Ecuador - Public investment review

repr No. :567fi-EC 1 itador: Public Investment Review 16,ernber 16, 1985 ,.atin America and the Cariblxzicn Regional Otfice O jOFFICIAL USE ONLY rt, i,. , i . 6 .... ': ', ,: ,,62 P jq j,1 : | }14 , 11 en~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~. . .... ! 4 a;L., :,.S, ''. .S ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~1'! : -k,'t 12i -ocument of the Wla rI' c' 21 ank Thisdocument has a rewstrirted uiltribution d ndi rn-y he u'.lt-d bv re plients Q,pnly in the performancte (- It heir Official duties its contentsin may not otherwise be disclosed without \,Vo irld B.ink autthor izationr. ! a; . /t 0 :;, ' ' ' 4, "t' 94'.~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~I ' .' . i . , " ,,i P ,,,i~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~  CURRENCY EQUIVALENTS Currency Unit: Sucre (SI) Intervention Rate Calendar 1984 September 1985 US$1 = s179 = Sf96.5 S/.1 = USS.O1 = US$.O1 S/.1,000 = US*12.57 = US$10.3b  FOR OFICILL USE ONLY GLOSSARY Or DEIAIE BEDE Banco Ecuatoriano de Desarrollo (Development Bank of Eciador) BEV Banco Ecuatoriano de la Vivienda (Ecuadorian Housing Bank) BNF Banco Nacional de Fomento (National Development Bank) BCE Banco Central del Ecuador (Central Bank of Ecuador) CEDEGE Comision de Estudios para el (Guayas Basin Development Desarrollo de Rio Guayas Comnnission) CFN Corporacion Financiera Nacional (National Finance Corporation) CEPE Corporacion Estatal Petrolera (Ecuadorian Petroleum Ecuatoriana State Corporation) CREA Centro de Reconversion del Azuay, (Economic Development Center for Canar y Morona-Santiago Azuay, Canar y Morona-Santiago) CONADE Consejo Nacional de Desarrollo (National Development Office) DNH Direccion Nacional de Hidrocarburos (Hidrocarbons National Directorate) DPCT Direccion de Planificacion y (National Directorate of Transport Coordinacion de Transporte Planning and Coordination) ENAC Empresa Nacional de Almacenamiento (National Entity for Storage and y Comercializacion de Productos Sale of Agricultural Products) Agropecuarios ENPROVIT Empresa Nacional de Productos (National Basic Products Company) Vitales FONAPAR Fondo Nacional de Participaciones (National Participation Fund) FONAPRE Fondo Nacional de Pre-inversion (National Pre-inversion Fund) FOPEX Fondo de Promocion de Exportaciones (Export Promotion Fund) IDB Inter-American Development Bank IEOS Instituto Ecuatoriano de Obras (Ecuadorian Institute of Sanitary Sanitarias Works) IESS Instituto Ecuatoriano de Seguridad (Ecuadorian Social Security Social Institute) IETEL Instituto Ecuatoriano de Telecomu- (Ecuadorian Telecommunications nicaciones Institute) INE Instituto Ecuatoriano de Energia (Ecuadorian Energy Institute) INEC Instituto Nacional de Estadisticas (National Institute of Statistics y Censos and Census) INECEL Instituto Ecuatoriano de Electri- (Ecuadorian Electrification ficacion Institute) INERHI Instituto Ecuatoriano de Recursos (Ecuadorian Institute of Water Hidraulicos Resources) INFA Instituto Nacional de la Familia (National Family Institute) INIAP Instituto Nacional de Investi- (Kttional Institute of Agricultural gaciones Agropecuarias Research) IThis dociuent has a resricted disibution and way be ued by reLipients only in the perfmlnce of| heir oftrKim duties. Its onntents may not otherws be disdosed without Wodd Bank autoizaton.  -2- PAHO Oficina Panamericana de la Salud (Panamerican Health Organtition) PREDESUR Programa Regional para el Desarrollo (Regional Program for the Deve op- del Sur del Ecuador ment of Ecuador's South) SEDRI Secretaria de Desarrollo Rural (Secretariat for Integrated Rural Integral Development) SECAP Servicio Ecuatoriano de Capacitacion (Ecuadorian Professional Tra!ulng Profesional Center) SOE State Owned Enterprise UCCV Unidad Coordinadora de Caminos (Feeder Road Coordinating Unit) Vecinales USAID US Agency for International Development Fiscal Year January 1 - December 31  SYNOPSIS This report, undertaken at the request of the Ecuadorian Govern- meut, analyzes the likely investments of the Ecuadorian public sector in the period 1985-88. The report provides macroeconomic projections that serve as a basis for estimating probable resources available, to both private and public sector, and assesses which public investment projects correspond more closely to the social and economic objectives of the Government. A brief analysis of the major institutional constraints that cut across all the sec- tors follows the macroeconomic projections. Chapters III to XI provide a brief description of the major public investment projects, evaluate the Government's proposed investment and recommend a list of priority projects.  ECUDOR: PUBLIC INVESThIT REVXW TABL OF CONTENTS Page No. EXCUITIE SUNKARY .................................... i-is Io IEE M NACRZOECNOIC FRANE0RK 1 Introduction 1.................1 Basic Assumptions ............. 3 Petroleum Production ....................... 3 Petroleum Consumption and Exports 3 Traditional Exports 4 ......4 Other Erports 4 Foreign Indebtedness and Direct Foreign Investment ............. 4** ......... 4 Foreign Exchange Availability-.-...0 ......... 5 Economic Growth .........6...................... 6 Private Savings and Investment 6 Credit Erpansion 6............ .........0 ..... 6 Public Sector Revenues ........................ 9 Petroleum Export Revenues .................. 9 Domestic Sales of Petroleum Products o...... 10 Non-Petroleum Revenues .............. 11 Other Income . 12 Public Savings .............................0* 13 Public Investment .... .... .... ... 