Colombia - Structural Fiscal Adjustment Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No: 27420 IMPLEMENTATION COMPLETION REPORT (TF-26673 FSLT-70920) ON A LOAN IN THE AMOUNT OF US$400 MILLION TO THE REPUBLIC OF COLOMBIA FOR STRUCTURAL FISCAL ADJUSTMENT DECEMBER 5, 2003 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Exchange Rate Effective December 5, 2003) Currency Unit = Peso MXP$ 11.410 = US$ 1 US$ 0.0876 = MXP$ 1 FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS Vice President: David de Ferranti Country Director Isabel M. Guerrero Sector Director Ernesto May Task Team Leader/Task Manager: David Michael Gould  COLOMBIA CO Structural Fiscal Adjustment Loan CONTENTS Page No. 1. Project Data 1 2. Principal Performance Ratings 1 3. Assessment of Development Objective and Design, and of Quality at Entry 2 4. Achievement of Objective and Outputs 5 5. Major Factors Affecting Implementation and Outcome 9 6. Sustainability 10 7. Bank and Borrower Performance 11 8. Lessons Learned 12 9. Partner Comments 13 10. Additional Information 14 Annex 1. Key Performance Indicators/Log Frame Matrix 15 Annex 2. Project Costs and Financing 21 Annex 3. Economic Costs and Benefits 23 Annex 4. Bank Inputs 24 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 26 Annex 6. Ratings of Bank and Borrower Performance 27 Annex 7. List of Supporting Documents 28  Project ID: P073572 Project Name: CO Structural Fiscal Adjustment Loan Team Leader: David Michael Gould TL Unit: LCSPE ICR Type: Core ICR Report Date: December 29, 2003 1. Project Data Name: CO Structural Fiscal Adjustment Loan L/C/TF Number: TF-26673; FSLT-70920 Country/Department: COLOMBIA Region: Latin America and the Caribbean Region Sector/subsector: Sub-national government administration (32%); Central government administration (26%); Compulsory pension and unemployment insurance (16%); Health (16%); Health insurance (10%) Theme: Public expenditure, financial management and procurement (P); Other economic management (P); Other public sector governance (S); Health system performance (S); Tax policy and administration (S) KEY DATES Original Revised/Actual PCD: 09/17/2001 Effective: 12/20/2001 Appraisal: 11/02/2001 MTR: Approval: 12/18/2001 Closing: 02/21/2003 Borrower/Implementing Agency: GOVERNMENT OF COLOMBIA/MINISTRY OF FINANCE Other Partners: STAFF Current At Appraisal Vice President: David de Ferranti David de Ferranti Country Director: Isabel M. Guerrero Olivier La Fourcade Sector Manager: Mauricio Carrizosa Mauricio Carrizosa Team Leader at ICR: David M. Gould Vicente Fretes-Cibils and Marcelo Giugale ICR Primary Author: David M. Gould and William Wiseman 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: S Sustainability: L Institutional Development Impact: M Bank Performance: S Borrower Performance: S QAG (if available) ICR Quality at Entry: S Project at Risk at Any Time: No There is no Quality at Entry Report available for this project  3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: Introduction Colombia's fiscal situation deteriorated noticeably in the mid-1990s, characterized by both significant deficits and the creation of large future liabilities. The primary causes of this situation were structural in nature and reflected the rapid expansion of the public sector and an increase in pension liabilities. Despite increased public sector spending, the government of Colombia could not respond to mounting social demands to provide essential services, most importantly in the realm of peace and security. The problem was compounded by structural rigidities in the tax and public expenditure systems that made it difficult to allocate scarce resources in an efficient and effective manner. Such a restricted fiscal position made Colombia particularly vulnerable and ill prepared to respond to the sharp economic recession that unfolded after 1998. Today, Colombia's economic situation shows tentative signs of growth and the fiscal situation, while still vulnerable, has shown sustained signs of improvement. Colombia's rate of economic growth has turned from a 4.2 percent decline in 1999, to 1.7 percent growth in 2002 and may reach as much as 3 percent growth this year. Moreover, the non-financial public sector deficit has fallen from 6.2 percent of GDP in 1999 to around 4 percent in 2002. The SFAL assisted the government in two important ways. First, it helped the government to begin a process of slowing the growth of fiscal imbalances. The proceeds from the loan helped to reduce the cost of borrowing and to lengthen the debt maturity by providing a confidence-building signal to international markets, all of which gave the government fiscal space for protecting social sector expenditures and implementing difficult structural measures. Second, the SFAL promoted reforms in the provision of public services that improved incentive structures and provided substantial efficiency gains. As a result, the fiscal rigidities facing the Colombian government were reduced and the fiscal situation is gradually stabilizing--important first steps in putting Colombia on a sustainable fiscal path. As recognized in the SFAL initiating documents, the loan was not without significant risk, especially considering that the program would be implemented over two different presidential administrations. But despite the risk undertaken, there was a tangible payoff to the program. While many of the reforms promoted by the SFAL are still only in their initial stages of implementation, the SFAL provided an important impetus to the government's reform program. Without support from the Bank it is doubtful that these reforms would have progressed as they have. Nonetheless, fiscal sustainability has not yet been achieved and further support for these reforms to ensure long-term sustainability is critical. Ongoing support is being provided by the Bank through a continuing program of Fiscal Institutional Adjustment Loans (FIALs) as well as other adjustment programs. However, the fiscal situation is still difficult as evidenced by a recent