obligations of SNP. systems. collection activities under SUNAT contract with ONP. * Fund future obligations of the Terms of reference and selection procedure established for contracting of FCR The investment administrator(s) selected for the long-term investment program of SNP and CV. investment advisor(s), and letters of invitation issued to pre-qualified investment the FCR, and report submitted on investment allocations and execution strategy. consultants. At least 10% of the full amount of the FCR fund invested under the program. Board of Directors of the FCR issues statement confirming that the assets and eamings of the fund established for and dedicated to the coverage of Recognition Study funded under terms of reference satisfactory to the Bank and analysis Bonds, are inviolable and can only be used for that purpose. initiated to project future obligations of, and required govemment contributions to the SNP and CV. ONP to issue report providing 10-year projections of govemment SNP and CV pension obligations, future pension reserves, and required budget funding for such. Government to establish a strategy to annually project, control and cover future budget transfers for pension obligations, over the next 3 years. * Reduce future fiscal SPP and SNP affiliation procedures equalized by SAFP and ONP to encourage Adoption of a mechanism to enable workers to move from the SNP to the SPP obligations to the SNP. migration of affiliates from SNP to SPP. (including option of using Recognition Bonds) to permit transferability to SPP of workers' accumulated SNP contributions as of the date of tramsfer, without incurring financial loss. Protection of Social Programs * Protection of key social The agreed budget allocations for key priority social programs for the second half Presentation of evidence, satisfactory to the Bank, that the 1999 monthly budget programs and basic services of 1999 provided under the corresponding monthly allocations to the relevant allocations for priority social programs were maintained at the agreed aggregate for low income sectors, and executing units. levels of at least S/. 2.2 billion for the second half of 1999. contingency programs to expand/maintain income Contingency plan defined, for the expansion of emergency employment Presentation of evidence, satisfactory to the Bank, that the year 2000 budget for generation for vulnerable generation in vulnerable communities, in the event of an economic downtum (as protected programs is maintained at least at a level equal to the 1999 budget in real communities in the event of triggered by changes in pre-specified and agreed set of economic/social terms (SI. 4.52 billion). adverse economic indicators). developments. In the event that any of the economic/social indicators defined for the contingency plan reach their trigger points, the Govemment will present evidence, satisfactory to the Bank that it has implemented the expansion of programs (the Contingency Social Protection Plan) in accordance with agreed procedures and budget amounts of at least S/. 30 million.  qSLUCA Dtt . Annex 2 39 - / MINISTERIO DE ECONOMIA Y FINANZAS OFICIO No. 114 -99-EF/10 FINANCIAL SECTOR POLICY LETTER Lima, May 29h, 1999 Mr. James Wolfensohn President The World Bank Dear Mr. Wolfensohn: 1. The Government of Peru is undertaking a wide range of actions in the financial sector with the objectives of enhancing the soundness of the banking system, promoting the development of domestic capital markets, and furthering progress in pension reform. We consider these actions to be essential to reduce the economy's vulnerability to external economic shocks and to consolidate the foundation for sustained economic growth and social development in the long run. At the same time, we believe that in the short run the government should take precautionary steps to protect the poorest sectors of the population from the possible negative effects of exogenous shocks and slowdown in economic activity. Therefore, the government is also introducing a safety-net approach to protect the most vulnerable groups in society and to maintain the gains achieved in poverty reduction in recent years. In support of these financial sector reforms and social protection programs, the government requests a financial sector adjustment loan in the amount of US$ 300 million from the International Bank for Reconstruction and Development. 2. In support of this request, this letter describes: a. The government's macroeconomic policy framework and external financing plan, that have recently been endorsed by the IMF. The framework covers the management of fiscal, external, exchange and monetary policies. b. The objectives of financial sector reform and the policy measures to be implemented, highlighting the govermment's commitrnent to strengthen the Peruvian banking system, promote the development of the domestic capital markets, and improve the public and private pension systems. c. The safety net program designed to protect the gains attained in poverty reduction and to mitigate any adverse impact of an economic downturn on the poor.  - 40 - I. Background 3. Peru witnessed a major economic turnaround during the 1990's. As a result of sound macroeconomic policies, major structural reforms, and the reestablishment of public security, hyperinflation was stopped, and sustained growth was restored. In fact, inflation declined from over 7,650 percent in 1990 to 6 percent in 1998, while average GDP growth reached 5.0 percent per year during 1991-1998. These accomplishments, in turn, allowed for an equally impressive improvement in social indicators: reduction in extreme poverty, increased investment in human capital, and extended coverage of health care. In particular, the incidence of extreme poverty fell from 26.8 percent of the population in 1991 to 14.7 percent in 1997, and it is the intention of the government to further reduce it to no more than 10 percent by 2000. 