15 Sensitivity Analysis ................. ..0-0 16 This report is based on the findings of an economic mission which visited Ecuador in November 1984. The mission was composed of: Pedro Belli (chief); Werner Dobisch (power specialist); Lea Donaldson (sanitary engineer); William McGreevey (health economist); Katherine Sierra (transport economist); Richard Lacroix (consultant, agriculture); Carmelo Mesa-Lago (consultant, social security); Humberto Petrei (consultant, public sector); and Yves Pret (consultant, irrigation specialist). Mr. Earl Kessler from USAID Resident Mission in Ecuador contributed to the Chapter on Housing. Mrs. Irene Chacon typed the Report.  -2- Page No. II. INSTITUTIONAL ISSUES ...... ................ . 18 Core Development Policy and Economic Management Agencies ......... ....................................... 18 Budget Preparation .............................. 18 Budget Execution ............................... 20 National Project Selection System ...........*.... 21 Monitoring Project Execution .................... 22 Earmarking ............ O-* ..................... 23 Pricing of Publicly Supplied Goods and Services . 25 III. PETROLEUM . ................................. 27 Introduction .*................................... 27 Energy Sector Organization ...................... 27 CEPE's Investment Program ............. .. ......... 28 Evaluation of CEPE's Investment Program ......... 29 Exploration ................................ 29 Oil Field Development ....................... 30 Storage and Transportation ................. 31 Refineries ................................. 31 Associated Natural Gas .................. . .. 32 Recommendations ..... ............................ 33 Other Sector Issues ............... ......... 33 Production Rates ... ....... .................. 33 Organizational Problems ................O.... 34 Exploration Contract ....................... 34 IV. ELECTRIC POWER SECTOR .................. o... ...... 35 Introduction ................... ................ 35 Power Sector Organization ..... .................. 35 Demand ................ ......... ........... 36 Existing Power Facilities ....................... 37 The Power Sector Investment Program ........... . . 37 Evaluation of INECEL's Investment Program ....... 38 Generation ................ ... * ..*........... 38 Transmission and Substations ............... 41 Subtransmission and Distribution ........... 41 Studies . ...... ........... .. .. ............. 41 Recommendations ............................ ..... 42 Other Sector Issues ............. ......... . 43  -3- Page No. IV. ELECTRIC POWRE SECTOR (Cont.) Financial History and Present Situation .... 43 Financial Structure ................. .. ... ... 43 Tariffs .................................... 44 Operating Costs ....................... ..0 45 Financial Prospects ...... . --0... .......... 45 Recommendations *................................. 46 V. AGR.C.L.URE *.........****.........*............. 47 Introduction .................* ....... .... *0****.. 47 Sectoral Organization ......... . .......... 48 Public Investment in Agriculture ................ 49 Evaluation of Public Investment in Agriculture .. 50 Irrigation .............................................. 50 Rural Development ............... . ........... 52 Research and Forestry ...................... 53 Recommendations ................................. 53 Other Sector Issues ............................. 54 VIe TRANSPORT AND COIUIIC.A&IONS .... ......... ...... 56 Introduction . .. ............ 56 Sectoral Organization ........................... 56 Public Investment in Transportation ............. 57 Evaluation of Public Investment in Transportation 58 Investment Priorities ..................... 58 Roads * .................................... 58 Ports ..................................... 61 Aviation ...... ......... ................ 61 Railways .......... .. 62 Telecommunications .........-.............. 63 Recommendations ......... ....................... . 63 Other Sector Issues ....... ....... 64  -4- Page No. VII. EDUCATION 6.................... ..........6 Introduction .... ....................... 66 Sectoral Organization .......................... 67 Sectoral Problems .............................. 68 Equity ......... ............................ 68 Quality and Efficiency ..................... 68 Primary Education .......................... 69 Secondary Education ........................ 69 Higher Education ........................... 70 Evaluation of Public Investment in Education .... 71 Primary Education .......................... 72 Secondary Education .. ...................... 73 Higher Education ........................... 74 Adult Literacy ............................... 75 Vocational Training .......6-4............. 75 Other Investments .......................... 76 VWIII. HEALT]H ................................. ................ 78 Introduction ................... .. ........ 78 Sectoral Organization ..................... 79 Health Resources and Infrastructure ............ 79 Stated Priorities vs. Actual E-rpenditures ...... 80 Shortcomings of Present Investment Strategy .... 80 Recommendations ... o ............................ 81 Ministry of Public Health .................. 81 IESS Investments in Health Facilities ...... 83 Reorganizing the Health Sector ....... o .......... 84 Other Sector Issues ...66-........ .......... .......0. 84  -5- Page No. IX. SOCIAL SECQRITI ................ 86 Introduction ... ......... ..... ............... 86 Social Security Investmeats ................ 86 Equity Considerations ........................... 86 Coverage ... ......... ................. 86 Benefits and Entitlement Conditions ........ 87 Contributions 87 Efficiency Considerations ........ .... 89 Health Care . ............ 89 Administrative Expenditures . ....... 89 Low Yield Investments. . ...... 90 State Debt .. ......................... 91 Recommendations .................. ......... 92 X. WATER SUPPLY AD SANIAIO .................... 