constitutional court ruling against a planed increase in the value-added tax, higher than expected military expenditure, and the failure to garner enough votes for the passage of an important fiscal adjustment referendum. Although a "Plan B" has been formulated by the government as an alternative to the referendum that can be implemented by executive decree, the near-term trajectory remains uncertain. Original objective The overall objective of the operation was to support the government's commitment to improve Colombia's fiscal accounts and implement structural fiscal reforms, an essential first step toward reaching full fiscal sustainability, sustaining high economic growth and achieving poverty reduction. The program focused on a core set of policies that strengthen the country's fiscal outlook. This policy package included: (a) - 2 -  rationalizing the system of transfers to local governments, and imposing more market-driven and more binding budget constraints on their finances; (b) establishing mechanisms to arrest the exploding cost of inefficiency in the provision of public health services; (c) halting the accumulation of pension-related contingent liabilities; (d) advancing the reorganization of public agencies and their current expenditures; and (e) setting up a better system for managing public debt. The components of the loan presented a package of reforms aimed at addressing the structural rigidities in Colombia's fiscal accounts. The loan was viewed as responsive to the borrower's circumstances in the light of fiscal rigidities that remain a key constraint to effective public policy in Colombia. It is also viewed as responsive to the borrower's development priorities given that it sought to promote a reform agenda identified and developed by the government itself. While the number of policy and institutional reforms was high, the program was not overly complex and the domestic commitment to the reform agenda meant that the goals of the loan were realistic and achievable. 3.2 Revised Objective: The Objective was not revised 3.3 Original Components: The FSAL supported a fiscal reform program that addressed six key areas with the aim of meeting the objectives described above. The Bank's financial support was programmed for disbursement in three tranches over a 14-month period with the disbursement of each tranche being tied to advances in the implementation of the fiscal reform program, including the meeting of certain key indicators (details of the conditions are provided in Annex A). Component 1: Macroeconomic framework; l Maintain a macroeconomic framework consistent with the objectives of the program. Component 2: Intergovernmental fiscal relations; l Implement a reform of the fiscal transfer system from the central government to subnationals, limiting the rate of growth of fiscal transfers and the rate of growth of the central administration operational expenditures for 2002 and thereafter. l Reform the tax system of territorial entities (Estatuto de Ingresos Territoriales) to increase subnational tax revenues by more than 20% in its first year of application. l Issue and implement a decree to regulate debt and borrowing of territorial entities that will contribute to halting unsustainable borrowing, limiting bailouts, and eliminating discretionality in the treatment of debt. Component 3: Health l Approve a national public hospital restructuring policy and implementation program, including the selection of at least ten departments and covering more than 15 percent of the FY01 public hospital budget. l Sign contracts with at least three subnational governments to finance the restructuring of public hospitals, including specific targets for labor cost reductions and productivity increases. - 3 -  l Transform at least 60% of the situado fiscal in FY01 (after legal mandatory deductions) to demand subsidies. Component 4: Reform of the Social Security Institute (ISS) l Implement a restructuring plan for ISS that will make it financially and economically viable, including negotiations with ISS unions about labor costs and benefits, debt restructuring including renegotiating 50% or more of ISS debt, and the reduction of at least 30% in the waiting list for elective surgeries. Component 5: Pension l Create a new social security department in the Ministry of Finance for improving social security system control that should generate substantial fiscal savings. l Congressional approval of a new law to reform the general pension system with the aim of putting it on a sustainable fiscal path or a law to reform at least one of the exempted pension regimes to bring them in line with the general pension regime. Component 6: Public Sector Reform l Reduction in total central government current expenditure in the government's approved budget for FY02 of more than 4 percent in real terms. Actual expenditure should not exceed these levels. l Reduction in central government's general expenditures of more than 15 percent in real terms in the government's approved budget for FY02 in relation to the same expenditures in the FY00 executed budget. These expenditures should be no higher in real terms than spending incurred in FY01. Component 7: Education l Amendment of the law to provide for certification of municipalities that represent at least 40 percent of the country's school enrollment enabling such municipalities to autonomously manage the provision of education services (including teacher payroll) and to establish education performance monitoring mechanisms; or (b) certification of municipalities that represent at least 14 percent of the country's school enrollment enabling such municipalities to autonomously manage the provision of education services (including teacher payroll) and intergovernmental performance agreements have been signed between the Central Government and such certified districts and municipalities. In either case, no extra budgetary transfers for education to certified districts or municipalities have taken place. 