4. In addition to its macroeconomic stabilization efforts, Peru implemented a wide array of market-oriented structural reforms during the 1990s. These reforms aimed at enhancing economic efficiency, stimulating growth, and improving social conditions by fostering domestic and foreign private investment, and increasing public sector savings and the quality of public sector investments and social expenditures. The reforms included the elimination of domestic price controls and subsidies, liberalization of the foreign trade regime, elimination of controls on capital flows, tax and customs reforms, and the reintegration of Peru into the international financial community. The privatization program included the sale to the private sector of major enterprises in the telecommunications, energy, financial, fishing and mining sectors. A private pension system was created in 1993, and workers have increasingly chosen to enroll in the private instead of the public pension system. 5. Against this background, the Peruvian economy suffered three exogenous shocks during 1998. First, the deepening of the Asian crisis further depressed the international prices of Peru's main export products. Second, the El Nifno phenomenon, which caused direct losses to physical infrastructure valued at about US$ 1.2 billion (approximately 2 percent of GDP), also took a toll on economic activity, especially in the agricultural and fishing sectors. Finally, the Russian crisis caused a virtual halt in capital inflows, resulting in a sharp real depreciation of the sol and a liquidity crunch, which in turn produced a severe contraction in domestic demand. Although the financial turmoil has abated, and capital inflows are coming back to the country, domestic demand is still depressed, and enterprises in the nontradable sectors that are highly indebted in dollars continue to suffer debt-servicing difficulties. II. Macroeconomic Policy Framework and External Financing 6. The government's economic program for 1999-2001 includes fiscal and monetary targets consistent with macroeconomic stability and addresses key structural problems in both the financial and real sectors. The program has been endorsed by the IMF and is the basis for a third consecutive three-year EFF agreement with the Fund. Moreover, a  - 41 - program of reforms in the financial and social sectors has been developed in close consultation with World Bank staff. The macroeconomic program aims at restoring GDP growth to 3-4 percent in 1999 and achieving a sustainable rate of growth of 6 percent by 2001. At the same time, inflation is envisaged to remain in the 5-6 percent range in 1999 and to drop gradually to 3 percent by 2001. 7. In order to support a prompt economic recovery, the government has targeted a combined public sector primary surplus equivalent to 0.9 percent of GDP in 1999 (reduced from 1.3 percent in 1998). This will result in an overall fiscal deficit of 1 percent of GDP in 1999, a deficit level well below the average for the region and mainly attributable to the recent slowdown of economic activity and the associated drop in tax revenues. This fiscal target will accommodate the lower tax revenues without cuts in public outlays or reductions in social programns that would deepen the economic recession and harm anti-poverty efforts. In the medium term, as GDP growth accelerates, fiscal policy will permit strengthening the budget position; thus, the primary surplus is projected to reach 1.6 percent of GDP in 2001. 8. Regarding monetary policy, the central bank will continue to utilize base money as its intermediate target in order to ensure that the growth of domestic credit is in line with the program's main objectives. In this vein, the government will continue to implement a flexible exchange rate policy, with discretionary central bank intervention in the foreign exchange market aiming to smooth out temporary fluctuations in the exchange rate. This policy will permit the economy to adjust to terms-of-trade or other external shocks and, at the same time, to reduce excessive volatility stemming from speculative capital movements. 9. During 1998, to provide additional liquidity to the economy, the central bank lowered the marginal reserve requirement on foreign currency deposits in successive steps from 45 percent to 20 percent. Also, at the end of 1998, the SBS introduced for prudential reasons a 20-percent liquidity ratio (including legal reserves) that banks must maintain against all short-term liabilities, including foreign borrowings. The continued close coordination between the Central Bank and the SBS will ensure that the banking system as well as individual banks have adequate liquidity. 10. The above program envisages a reduction in the current account deficit of the balance of payments in 1999 to about 5 percent of GDP (compared to 6 percent in 1998), despite some further decline foreseen in Peru's terms of trade. Official foreign borrowing will be increased in the face of the continued weakness of private capital flows. Nevertheless, it is expected that more than two-thirds of the current account deficit will be financed from private sources, including revenues from privatization and other foreign direct investment. Gross international reserves will be maintained at about the current level of 1 1 months of import coverage.  - 42 - III. Structural Reforms and Protection of Social Programs l1. In addition to appropriate short-term, counter-cyclical macroeconomic policy, the government recognizes that renewed growth requires that the domestic banks have the capacity to refinance private sector debt, as current debt-servicing difficulties, resulting from the recent external shocks, could preclude a sustained recovery. For this reason, resources borrowed abroad by the public sector are being on-lent to banks by the Peruvian Development Corporation (COFIDE), a second-tier public financial institution. This program, which has a US$ I billion ceiling, will provide long-term funds to the domestic banking system to permit the maturity of bank loans to be lengthened, and to provide additional liquidity to the system. It is understood that this program will neither entail fiscal subsidies nor be used to support insolvent borrowers or unsound commercial banks. Thus, these credits will be subject to COFIDE 's prudential limits for individual banks, the participating banks will bear the credit risk on the refinanced loans, and related party debts will not be refinanced under this program. 