93 Introduction ........ ............... 93 Sectoral Organization .......93 Sector Financing ...... 94 Sectoral Efficiency and Equity .... ..... 94 Efficiency ........-. - .............. 94 Equity ................... 95 Recommendations ......................... -. ... 95 Other Sector Issues 97 XI. BDUSING. ............. .... ..... 98 Introduction .... .................. ....... 98 Public Investment in Housing .................... 99 Equity Considerations ......... ........ 100 Efficiency Considerations ........... -....... 101 Managerial Financial Constraints .......101 Housing Finance and BEV ....... 101 Housing Finance and IESS ................... 102 Conclusions .. ... ...... . ............ 103 STATISTICAL APPENDIX ................. 104 - 195 MP  ECUADOR: PUBLIC lNVEITEI REVI3E LIST OF TEXT TABLES Page No. CHAPTER I I.1 Projected Petroleum Production, Consumption and Exports, 1985-88 ..................... ................ ... 3 1.2 Sources and Uses of Foreign Exchange, 1985-88 ............. 5 I.3 Economic Growth, 1984-90 ............... ... . ............. . 6 1.4 Private Sector Account, 1984-88 ........................... 7 I.5 Monetary System Account Stocks, 1984-88 ................... 8 I.6 Expected Public Revenues from Petroleum Exports, 1985-89 . .. ............................ ........ 10 I.7 Projected Domestic Sales of Petro]eum Products, 1984-88 ... 11 I.8 Non-Petroleum Tax Tucome of the Public Sector, 1983-88 .... 12 I.9 Distribution of Transfers from Petroleum Revenues to the NonrFinancial Public Sector, 1985-88 ................... 13 I.10 Public Sector Account, 1984-88 ................. 0......O..-* 14 I.11 Recommended Public Investment Program 1985-88 ............. 16 1.12 Total Commodity Exports, 1985-88 ....................... 17 CHAPTER III II.1 CEPE's Investment Plan, 1985-88 ......29 II1.2 Recommended Investments in Petroleum Sector, 1985-88 ...... 33 CHAPTER IV IV.1 Electrification Rates in Selected South American C,ountries ..................0...... 35 IV.2 Estimates of Demand for E]ectric Energy 1985-95 ........... 36 IV.3 INECEL's Proposed Investment Plan in Power Sector 1985-88 ......................................... 39 IV.4 Recomended Investment Plan in the Power Sector, 1985-88 ........ 42 IV.5 INECEL: Earmarked Petroleum Revenues Received Relative to Capital Expenditures 1975-83 ............... . 43 IV.6 INECEL: Electricity Tariffs, 1970-84 .......... ........... 44 IV.7 Projected INECEL Income Statement, 1985-89 .... ............ 45 IV.8 INECEL: Key Financial Indicators, 1985-89 (as a Function of 25 Percent aad 50 Percent Tariff Increase) 46  -2- Page No. CHAPTER V V.1 Proposed Investment Program in Agriculture, 1985-88 ..-..... 49 V.2 Recommended Investments in Agriculture, 1985-88 ........... 54 CHAPTER VI VI.1 Proposed Transport Investment Program 1985-88 ............. 57 VI.2 Ongoing Projects not Justified or Overdesigned ............ 59 VI.3 Recommended Road Investment Program, 1985-88 .... .60 VI.4 Proposed vs. Recommended Investment Prograi in Transportation, 1985-88 .....99999................ 999999 63 CHAPTER VII VII.1 Public Expenditures on Education in Various Countries 99999 66 VII.2 Student Enrollment 1970 and 1983 .............. ............ 67 VII.3 Student Enrollment in Secondary School ..................... 70 VII.4 Proposed Public Investment in Education, 1985-1988 ...*..............*.. ..... 9999 72 VII.5 Recommended Public Investment in Education, 1985-88 ....... 76 CHAPTER VIII VIII.1 Selected Health Indicators in Six South American Countries, 1982 ....... .9999....O.......9..9...9..9 78 VIII.2 Recommended Ministry of Public Health Expenditures on Health, 1985-88 ........ ......... * 82 VIII.3 Recommended Distribution of Capital Expenditures Between Primary Health Care and Hospitals, 1985-89 ...... 83 CHAPTER IX IX.1 Total Legal Contributions to Social Security, Selected Groups of Insured: 1984 ...........*..*.....**.*.**..... 88 IX.2 Index of Real Value of Annual IESS Pensions, 1970-82, Selected Years 999...................*................ 91  -3- Page No. CHAPTER X X.1 Water Supply and Sewerage in Selected Latin American Countries ............................................... 93 X.2 Recommended Public Investment in Water Supply and Sewage, 1985-88 ............................................. 97 CHAPTER XI XI.1 Housing Finance and Illustrative Market Segmentation, 1984 ........... ........................... 98 XI.2 Government's Housing Investment Program, 1985-88 .......... 99 XI.3 Housing Bank's Investment Program ......................... 100 GRAPHS 1.1 Public and Private Investment, 1980-88 .... ................ 15 IV.1 Electric Energy Balance, 1984-96 .......................... 38  ECUADOR PUBLIC INVESTMENT REVIEW EXECUTE SUMARY i. Ecuador has both the human and natural resources to ccntinue recovering from the 1982-83 recession and enter a period of sustained econo- mic growth. The country's oil reserves are ample enough to provide the Authorities with a financial breathing spell while they continue to implement the policies necessary to re-orient the economy towards other ewports and away from inefficient import substitution. Ecuador can go through this adjustment process without a major financial and economic disruption, but the outcome is uot preordained; the transition period will require very careful management of the economy. ii. During the adjustment period-indeed, even without adjustment-eco- nomic growth will be constrained by foreign exrchange and savings. Two of the main past sources of foreign exchange-rising international petroleum prices and foreign loans--will be drastically reduced. In addition, Ecuador will have to bear the burden of an e'rternal debt whose interest payments will absorb about one-quarter of its erports and about one-third of its