3.4 Revised Components: The components were revised, but not substantially. A partial waiver was sought for release of the "floating tranche" relating to the commitment to approve the new subnational tax law (Estatuto de Ingresos Territoriales, component 2, part 2 above). Although the law that was passed did not contain the exact measures envisaged in the draft law submitted to Congress, it complied with the overall goal of increasing subnational revenue. Nonetheless, the revision of this component did factor into the overall rating of the - 4 -  program. 3.5 Quality at Entry: Quality at entry is rated satisfactory based on: (i) consistency of objectives of the loan with the government of Colombia's reform agenda and therefore, (ii) strong ownership of the program on behalf of the government, (iii) demonstrated capacity of the implementing agency, and (iv) adequate project design that correctly identified risks and mitigating factors. The country assistance update note issued on November 16, 2001 considered the adjustment loan operation as a way to support fiscal reforms and Colombia's ongoing efforts in this area. Overall, the components described above were adequately designed for meeting the general objectives of the loan (i.e., beginning the process of putting the fiscal accounts on a sustainable trajectory). Partnership with the IMF in monitoring and supporting the macroeconomic environment was extremely helpful during a period of particularly turbulent external economic conditions and domestic security concerns. The components of the loan took into account the capacity of the implementing agencies and the lending instrument itself was appropriate for the objective. The design of the lending program, which included two scheduled tranches and final floating tranche, allowed for sufficient flexibility to accommodate the uncertain timing in the completion of the final conditions of the loan (particularly the congressional approval of territorial tax reforms). With the benefit of hindsight, the restructuring of the Social Security Institute (ISS) would likely have benefited from a longer-term strategy to boost management and implementation capacity during the loan period to ensure success. Restructuring of the ISS has lagged other reforms due to, in part, strong vested interests, but also to a lack of a clear strategy for reform. To address this problem, the management of the ISS is currently formulating a strategy for further reform, but much work still needs to be done. In addition, a slower disbursing programmatic loan, utilizing executed budget figures rather than initial approved budget figures, would have proved a more accurate monitoring indicator for judging fiscal stance, but the programmatic approach was not available at the start of the SFAL. The relatively short period between disbursements required monitoring indicators based on partial and preliminary assessments of budget outlays and not final outcomes. The trade-off, of course, is that waiting for final budget figures would have substantially delayed the country's much needed access to funds. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: Outcome is assessed as satisfactory The SFAL proved to be an important element in ensuring the continuity of fiscal reform during the political transition in Colombia. While the loan was approved and the first tranche released during the Pastrana administration, the new Uribe government demonstrated a solid commitment to continuing fiscal reform through the SFAL and fulfilled the requirements for disbursement of the second and floating tranches of the loan. The program achieved many of its immediate goals as set out in the conditions for tranche release. This initiated a series of reforms that in the medium-term will produce further improvement towards fiscal - 5 -  sustainability and the provision of services. While the SFAL took initial steps to restrain growth in spending and reduce moral hazard with regards to subnational governments and decentralized social security institutions, needed supplementary measures to effectively reduce budgetary entitlements are being pursued in subsequent projects. Similarly, the SFAL took important steps towards institutionalizing a system of inter-governmental fiscal agreements for the provision of education services that will also take several years to bear significant results. Although it is too early to determine if the program had a measurable impact on trend economic growth or poverty, it likely helped the country weather an extremely volatile external environment by reducing market concerns over the sustainability of its fiscal imbalances. Many of the reforms initiated under the SFAL have been continued with the support of the Bank through the Fiscal and Institutional Adjustment Loans (FIAL I and II) and through the Labor and Social Structural Adjustment Loan. 4.2 Outputs by components: Component 1: Macroeconomic framework; This element is rated satisfactory During the program period Colombia encountered several economic challenges. It faced issues of contagion resulting from economic problems in Venezuela, the largest market for Colombia's nontraditional exports; the worsening of market sentiment toward Latin America; and slow economic recovery in the United States, Colombia's main trading partner. Internally it faced increasing security costs at the same time as it was undergoing a political transition. In light of these issues and its efforts to maintain a stable economy, despite a significant deterioration in its fiscal deficit in 2002, the macroeconomic framework is evaluated as having been consistent with the objectives of the program. Fiscal performance improved markedly between 1999 and 2001, but the public sector finances weakened in 2002. When the Uribe administration took office in August 2002, the deficit of the combined non-financial public sector risked rising to nearly twice the target of 2.6 percent of GDP under the IMF's Extended Fund Facility (which started in 1999). The fiscal slippage reflected increased military spending, a