12. The government considers that the deepening of the structural reforms will foster private investment, reduce reliance on external capital flows and enhance efficiency throughout the economy. Thus, the government will continue to implement its ambitious privatization program, including the sale of all its remaining shares in previously privatized enterprises, privatization of the remaining publicly owned mining and some small manufacturing enterprises, and the sale of a number of publicly owned fixed assets. Also, as a complement of the privatization program, the government is increasing the use of concessions to foster private sector participation in the economy. Within this program, the government will award concessions for the management of a number of forests, at least two highways, and several seaports and airports, including Lima's international airport. This program will also include the concession of several fields for mining and oil exploration as well as all state railway lines. The Treasury's receipts from the privatization and concession programs are expected to total at least US$800 million in 1999. 13. The government is committed to strengthening and increasing the efficiency of its social policies. Key social programs, such as basic education and basic health, have been given priority in the budget. As the government remains firmly committed to reducing poverty and improving the quality of life of the poorest segments of the population, the central government budget for 1999 contemplates a reallocation of resources away from military expenditures towards the education and health sectors. It will continue to improve the targeting of existing poverty alleviation programs and will strengthen them through better design and closer coordination among ministries. 14. In order to protect the gains attained in poverty reduction and to mitigate any adverse impact of an economic downturn on the poor, the government has designed a safety net program that consists of two elements: first, the protection of the budget of high-priority social programs and, second, a contingency plan for emergency employment creation. The high-priority social programs identified by the government include those that are targeted to the poor and are essential for provision of basic education, rural development, nutrition, and basic health. The programs protected cover about 14 percent of the government's total budget for 1999. The government will monitor expenditures under these programs, with  - 43 - the aim of ensuring that they are carried out efficiently, and provide monthly reports to the Bank on their actual expenditures. The program of protected high-priority social programs will be continued through the year 2000 with the same level of resources, in real terms, as in 1999. 15. In addition, the government has identified emergency employment measures that will be put in place if an economic downturn occurs. This contingency plan will permit the expansion of existing programs presently being operated by the Emergency Social Fund (FONCODES), the National Nutrition Program (PRONAA), and the Rural Roads Program. A set of indicators has been developed, along with a set of trigger points and these indicators will be monitored to determine when it might become appropriate to enact the contingency plan. IV. Financial Sector Policies 16. In support of its macroeconomic policy, the government has implemented a series of reforrns since 1990 aimed at enhancing the strength and efficiency of the financial sector. Among the principal actions have been the liberalization of interest rates and the elimination of state intervention in the allocation of credit; the privatization of state-owned commercial banks and the liquidation of state development banks; the progressive improvement of banking and capital markets laws and the institutional strengthening of the related supervisory agencies; and the opening of the financial system to private pension funds and first steps toward covering the unfunded liabilities of the public pension system. These reforms have been essential to support and sustain the high rates of growth achieved in the 1990s. However, they now need to be strengthened, and the current regulatory frarnework needs to be adapted to the new problems and challenges posed by recent international and domestic financial developments. 17. The Peruvian government considers the policies and measures described in this section as essential to the realization of its commitment to strengthen the Peruvian financial system. These policies, complemented by those referred to earlier aimed at protecting the basic social programs, should contribute to sustained economic and human development. To achieve these objectives, the policy strategy for 1999 and 2000, rests on three pillars: a. Further strengthening banking supervision, b. Capital market development, and c. Pension system reform. The specific policy steps that the government intends to take are elaborated below.  - 44 - Strengthening Bank Supervision 18. The government has taken continuing actions over the past several years to enhance the soundness of the banking system through the improvement of the legal and regulatory framework, the supervisory capabilities of the Superintendency of Banks and Insurance (SBS), and the latter's internal guidelines for the monitoring of, and when necessary changing, bank behavior. A modem banking law, promulgated in 1996, established new risk-based supervision (consistent with international standards), including consolidated supervision faculties for the SBS, and a general framework for preventing money laundering and for introducing capital requirements for market risks. Thus, minimum requirements for credit, market and liquidity risk management and control practices have been put in place; and requirements for entry into the banking system have been tightened. 