domestic savings. These burdens will dampen growth and incomes. Without the adjust- ment and proper policies, however, growth and incomes will be far less. iii. In a complete reversal of the recent past, the savings effort will have to be undertaken mainly by the public sector. Higher domestic prices for petroleum products sold by CEPE, the state petroleum enterprise, and the recent devaluations of the sucre could increase public revenues relative to the rest of the economy. The public sector not only needs to avoid increasing public consumption, it also must save enough to finance effective investment projects and have monies left over to provide the monetary system with resources to increase credit to the private sector. A public sector surplus will be necessary to substitute, albeit partially, the generous foreign borrowings of the late 1970s and early 1980s. For this reason, it is recommended that no newl projects be started until 1987 or even 1988. This delicate balance between public and private needs will present a most demanding challenge to the Authorities' fiscal discipline. iv. To encourage efficient resource use, the Authorities need to con- tinue with their program of economic reforms (liberalizing trade, continue increasing domestic petroleum product prices), and also tackle institutional obstacles. At a minimum they a]so have to (i) avoid a real appreciation of the exchange rate; (ii) set interest rates at positive real levels in order to encourage resource mobilization and increase the likelihood that the private sector will invest efficiently; (iii) adopt financial instruments that would ease cash flow problems on long-term loans at times of high nomi- nal interest rates; and (iv) reduce the degree of earmarking in order to have more control over the use of public revenues. A reform of the public sector budgeting and investment planning processes would also help enhance the effi- ciency of resource use in the sector. v. This report, based on the findings of a mission that visited Ecuador at the Government's request, provides a macroeconomic framework to estimate probable resources available, analyzes the public investment pro- gram, and assesses which projects correspond more closely to the social and  - ii - economic objectives of the Government. The report also recommends an invest- ment program that is consistent with both resources available and the need to transfer funds to the private sector via the monetary system. Petroleum vi. Investments in secondary recovery, oil field rehabilitation and the ancillary activities (pipelines and storage) that aid oil exports are Ecuador's best short-term hope of alleviating the foreign exchange con- straint. There is no other activity--be it in the private or the public sec- tor-that can generate so much foreign exchange as fast as secondary recovery and oil field rehabilitation. For every dollar invested in these activities during the next four years, Ecuador could expect to increase its exports by as much as thirteen dollars. In the medium term, however, only new discov- eries through exploration will prevent oil exports from falling. To avoid the latter, the Government needs to define further its exploration strategy, especially the division of labor between CEPE and the multinational oil com- panies. Ecuador needs to drill at least 18 wells per year to prevent exports from falling. CEPE's exploration plan for 1985 is excessively modest-it calls for only one well. If CEPE is to have a more active exploration pro- gram in the future, it needs to hone its skills by drilling at least four vells per year. If the Government would prefer the multinational oil compa- nies to carry the exploration burden by themselves, the exploration service contract must be made more attractive. vii. CEPE's investment program in refinery facilities has undergone trimming and improvement. In particular, the Atahualpa refinery--a billion dollar proposition with a negative rate of return7--has been postponed indef- initely. Other planned refinery investments are sound. The small refinery in the Amazon region designed to supply the needs of this remote region is particularly attractive. The expansion of the Esmeraldas refinery is less attractive, but could be undertaken if suppliers' credits are available. viii. The Amistad natural gas field in the Gulf of Guayaquil has consi- derable natural gas reserves that could serve as another source of energy. There is, however, no marketing study and hence no economic feasibility study. These two studies should be undertaken before investing in the exploitation of this natural resource. ix. Domestic petroleum products prices are an important ingredient of the careful economic management that Ecuador will require. Higher domestic prices are necessary not only to channel more resources to the public sector, but also to improve the balance of payments. The ability of the Authorities to tackle domestic petroleum products prices is one of the key assumptions of this report's projections. Electric Energy x. Ecuador has twice as much electricity generating capacity as peak demand. Once the Agoyan Hydroelectric Project enters into operation in 1987 with 150 MW, there will be enough generating capacity to meet demand until 1993. INECEL's investment program is designed to substiture hydrogeneration for therwal in order to save fuel for exports (or reduce the need for  - iii- imports). This is a good justification, but one that needs to be compared with others that achieve the same result (secondary recovery, for example). At the time that the mission was in the field, INECEL's investment plan included two projects (Paute -C- and Daule-Peripa) that would be best delayed. xi. Paute -C- is a hydroelectric project consisting of a tunnel to carry water from the existing