revenue shortfall on account of lower-than-expected economic growth and spending commitments made by the previous administration. Economic activity in 2002 was sluggish (real GDP growth was about 1.6%) and inflation remained subdued (7% year-on-year). International reserves increased in 2002 and there was no major central bank intervention to support the currency, which depreciated in nominal terms against the US dollar. Due to weak demand for imports and the domestic currency depreciation, the current account deficit fell to about 1.8% of GDP in 2002 from 2.5% of GDP in 2001. Faced with the fiscal challenges, the new government took steps to rein in the budget deficit. First, it levied a one-off tax on net wealth to finance the effort to take control of the security situation. Second, in December 2002, it presented and won approval by Congress for a policy package containing both temporary and permanent taxation measures. While the deficit ultimately rose to 4.1 percent of GDP in 2002, it was less than what may have occurred had the new administration not acted decisively when it did. Following the actions of the government to reign in the deficit, in January 2003, the IMF board approved a two-year SDR 1.5 billion Stand-by arrangement in support of Colombia's economic program. The government has successfully completed reviews under the recent stand-by arrangement with the IMF up through the end of March 2003. While the failure of October's referendum on fiscal reforms has raised questions about the country's ability to meet its fiscal targets under the IMF program, the government has been working on implementing an alternative strategy (with support from the Bank and the IMF) to achieve similar results. - 6 -  Component 2: Intergovernmental fiscal relations; This element is rated satisfactory. The government committed to implement a reform of the fiscal transfer system from the central government to subnationals, limiting the rate of growth of fiscal transfers and the rate of growth of the central administration operational expenditures. The Constitutional reform of 2001 combined the three major sources of transfer financing into the Sistema General de Participaciones. Within this reformed framework, the government explicitly prohibited the distribution of any cash transfers to subnational governments except where the distribution is specified by formula or law. On the expenditure side, the constitutional reform limited the rate of growth of total transfers to subnational governments to last year's inflation plus 2 percent and limited the growth of central operational expenditures to inflation plus 1.5 percent. To help control general administration costs, subnational governments received structural adjustment loans to finance downsizing of personnel. The government also committed to regulate subnational debt, and in accordance with Law 617 of 2000, since July 2001, the central government has not provided bailouts to territorial entities or guarantees on their debt. Further, it linked borrowing by subnational entities with the rating of two international credit rating agencies and restricted commercial borrowing for all entities having loans subsidized under Law 617 of 2000. The commitment to reform the tax system of territorial entities (Estatuto de Ingresos Territoriales) to increase subnational tax revenues by more than 20%, was substantially met by the passing of Law 788-2002, which is projected to raise subnational revenues by the stipulated margin in 2003 and is on its way to doing so. The measure of greatest fiscal importance in the draft law submitted in 2001 was the rationalization of alcoholic beverages taxes that was included in Law 788-2002 along with measures to establish rates and rules for setting gasoline taxes, norms on the taxable value of mortgages and open collaterals and the use of public-private systems for collecting registry taxes, and norms on tax procedures for departments and municipalities. In regard to this law, a waiver was sought for the release of the floating tranche given that the draft law was not approved in its original form. However, as mentioned above (section 3.4), the final version of the law contained most of the intended results of the proposed reforms and had the effect of increasing subnational revenue by more than 20%. Component 3: Health sector; This component is rated satisfactory The government's main commitments with respect to health services were to (a) reduce inefficient supply-side subsidies; and (b) limit the fiscal costs to the national government while improving service. Under the SFAL, the government implemented a National Hospital Restructuring Policy. The pilot phase of the program in 2002 covered more than 10 departments and 15% of the total hospital budget. The program included specific targets for cost reduction and productivity increases which generated more than 5% in fiscal savings per month. The government also completed its commitments to transform over 60% of the situado fiscal from supply subsidies to demand subsides. Component 4: ISS Reform; This component is rated unsatisfactory The government implemented a restructuring plan although it did not achieve its goal of putting the ISS on a financially and economically viable path. The specific measures implemented included renegotiating special-benefit agreements with the labor unions, restructuring the ISS debt, improving its financial management, eliminating 8,000 vacant positions, and closing ambulatory health facilities. The government still plans to restructure the provision of direct health services and reduce the operation of the ISS to make it consistent with current and future demand and the possibility of closing the ISS if the reform process is not successful is still an option. It is clear that further reform and sustained capacity building will be - 7 -  needed if ISS is to become a viable organization. Component 5: Pension; This element is rated satisfactory The government created the Social Security Economic Regulation Agency (Direcci