19. Modifications to the law were introduced in late 1998 and 1999 to enhance the efficiency of the whole resolution process, by increasing the capacity of the SBS to enforce prompt corrective actions and improving resolution and liquidation mechanisms. The triggers for enhanced surveillance have been clarified and sharpened, and the SBS has been authorized to call for a capital infusion by shareholders, or by a third party when shareholders cannot fully replenish lost capital. The law has also introduced new procedures for failed bank resolution, which are subject to a least-cost criterion and follow a "good bank/bad bank" approach that serves to maintain the value of good assets while expediting and reducing the costs of liquidation of the bad assets. Finally, the law and its regulations empower the Deposit Insurance Fund (FSD), under carefully defined and circumscribed conditions, to enter into the rehabilitation of a bank to prevent systemic destabilization. To make these modifications operational, the necessary regulations and complementary decree will be issued and enacted by May 24, 1999, and a statute defining the operations of the FSD will be issued by FSD's Administrative Council and approved by SBS by June 15, 1999. 20. To further strengthen bank supervision, the SBS will continue with the implementation of a risk-based supervisory strategy. A directive issued in May 1999 will provide guidelines, so that field supervisory staff apply timely and consistent corrective actions to prevent unsafe banking practices. Capital for market risks will be required according to a planned schedule, starting with foreign exchange exposures effective in June 1999; and following with exposures to changes in stock prices effective in December 1999 and interest rate exposures effective in June 2000. The SBS will also seek to strengthen the role of internal and external auditors to ensure their effective independence from management. In this regard, regulations will be issued requiring an explanation from the Board of Directors, to the satisfaction of the SBS, whenever an internal auditor is laid off, or an external auditing firm is changed. In addition, the SBS will take steps to develop a new information system to improve information-sharing between SBS and the banks and to allow for more effective use of the information in the supervisory process. Moreover, an information systems auditing software will be used during on-site inspections starting in April 2000. In addition, SBS has arranged to hire an international expert to implement an in-depth pilot project aimed at developing new supervisory methods that will better  - 45 - integrate off-site analysis and on-site inspections, while building technical capacity through an innovative approach to the on-the-job training of its bank examiners. The lessons learned in the pilot project will be incorporated by SBS into its supervision methodology. 21. Consistent with international practice, the government will extend to the appropriate levels of SBS staff the legal protections or risk insurance necessary to enable them to carry out their supervisory functions. Also, to ensure the independence of the supervisory function from external interference, and its ability to hire and retain the quality of staff necessary, SBS's budgetary autonomy will be recognized in the budget law. 22. To further enhance financial sector supervision, the government considers that the coordination of the activities of the different supervisory agencies and the timely sharing of information among them is essential to reduce the risks associated with related-party lending and the activities of financial conglomerates. In this area, the SBS, the Superintendency of the Private Pension Fund Administrators (SAFP), and the National Securities Commission (CONASEV) are proceeding to strengthen formal institutional mechanisms for consultation and the systematic sharing of information in order to ensure the consistency of prudential norms and facilitate consolidated supervision. 23. The government is aware, in the light of last year's liquidity crunch, of the need to improve the means by which solvent but illiquid banks can access public resources in an orderly manner, while assuring that such resources are not used to support mismanaged and insolvent institutions. As part of the reform of the overall supervisory framework, the recent amendment to the banking law has made more flexible the lender-of-last-resort function of the Central Reserve Bank (BCR) by extending the time limits on access to this discount facility for healthy banks with temporary liquidity shortages. Capital Market Development Policies 24. The government, with the support of the Bank, will, carry out a comprehensive study aimed at identifying the most important obstacles that hinder the development of domestic debt markets and at developing an action plan to address them. Also, the government will review CONASEV's regulatory and promotional responsibilities to ensure that CONASEV's activities are and remain properly focused on the domestic capital markets, and that its resources are adequate to the performance of those responsibilities. 