Paute-Amaluza dam to a turbine. The total cost of the project is estimated at US$250 million; its generating capacity at 500 MW, for a cost of only US$500,000 per MW. The Paute-Amaluza dam, however, is silting so fast that at the present rate it will be fully silted in five to six years. The Paute-Mazar dam, to be built upstream, was considered by INECEL as one of the solutions to the silting problem. Aside from its cost -about US$900 million-silting is taking place so fast that by the time Paute-Mazar is built, Paute-Amaluza would be silted. The mission recommends that initiation of work on Paute -C- be delayed one or two years, until alternative solutions to the silting problem are studied (including a diver- sion tunnel), and to cancel the project if the siltation problem has no eco- nomically sound solution. xii. The Daule-Peripa Hydroelectric Project is not needed until the early 1990s and could be delayed one or two years. In any event, its rate of return (if calculated solely on fuel savings) is on the threshold of accepta- bility (lower than that of Esmeraldas expansion, for example) and INECEL has more urgent needs, such as the completion of its distribution system. As domestic demand catches up with generating capacity, Daule-Peripa will become a more economically attractive project. The mission recommends postponing this project at least one year. xiii. INECEL plans to complete its transmission ring in the central part of Ecuador and also to establish links between the ring and remote centers of consumption. These investments are of high priority. INECEL needs to com- plete its distribution network in order to diminish distribution losses, improve the efficiency of its system, and reach more consumers. These investments also have a high priority. Last, but not least, INECEL needs to increase electricity prices to discourage wasteful consumption and improve its finances. Agriculture xiv. In the medium term, agriculture has the potential to become again one of Ecuador's engines of economic growth, second only to petroleum. Although public investment in the sector may help realize this potential, the Authorities' economic policies regarding the exchange rate, interest rates, and agricultural prices will be more influential. xv. Annual public investment in agriculture was 10 percent of total public investment, or 0.7 percent of GDP in 1975-83. About 80 percent of this investment has been channelled to infrastructure-irrigation, roads, and water supply. Planned investments follow the same pattern, with the bulk directed to irrigation works, in particular Daule-Peripa and Tahuin. Inves- munts associated with integrated rural development emphasize roads, water  - iv - supply and schools and amount to 16 percent of the investment plan in agri- culture. Only a small proportion (7 percent) is allocated to research and extension services. xvi. According to the IDB, Daule Peripa, a multiple purpose project, has a low rate of return, but at this point it is so far advanced that to stop it would be more costly than to finish it. The project's main components include a dam, irrigation works on both banks of the Daule river, and a hydroelectric plant. Financing for the dam and irrigation works on the river's right bank is firm; but financing for the rest is not. The hydro- electric component may be deferred a year or two without major economic loss; deferral of the 33,000 ha. irrigation component on the river's left bank is not advisable on economic grounds, but scaling it down might be justifiable, and is worth investigating. The Tahuin dam is also very far advanced and it would not be economical to halt its construction. The irrigation channels of both projects have yet to be constructed, but it would be preferable to finish them also. Medium-size and smaller irrigation projects do not absorb much resources, but often are started without an economic evaluation and/or regard for INERKI's execution capacity. As a result, lengthy delays are com- mon. The mission recommends that no more irrigation works-small, medium, or large--be started without previous rigorous economic evaluation. xvii. It would be desirable to improve agricultural extension and research. Owing to low technological levels and poor agronomical techniques, national yields in Ecuador are generally low. But the country lacks the ins- titutional capacity to use research and extension as effective development tools. The mission does not recommend reducing the budget of these two acti- vities, but institutional strengthening and fund disbursement ought to pro- ceed in parallel. xviii. Execution of integrated rural development projects, with the excep- tion of the social components, has been agonizingly slow. In particular, the feeder road component has lagged behind all others. These are powerful argu- ments for abandoning the rural development effort altogether. On the other hand, the investments associated with these projects (feeder roads, rural health, and rural education) are all of high priority. Feeder roads, in par- ticular, are required to increase rural incomes, provide the wherewithal to give proper maintenance to schools and health facilities, and stimulate the demand for credit. The main obstacle to the construction of feeder roads has been the low priority granted them by the Ministry of Public Works. The mission recommends that rural development projects be given one last chance urder a different institutional arrangement. Transportation xix. Ecuador made impressive progress in the 1970s in the expansion of its transport network, more than doubling the total length of paved roads, increasing the length of gravel roads by 50 percent, and adding some 5,200 kms. of earth roads. Ecuador now has an adequate primary road network. With three major ports and two