25. The government will also improve the strategic management of public debt by modernizing the current legal, policy and institutional framework in this area. Public debt management in the future will progressively be based on an asset-liability approach with proper and explicit risk coverage mechanisms. In this context and in order to foster the deepening of domestic capital markets by private agents, the government will study the feasibility and appropriateness of issuing domestic long-term government securities. This could have important benefits in relation to establishing a yield curve, facilitating price formation and improving the liquidity of medium and long-term credit markets. The development of long-term instruments will, at the same time, establish new investment opportunities for private pension funds, insurance companies and households, and should  - 46 - also contribute to increase the demand for domestic-currency denominated securities and therefore the demand for base money. Pension System Reform 26. Pension system reform has been a major achievement of the structural reforms program of the government. Its objectives are to: provide higher and more secure returns to workers' savings for retirement, while expanding the covered population; generate a growing, dependable source of contractual savings available to finance long-term investments, while enhancing the depth and liquidity of Peru's financial and capital markets; and reduce the future fiscal burden of the public pension system, while moving toward the full funding of existing liabilities. Several measures have been taken in recent years to achieve these objectives. In order to build on the progress already made toward these objectives, the government will take additional steps to: (i) improve the collection of contributions to both public and private systems from public and private sector employers; (ii) reduce the administrative costs of both systems; (iii) modify the regulatory regime governing the private system in order to reduce its financial risks, enhance its investment opportunities, encourage pension product diversification, and stimulate competition; and (iv) define a strategy for the funding of the future obligations of the public system. 27. The expected future retirement benefits of workers affiliated with the private pension system (SPP) are currently being reduced by high levels of arrears in employer remittances of contributions to the AFPs. At the same time, the future fiscal burden of the public pension system (SNP) to the Treasury is increased by employers' arrears to that system. To improve the collection of contributions to the SPP, a law has been submitted to Congress to grant the SAFP access to the personnel records of private sector employers in payments arrears, to authorize a settlement regime, to extend payment periods for contributions in arrears, and to assess penalties for noncompliance within the time limits set for making payments current. 28. A complementary Supreme Decree will require public sector employers at the national level to determine their debts to the SPP within 15 months and to recognize and pay such debts. The SAFP and public sector employers will cooperate to make available and review the latters' personnel records and determine the amount of public debts to the SPP as promptly as possible. To eliminate one important source of arrears, all non-contributing SPP affiliates in the public sector will be checked before year-end against the SNP individual accounts database, and payments being erroneously made by their employers to the SNP will be redirected to the SPP. The same methodology will then be applied to private sector affiliates of the SPP. 29. By the end of 1999, the reconciliation process will be completed, and collections begun or authorized with respect to delinquent private sector employers enrolled in the extended payment program. Starting in July 1999, a vigorous program to inspect personnel records will be undertaken by the SAFP to determine the arrearages of private sector employers not enrolled in the extended payment program, and enforcement actions  - 47 - will be brought to require payment. An initial target has been set of 200 inspections by August 31, 1999 and an average of at least 100 inspections per month thereafter. Every effort will be made to exceed those targets. 30. To improve the net returns realized by workers from their contributions to the SPP, thereby making the SPP more attractive to potential affiliates and encouraging broader worker coverage, the government will undertake a study to identify measures, including regulatory changes, to reduce the AFP's operating costs. The study will also include an examination of options for introducing new pension products that may better match the needs and objectives of different groups of current and potential affiliates, as well as options to enhance competition among pension fund administrators, including allowing variations in the structure of contributions and commissions. In addition to this study, the government has equalized the affiliation procedures of the SPP and the SNP, and will take measures to increase incentives for affiliates to transfer from the SNP to the SPP, including fuller reflection of affiliate contributions in Recognition Bonds. 31. To permit the AFPs to better manage their risks, thus contributing to the reduction of systemic risks in the financial sector, the government will: identify categories of foreign assets that qualify as allowable investments of the private pension funds, eliminate the requirement of a positive real rate of return on pension funds in order to reduce systemic risk during a general market downturn, and review existing investment regulations with a view to expanding investment opportunities consistent with prudential adequacy and responsiveness to market possibilities. The regulations to be assessed will include, inter alia, limits on investments in Brady bonds and the subordinated debts of commercial banks, and participations in privatizations and in the local and international syndications of Peruvian companies. As macroeconomic conditions permit, the ceiling on the portfolio share of investments abroad for private pension funds will be increased. 32. The assets of the Consolidated Pension Reserves Fund (FCR) allocated to finance the service of the Recognition Bonds, and the incomes earned on those assets, are considered inviolable and will not be diverted to any other purposes. The government will also enhance the financial management of FCR funds, by employing professional investment advisers and introducing an adequate policy framework that will allow diversification for the fund's portfolios into assets with long-term maturities. At least US$220 million equivalent of the fund's portfolio will be made available for long-term investment during 1999. 33. To improve public system (SNP) collections in the future, the ONP has entered into a contract with the National Tax Superintendency (SUNAT), under which the latter will administer the collection process and create a register of affiliates that will allow the government to better project future pension obligations of the SNP. Based on annual projections of the future obligations of the SNP and CV systems, and of the resources of the FCR, it is the government's intention to define a strategy for controlling and covering future budgetary transfers for pension obligations. In addition, with a view to reducing the future fiscal obligations of the SNP, the government will carry out a study of alternative  - 48 - actions, including its possible conversion into a fully financed regime with individual accounts. V. Conclusions 34. Significant progress in modernizing the economy's financial sector and improving public policies in the social sectors has already been achieved. As described in this letter, the government is committed to making further progress in these areas. The policies to be implemented in the following two years should strengthen the soundness of the Peruvian financial sector and protect the poorest sectors of the population. Therefore, the Peruvian government requests your favorable consideration of its request for a new financial sector loan Yours sincerely, Vtory Wa( Mist of conomy and Finance  - 49 - Annex 3 ANNEX 3. TIMETABLE OF KEY PROCESSING EVENTS Time taken to Prepare: (Identification to Negotiations) 6 months Prepared by: Government and World Bank Staff Identification Mission Departure: November 26, 1998 Regional Operations Committee: April 26, 1999 Appraisal: May 3, 1999 Negotiations: May 25, 1999 Board Presentation: June 29, 1999 Planned Date of Effectiveness: July 15, 1999 Closing Date: July 31, 2000  - 50 - Annex 4a Peru Status of World Bank Operations IBRD/IDA As of 24-May-99 Original Amount in US$ Millions Fiscal Project ID Year Borrower Purpose IBRD IDA Cancellations Undisb. Number of Closed Projects: 71 Active Projects PE-PE-39086 1999 GOP URBAN PROPERTY RIGHT 38.00 0.00 0.00 36.00 PE-PE-54667 1998 GOVERNMENT OF PERU EL NINO EMERGENCY LN 150.00 0.00 0.00 118.23 PE-PE-40125 1997 GOVERNMENT OF PERU FONCODES II 150.00 0.00 0.00 65.80 PE-PE-42442 1997 GOVERNMENT OF PERU SIERRA NATURAL RES. 51.00 0.00 0.00 27.62 PE-PE-8037 1997 GOVERNMENT OF PERU IRRIG. REHAB 85.00 0.00 0.00 63.79 PE-PE-37047 1996 REPUBLIC OF PERU RURAL RDS. REHAB & M 90.00 0.00 0.00 20.90 PE-PE-8051 1995 SEDAPAL LIMA WAT.PRIVZN 150.00 0.00 0.00 75.76 PE-PE-8055 1995 GOVERNMENT PRIM.EDUC 146.40 0.00 0.00 90.88 PE-PE-8045 1994 GOVERNMENT TRANSP.RHB 150.00 0.00 0.00 19.89 PE-PE-8048 1994 GOVERNMENT BASIC HLTHINUTRITION 34.00 0.00 0.00 12.61 Total 1,044.40 0.00 0.00 531.48 Active Projects Closed Projects Total Total Disbursed (IBRD and IDA): 512.92 2,975.35 3,488.27 of which has been repaid: 0.00 1,237.13 1,237.13 Total now held by IBRD and IDA: 1,044.40 1,738.22 2,782.62 Amount sold : 0.00 18.31 18.31 Of which repaid : 0.00 18.31 18.31 Total Undisbursed : 531.48 0.00 531.48  - 51 - Annex 4b Peru Statement of IFC's Committed and Disbursed Portfolio As of 28-Feb-99 (In US Dollar Millions) Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1979/83/90/93 Buenaventura 0.00 1.69 0.00 0.00 0.00 1.69 0.00 0.00 1982/92/95 Wiese Leasing 8.18 1.43 0.00 8.57 8.18 1.43 0.00 8.57 1984 Minera Regina 1.89 0.00 0.00 0.00 1.89 0.00 0.00 0.00 1993/94 Yanacocha 5.02 .33 0.00 .71 5.02 .33 0.00 .71 1993/96 Quellaveco 0.00 0.00 11.52 0.00 0.00 0.00 8.86 0.00 1994 Banco Credito 5.14 0.00 0.00 0.00 5.14 0.00 0.00 0.00 1994 Peru Prvtzn Fund 0.00 20.00 0.00 0.00 0.00 13.89 0.00 0.00 1994 PPF Cayman 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1994/96 AFP Horizonte 0.00 .23 0.00 0.00 0.00 .23 0.00 0.00 1997 Interbank-Peru 20.00 0.00 0.00 100.00 20.00 0.00 0.00 97.98 1998 agroguayabito 7.00 1.00 0.00 0.00 0.00 1.00 0.00 0.00 1998 Latino Leasing 10.00 2.50 0.00 0.00 10.00 2.50 0.00 0.00 1998 Paramonga 22.00 0.00 0.00 23.00 14.18 0.00 0.00 14.82 Total Portfolio: 79.23 27.18 11.52 132.28 64.41 21.07 8.86 122.08 Approvals Pending Commitment Loan Equity Quasi Partic 1998 WONG 25.00 0.00 5.00 60.00 Total Pending Commitment: 25.00 0.00 5.00 60.00  - 52 - Annex 5 List of Protected Social Programs Second Semester 1999 ($US equivalent) Sector Program Sub Program Total Administration and Planning 366,239 f Administration Financial Assistance 366,239 Governmental Supervision and Coordination 107,831 Planning Agriculture 15,330,646 Administration General Administration 881,811 Preservation of Soil Conservation 1,561,897 renewable natural resources Promotion of Rural Extension 121 agricultural Agricultural promotion 984,542 production Promotion and Community Assistance 11,439,978 Social and Assistance to farming and indigenous 9,457 Community communities Promotion and Assistance Promotion and Rural Extension 270,630 Rural Extension Agricultural Promotion 182,209 Assistance and Social Insurance 148,052,804 Solidarity Assistance to farming and indigenous 511,431 Assistance communities Elderly Assistance 88,867 Child and Adolescent Assistance 6,108,354 Public Buildings 389,309 Promotion and Social Assistance 17,141,696 Promotion and Assistance to farming and indigenous 9,746 Social and communities Community Child and Adolescent Assistance 4,483,284 Assistance Financial Assistance 6,411,596 Promotion and Community Assistance 41,683,210 Promotion and Social Assistance 71,183,473 Promotion and Promotion and Community Assistance 41,837 Rural Extension Education and Culture 302,150,920 Administration Financial Assistance 188,481 Special Assistance Compensatory Education 5,785,560 Initial Education Daycare 12,88,579 Kindergartens 49,275,133 Primary Education Primary schooling 233,616,565 Eradication of illiteracy 4,887,181  - 53 - Higher Education University Extension 591,309 Higher University 15,228 Educational School Buildings 6,500,069 