international airports, Ecuador also has adequate maritime port and international airport facilities. The country also has a dilapidated railroad that serves no useful economic purpose. Ecuador's needs are now concentrated in maintenance of its primary road network; reconstruc-  tion of the roads damaged by floods in 1982-83; and construction of feeder roads, secondary roads, and domestic airports, the latter particularly in the remote Oriente regions where the road network is inadequate or non-existent. xx. The Government's investment program places emphasis on new primary road construction, two new international airports, and rehabilitation of the railroad. Over a quarter of the funds allocated for ongoing roads is for roads that are either not economically justified or overdesigned. By lower- ing design standards, stopping investment in uneconomic roads, and deferring lesser priority roads two to three years, the emphasis of the road program would automatically fall on road rehabilitation and feeder road construction, satisfying more closely the country's economic needs. xxi. Ecuador does not need two new international airports. The safety hazards of the Quito airport limit service to daylight traffic. Traffic diversion to Guayaquil, when necessary, is time consuming and inconvenient, but the time savings associated with a new Quito airport would not appear to justify the US$250 million investment. Better navigational aids, however, may be warranted at both Quito and Guayaquil airports. Domestic airports in the Oriente region are important. This remote region needs to improve its communications with the rest of the country, but its sparse population does not warrant road construction and airports are a better alternative. xxii. Rehabilitation of the railway would cost about USS100 million and would have a negative rate of return. It is not advisable on economic grounds. xxiii. Ports have enough capacity to handle traffic during the next five years. The port of Guayaquil may need minor dredging and some minor invest- werts to improve efficiency. Education xxiv. The Ecuadorian u,dstitution stipulates that 30 percent of the Cen- tral Government's budget should be spent on education, and as a result, Ecuador's public expenditures on education are among the highest in the world relative to both Central Government expenditures and GDP. This requirement, together with rapidly increasing fiscal revenues during the petroleum boom, enabled Ecuador to accelerate educational services to a rapidly increasing population. Students in primary education increased by 65 percent between 1970 and 1984 and those in secondary education doubled. Ecuador is one of the few middle-income countries to have practically attained nine years of universal education in its urban areas, although rural areas are less well served. xxv. Primary rural education shows the greatest deficiency and requires the highest priority. In addition to more classrooms, better and cheaper textbooks are required. Also, more bilingual teachers (Spanish-Quechua) are needed. In urban areas more classrooms will be needed owing to rural-urban immigration. xxvi. The rapid increase in enrollment at the secondary level has had a deleterious effect on quality. High school graduates are often ill prepared to enter the labor force-their training is often too theoretical and defi- cient in the skills needed by employers. The emphasis of current expendi- tures needs to be redirected towards quality improvement as opposed to expan-  - vi - sion of services. More needs to be spent on school maintenance, utility bills, and consumable teaching materials. Books are in short supply, their quality is wanting, their contents inappropriate, and their cost too high. Equipment is also scarce. The Government could consider a more active role for secondary private schools, using scholarships as a means to provide edu- cation to qualified but needy students. xxvii. Ecuador has 17 institutions of higher learning, nine of which are technical schools. Free tuition combined with free admission have created a large demand for university studies by high school graduates who are ill pre- pared to enter the labor market. The universities, whose budgets swell with enrollment, have consistently accommodated their demand. At present rates, by 1990 fully 7 percent of Ecuador's labor force would possess university degrees-a percentage well above that observed in countries at a similar stage of development and even some developed countries. Quality improvement through consolidation of existing campuses and specialization, rather than expansion, is the number one priority in higher education. These goals do not require substantial additional resources, but rather a redistribution of resources away from higher education towards primary rural, primary urban, and secondary education, in that order. Public Bealth xxviii. Public expenditures on health care increased at an annual real rate of about 13 percent between 1973 and 1982, and health conditions improved considerably in Ecuador. In the past 20 years, the life expectancy of Ecuadorian citizens increased by 12 years, infant mortality was cut in half, and fertility fell by about 20 percent. Ecuador now spends 3.3 percent of its GDP on public health care-only a slightly lower proportion than its neighbors. xxix. The improvements, however, have not been widely shared. Neither rural nor periurban residents have the population and health services avail- able to urban residents. Infant mortality hardly declined in the less developed provinces, while it fell by more than one-quarter in Guayas and Pichincha. In rural areas the infant mortality rate is at least twice the national average. Delivery of services is also uneven. For over half the rural population, public health facilities