Infrastructure Public Buildings 2,815 % Energy and Mineral Resources 1,209,383 Energy Rural Electrification 1,209,383 l7 1Generation of Electric Energy 253,578 Justice 34,522,503 Justice Administration of Justice 29,605,416 Child and Adolescent Assistance 1,357,048 Defense of Constitutional and Legal 2,732,459 Rights lPublic Buildings 827,580 Fishery _ 300,556 Promotion of Development of fisheries 93,866 l_____________ fishery production Fostering fisheries 206,690 Health and Sanitation 146,756,466 Administration General Administration 30,765 Financial Assistance 3,472,851 Public Announcements 17,413 l _____________ ________________ F Public Buildings 10,946,362 Collective Health Basic food and nutrition 13,409,582 lBasic medical attention 113,817 Control of health risks and injuries 1,170,656 E,pidemiological control 5,352,197 PFublic Announcements 1,258,724 Applied research 484,174 Promotion and social assistance 1,005,276 Regulation and control 175,334 Ambulatory health 2,531,922 Individual Health Basic Food and Nutrition 4,052,924 Basic Medical Attention 65,055,361 Control of health risks and injuries 30,894,660 Public Buildings 2,495,040 l________________ Promotion and social assistance 1,642,253 Sanitation Environmental health 36,397 General sanitation 2,610,759 Transport 8,305,034 Land transport Rural Roads 8,289,155 lRehabilitation of highways 15,879 Housing and Urban Development 370,168 Urban Urban Planning 370,168 Development Total 657,726,128  - 54 - Annex 6 (Annual percentage change) Real GDP 7.3 2.5 7.2 0.7 3.0 5.5 6.0 Real domestic demand 11.9 0.2 6.7 -0.2 -1.3 4.7 5.6 Of which: private consumption 8.1 1.6 4.0 -0.3 1.6 4.0 4.8 Consumer prices End of period 10.2 11.8 6.5 6.0 6.0 4.0 3.0 Period average 11.1 11.5 8.5 7.3 4.5 5.1 3.5 Exports (U.S. dollars) 21.9 5.8 15.5 -17.7 12.4 15.0 11.4 Imports (U.S. dollars) 38.7 1.8 8.3 -4.1 -4.5 9.5 8.5 Terms of trade 2.8 0.2 5.2 -8.0 -10.3 3.0 4.1 Real effective exchange rate (- depreciation) -3.3 0.9 7.4 -11.1 ... ... ... I. Money and Credit Broad money 24.2 28.0 22.7 4.5 7.3 10.8 10.5 Credittothe private sector 33.0 35.6 36.9 13.7 13.4 9.7 8.7 Interest rate (annual rate) Loans in domestic currency 33.5 30.6 30.4 36.5 ... ... ... Loans in foreign currency 17.2 16.8 15.6 18.9 ... ... (In percent of GDP) II. Savings and Investment Gross domestic investment 24.4 23.3 24.5 24.6 22.9 23.6 24.1 Public sector 4.3 3.8 3.8 3.8 3.9 3.9 3.8 Private sector"' 20.1 19.5 20.7 20.8 19.0 19.7 20.3 National savings 17.1 17.4 19.1 18.4 17.8 18.6 19.2 Public sector"' 2.1 3.5 4.4 3.7 2.9 3.2 3.6 Private sector 15.0 13.9 14.7 14.7 14.9 15.4 15.6 External savings"' 7.3 5.9 5.2 6.2 5.1 5.0 4.9 Ill. Combined Public Sector Combined public sector primary balance 0.4 1.3 1.8 1.3 0.9 1.3 1.5 Central govemment 1.6 2.7 2.9 3.0 2.8 3.2 3.6 Rest of general government -1.6 -1.8 -1.9 -1.9 -2.1 -2.1 -2.2 Public enterprises 0.4 0.4 0.7 0.1 0.1 0.1 0.0 Central bank operating balance 0.0 0.0 0.1 0.1 0.1 0.1 0.1 Interest due 3.2 2.3 1.7 1.7 2.1 2.1 1.9 Financing 2.8 1.0 0.0 0.4 1.2 0.8 0.3 Extemal 2.3 0.7 -0.5 0.3 1.7 -0.1 -0.1 Intemal 0.5 0.3 0.5 0.1 -0.5 0.9 0.4 Privatization receipts (net) 1.5 3.2 0.8 0.3 1.4 1.6 1.1 Other'r -1.0 -2.9 -0.3 -0.2 -1.9 -0.7 -0.7 (In percent; unless othervise Indicated) Memorandum items: Velocity of money5 5.9 4.8 4.7 4.5 4.2 4.1 3.9 Credittotheprivatesector/GDP 15.0 19.5 22.2 25.5 29.0 29.9 30.6 Share of foreign currency deposits in total bank deposits 72.4 74.9 72.0 77.0 77.8 77.4 76.7 Share of foreign currency loans in total lending 71.1 74.2 77.2 78.8 81.7 81.9 81.8 Nonperforming loans/total loans' 6.1 5.4 5.8 8.1 ... - Provisions/nonperforming loans" 77.6 79.0 79.7 84.5 ... Risk-based capital-to-assets ratio 9.4 10.0 10.2 11.2 ... ... ... Total medium- and long-term foreign public debt/GDP7' 45.1 42.8 30.0 31.1 35.9 33.8 31.2 Total extemal debt to exports of goods and services 490.2 460.4 335.3 388.7 366.1 327.4 300.8 Public external debt service/exports of goods and services 37.9 30.9 23.8 28.1 25.9 23.4 22.6 Total grossofficial reserves to short-term extemal debt"' 89.3 109.7 110.8 92.8 93.9 114.2 113.9 Total gross official reserves to broad money 78.0 80.7 79.8 79.1 73.9 68.5 64.9 Gross reserves (in months of imports of goods and nonfactor servicese' 5.9 7.5 7.9 7.0 7.3 8.2 7.7 Sources: Central Reserve Bank of Peru; and Fund atff estimates. "Indudes changes in inventories. "Exdudes privatization rceipts. t GDP ronverted into U.S. dollars at the penod average exchange rate, Inicudes stabstcal descrepency, variation in domestic arrears, and impact of valuaton of privatization receipts at program exrhange rates. ' Defined as the inverse of the rteo of broad money to GDP. 'Annual average. r Indudes central Resenve Bank of Peru debt ' Includes debt service to the Fund. 8 Net of finandal intermediares! foreign currency deposits vwith the central reserve bank.  - 55 - Annex 6 A. Balance of Payments Current account -4,319 -3,604 -3,410 -3,900 -3,043 -3,009 -3,172 Merchandise trade -2,186 -2,000 -1,739 -2,589 -1,522 -1,322 -1,228 Exports 5,576 5,897 6,814 5,610 6,307 7,253 8,079 Imports -7,762 -7,897 -8,553 -8,199 -7,829 -8,575 -9,307 Services and transfers -2,133 -1,604 -1,671 -1,311 -1,521 -1,687 -1,944 Financial and capital account 3,696 4,565 5,012 2,587 3,349 3,501 3,679 Public sector -292 -415 -60 -76 1,084 -24 -196 Disbursements 567 463 777 783 2,011 749 725 Amortization -859 -878 -837 -859 -801 -773 -921 Bonds (net) 0 0 0 0 -126 0 0 Capital transfers (net) 19 3 -6 0 0 0 0 Privatization 547 1,688 145 50 850 942 685 Private sector 3,422 3,289 4,933 2,613 1,415 2,583 3,190 Foreign direct investment 1,536 1,882 1,884 1,918 1,395 2,394 2,895 Other private capital 1,886 1,407 3,049 695 20 189 295 Medium- and long-term loans 415 219 378 605 684 458 380 Portfolio investment 145 342 327 -370 -197 -36 -27 Financial intermediaries" 306 -205 2,683 -79 -188 -161 -159 Short term (incl. errors and omissions) 1,020 1,051 -339 539 -279 -72 101 Financing 624 -961 -1,602 1,313 -306 -492 -508 Change in central bank reserves (- increase) -933 -1,883 -1,628 949 -385 -492 -508 Exceptional financing 1,557 922 26 364 79 0 0 Debt relief 727 602 5,309 373 88 0 0 Change in arrears23 680 319 -6,138 -9 -9 0 0 Exceptional financing identified 150 1 198 0 0 0 0 Purchases of guarantees 0 0 -133 0 0 0 0 Financing of DDSR operations 0 0 790 0 0 0 0 B. External Debt (end-of-period data) Total external debt 33,433 33,466 28,013 28,834 30,482 33,665 33,835 Medium and long term 28,033 27,766 21,605 22,189 23,840 24,169 24,209 Public debt 25,652 25,197 18,787 18,911 20,062 20,038 19,842 Multilateral creditors 3,840 3,670 4,530 4,929 5,677 5,829 5,924 Bilateral creditors 11,462 11,237 9,043 8,712 8,733 8,604 8,456 Paris Club 9,424 9,152 8,677 8,445 8,558 8,477 8,360 Other bilaterals 2,038 2,085 366 267 175 127 96 Private creditors 10,350 10,290 5,214 5,270 5,652 5,605 5,462 Central reserve bank3' 955 924 795 650 466 361 217 Private 1,426 1,645 2,023 2,628 3,312 3,770 4,150 Short term 5,400 5,700 6,408 6,645 6,642 9,496 9,626 Total outstanding arrears 10,231 10,541 30 23 14 14 14 (In percent of GDP; unless otherwise specified) Memorandum items: Current account balance -7.3 -5.9 -5.2 -6.2 -5.1 -5.0 -4.9 In percent of exports of goods and services -63.3 -49.6 -40.8 -52.6 -37.5 -32.3 -30.9 Foreign direct investment and private medium- and long-term capital in percent of the current account deficit 45.2 58.3 66.3 64.7 68.3 94.8 103.3 Exports 9.4 9.7 10.5 8.9 11.0 12.0 12.6 Imports 13.1 13.0 13.1 13.0 13.7 14.2 14.5 Total medium- and long-term public debt4' 45.1 42.8 30.0 31.1 35.9 33.8 31.2 Public debt service5' 37.9 30.9 23.8 28.1 25.9 23.4 22.6 Sources. Central Reserve Bank of Peru; Ministry of Economy and Finance; and Fund staff estimates. "Includes variations in financial intermediaries' reserve requirements on foreign currency deposds. Includes accumulation of arrears to private and bilateral creditors pending the conclusion of debt negotiations, and payments and rescheduling of arrears. In 1997, stock of arrears includes prncipal only. Exdcudes the Central Reserve Bank Of Peru's reserve tranche with the IMF. nlcudes imputed interest on arrears; in 1997 includes principal arrears only. As a percent of exports of goods and services. Inlcudes debt service to the Fund.  - 56 - Peru at a glance Annex 7 Latin Lower- POVERlTY and SOCIAL America' middle- Peru & Carlb, Ancome; Development dlamond' Population, rbld-year (millions) 2417 494 2,285 Life expectancy GNP per capita (Atlas method, US$) 2,4600 3,880 1 230 GNP (Atlas method. U.S$ bilmon.5) 60.9 1,917 2.818 Average annual growth, 1091497 Population I(%) 2,0 1,7NP Labor force m% 3,1 23 1.3 GPGross per primary Most recent estimate (Istast year avaIlable, 199147) capita enrollment Poverty (% of poplation below national poverty line) 84 Urban populaiton f% of lotapopulf ioan) 72 74 42 Life expectancy t birth yer)69 :70 69 Infarnt mortality (perl,000 live bIrths) 40 32 36 Childmalnutrition (% ofchildren under ) 1.,Access to safe water Access to safe water (%ofp'opullatiorl) 80 ~ 73 34 llliteracy(%Notpopulalion age 15+) 11 13. 19 Gross primary enrollmient (% of school-age population) 123 111 11'ller Mvale 126 5 118 Lower-middle-income group Female 121., 13 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1976 1986 1996 1;997 Economic ratlos* GDP (US$ b lon)15.5 13.0 81.0 639 Gross domestic i)nvestmentlGDP 21.9 21.4 23.3 24.5Trd Exports of goods and serviceL-sGOP 12.0 13.9 12.0 12.6Trd Grossdornestic savings/GflP 13.8 20.0 18. 20.8 Gross national savings/GDP 15.3 17.3 192T current account balanoeIGDP -7.7 -7.7 -59.9 -omst.3' Interest p4yments/GPI 2.2 1.3 2.1 1.~3 DoetcInvestment Total debt lGDP 48.8 82.8 481 ~47. Savings Total debt service/expeirts 49.3 210 35.5 31.1 Present value of debt/GDP .,38.9 Present value of debtlexports . .. 287.2 Idbens 1976-6 1987-9 1996 1997 1998-02 (average annual growth) GDP 1.3 2.3 2.5 7.2 4.1 -Peru GN4P per capita -1,4 1.1 -0.2 0.5 2.4 Lower-middle-income group 1~xp~oftsgoods,and services 2.4 6.1 10.2 13.0 10.5 _______________ STRUCTURE of the ECONOMY 1976 1936 1996 1997 Growth rates of output and Investment(% (%. of GDP) 40 Agriculture 15.3 11.2 7.4 6.9 Industry 34.2 27.4 36.9 36.4 20 Manufactcnumping 74.1 24.2 23.2 22.09 0 9 ~ 4 Services 50.5 61.1 55.8 56.7 0 I General govemment consumption 12.2 9.6 8.1 8.4 GDI ---GDP Imports of goods and servir-es 20.2 15.3 16.4 18.6 ________________ (average anual growth)1976486 1987-97 1996 1997 Growth rates of exports and Imports ) Agriculture 1.4 3.0 5.0 0.5 30 Industry 1.5 1.6 2.6 5.9 Manufacturing -0.1 1.2 2.5 6.0 20 Services 1.0 2.7 1.8 8.8 10 Private consumption 0.5 1.6 1.6 4.1 General govemment consumption 1.3 0.0 1.9 4.6 0 Gross domestic investment -0. 1 5.8 -3.1 12,7 92 93 94 99 95 97 Imports of goods and services -1.3 8.3 0.6 11.3 Exports l--mports Gross national product 1.0 3.2 1.8 2.4 __________________ Note: 1997 data are preliminary estimates. The diamonds show tour key indicators in the country (in bold) compared with its income-group average, If data are missing, the diamond will be incomplete.  - 57 - Peru PRICES and GOVERNMENT FINANCE Domestic prices 1976 1986 1996 1997 Inflation (%) (% change) 000 Consumer prices 33.3 77.9 11.8 6.5 400 Implicit GDP deflator 29.1 74.7 9.8 8.3 300 200 Government finance 100 (% of GDP, includes current grants) 0 - Current revenue .. 12.6 14.2 14.1 02 93 94 95 95 97 Current budget balance .. -3.7 3.4 2.2 GDP deflator : CPI Overall surplus/deficit .. -7.3 -1.2 -0.9 TRADE (US$ millions) 1976 1986 1996 1997 Export and Import levels (US$ mIllilons) Total exports (fob) .. 2,576 5,897 6,814 10,000, Copper .. 451 1,052 1,096 Fish flour .. 206 835 1,031 8,0000 Manufactures . 653 1,590 2,043 5,000 Total imports (fob) . 3,179 7,885 8,552 4,000 Food .. 432 1,072 1,107 w i i Fuel and energy .. 84 734 780 2,000 Capital goods .. 1,016 2,417 2,816 o 91 92 93 94 S 05 6 97 Export price index (1995=100) 66 102 97 Import price index (1995=100) .. .. .. . * Exports K Imports Terms of trade (1995=100) .. .._.._.. BALANCE of PAYMENTS (US$ millions) 1976 1986 1996 1997 Current account balance to GDP ratio (