are practically inaccessible. Only a third of pregnant women receive prenatal care, a fifth of births are attended by professionals, and fewer than one child in 20 receives any medi- cal care at all between ages one and five. Finally, delivery of services also varies among public sector entities. In general, IESS members and the military receive better health care than the rest of the population (except for those who can afford private health care). xxx. Past allocation of resources placed excessive emphasis on hospital- based care instead of basic care offered through health posts and health clinics. At present, both the overall hospital occupancy rate and the number of attendants per hospital bed are low--58 percent and 0.7 respectively. Ecuador's present needs-and the Ministry of Public Health's stated priori- ties-are in basic health care directed primarily at women of childbearing age and their children; workers, and the aged. A redistribution of resources away from hospital-based health care and towards basic health care is called for.  - vii - xxxi. Curtailing funds for new hospital construction need not reduce the quality and coverage of hospital-based care if accompanied by better coordi- nation of efforts between IESS and the Ministry of Public Health. New hospi- tal construction is not advisable. The Ministry of Public Health already has many unfinished facilities whose construction has been halted for lack of resources to provide for staffing, equipment, and maintenance. Social Security xxxii. In social security, as well as in education and health, Ecuador has made considerable progress. Coverage of the total population and of the work force more than doubled in the past 20 years. Insured members are covered against many risks, and the social security system has consistently generated a cash surplus. Benefits, however, are unequally distributed. Certain groups are legally excluded and coverage of legally included groups favors urban areas. The financial viability of the system, moreover, is now in jeopardy owing to negative real yields on the Social Security Institute's investment portfolio, a large debt owed by the State, high overhead, and overly generous benefits. These problems not only impede an accelerated expansion of IESS services, they gradually decapitalize the pension fund. xxxiii. With only 11 percent of the total population and only 23 percent of the work force covered by social security, Ecuador ranks in 16th and 13th place respectively, among Latin American countries. Coverage is higher in the more urbanized provinces, among the higher income groups, and among Government employees. With few exceptions, the neediest are excluded from the system. Those insured enjoy more benefits and easier conditions for entitlement than in most countries of the region. The overall retirement age-55 years of age with 30 years of work-places Ecuador among the four Latin American countries with the lowest retirement age. xxxiv. The IESS's administrative costs are among the highest in Latin America. In 1983 they set a record for the hemisphere; 17.4 percent relative to current expenditures. Administrative expenditures in other Latin American countries range from 3 to 13 percent and in two-thirds of the countries is below 9 percent; in developed North American, European, and Asian countries they range from 2 to 3 percent. On the other hand, the IESS not only manages a pension plan, but also provides medical care and runs what in effect is the country's largest housing bank. To fund these activities, the generous bene- fits available to its members, and meet the exigencies of its inefficient administrative apparatus, IESS charges the 6th highest contribution rate in Latin America. xxxv. IESS'j health orientation is similar to that of the Ministry of Public Health. The emphasis is on curative rather than preventive medicine and on urban, low-health risk groups, rather than on pregnant women and children. Coverage of the rural population is minimal, despite a peasant insurance program. xxxvi. Owing to the relative youth of the insured population and the growth in the number of insured in recent years, the IESS has had a substan- tial cash surplus throughout its history. The Institute has invested these funds in low-yield financial instruments mostly in subsidized loans to its members often at negative real interest rates. As a result, about 65 per- cent of the purchasing power of the portfolio has been eroded by inflation.  - viii - If IESS had invested its portfolio at interest rates above inflation since 1974-say 3 percent higher than inflation-its portfolio would now be worth approximately three times as much as its current book value. Systematic delays by the State in honoring its obligations with the IESS have aggravated this situation. Fortunately, IESS has also invested in real estate, counter- acting to some extent the erosion of its equity. xxxvii. IESS' investment practices are taking a financial toll that is becoming evident. IESS' current surplus as a percentage of current income has declined from 43 percent in 1976 to less than 10 percent in 1983. An actuarial deficit (the difference between expected payments and expected con- tributions) estimated at S/457 billion already exists. If these practices continue, a cash deficit will occur before the end of the decade. Thus, rather than contributing to domestic savings, the IESS could soon be dis- saving. Fortunately, the IESS has also investead in real estate, counter- acting to some extent the erosion of its equity. xxxviii. The Government of Ecuador still has time to avert an IESS financial crisis. The Institute's internal efficiency could be improved by freezing new hirings, controlling the growth of salaries and benefits, and firing incompetent personnel. The decapitalization of the pension fund could be arrested if (i) IESS investments are shifted to higher-yielding financial instruments; (ii) special programs--e.g., health-are self-financed; and (iii) the State pays its obligations on time. IESS also needs to make con- tributions and benefits more uniform and to coordinate its delivery of health services more closely with the Ministry of Public Health. Water Supply and Sanitation xxxix. Ecuador has also made considerable progress in providing its popu- lation with potable water and sewerage services, but service levels are still among the lowest in South America and the benefits have not been equally shared. Systems, moreover, are highly inefficient (40 to 60 percent of losses being the norm) and the quality of service is generally poor. Although there is a clear need to improve water and sewerage services, there are many institutional obstacles that must be overcome in order to improve both the investment planning process and the efficiency of resource use in the sector. xl. Planning is usually overoptimistic and construction does not always await secured financing. At present, over 60 percent of works in construc- tion are paralyzed for lack of financing. Efficiency of resource use has been adversely affected by poor design criteria, lack of capital cost recovery, and inappropiate suppliers' loans. xli. Proposed investment in the sector correctly emphasizes water supply over sewerage. In addition, the mission considers that higher priority should be accorded to those projects that redress service level disparities and that complement other public investments. In addition, practical consi- derations dictate that those communities with a s-rong commitment to adequate maintenance and cost recovery practices be given preference, as well as those projects with realistic demand forecasts. In water, projects in execution which deserve first priority include Guayaquil (first stage), Mendez, Tabacundo, Puyo, Salitre, Macara, Corazon-H4oraspungo, and Polara. New pro- jects include Mica-Tambo, La Troncal, San Lorenzo, El Empalme, Zamora,  - ix - Guayaquil (second stage), Riobamba, Cuenca, and Otavalo. In sanitation, the higher piiority projects in execution include Arenillas, Huaquillas, Santa Rosa, Macara and Quevedo; new projects include El Empalme, Quito, Machala, Zamora, and Cuenca. Hmuiug xlii. According to the 1982 census, there are about 600,000 dwelling units in Ecuador that lack sewage, water, or electricity. In addition, there are 45,000 new families being formed yearly. It is in this sense that Ecuador has both qualitative and quantitative housing deficits. xliii. Public sector intervention in the housing market has traditionally taken place through IESS and the Ecuadorian Housing Bank (BEV). IESS has been the dominant institution with about 60 percent of all housing loans out- standing, including those granted by the private financial institutions. xliv. In order to fulfill an electoral promise, the Government charged BEV with the responsibility of implementing a very ambitious housing plan that calls for delivering some 225,000 housing units (including sites and services) during the Government's four-year term (1985-1988). If fulfilled, this plan would be tantamount to quadrupling BEV's annual highest historical output in every year from 1985 to 1988. BEV has already taken steps to strengthen its managerial skills in order to meet the target, but it is too early to tell whether these steps are enough. At this point BEV's four-year plan is merely indicative and only the 1985 plan is firm; the 1986-1988 portion of the plan is yet to be financed. BEV, furthermore, is looking to 1985 as a test year to assess what further measures are required to deliver the Government's ambitious housing plan. xlv. BEV's indicative four-year plan is well-directed; funds are alloca- ted to housing units that are within the reach of the majority of Ecuadorian families. The main problem with the Government's housing plan lies with the financial instruments now permitted within Ecuador's legal framework and with the plan's financial requirements. These financial instruments were con- ceived during times of stable prices when nominal interest rates were low. The recent upsurge and ensuing variations in inflation have rendered these instruments obsolete and new instruments with variable interest rates are needed. These obsolete instruments with high, nominal, fixed interest rates render real initial payments excessively high and real final payments corres- pondingly low. As a result, they price many families out of the market, families whose incomes, in the absence of inflation, would enable them to buy even the more expensive housing units. Moreover, unless inflation remains stable, these instruments entail a windfall gain for either the lender or the borrower. At present interest and inflation rates, a 15-year loan entails an implicit subsidy from BEV to the borrower amounting to about one-third of the loan. BEV needs to adopt instruments embodying variable interest rates during the life of the loan with some form of capitalization of interest or indexing of principal. Of course, BEV alone cannot design new financial instruments, it must await a reform of the entire financial systems IESS dominance of the housing market and low-interest rate loans (6 percent per year compared to BEV's 21 percent) introduce another problem that not only distorts the housing finance market, but threatens to decapitalize IESS. Although these financial issues are not the main subject of this report, they are of vital importance to the efficient use of resources and to Ecuador's future growth.  1. TM MACROECONOMIC FRANKR Introduction 1.01 Ecuador is emerging from the recession which brought its GDP down by about 3 percent in 1983. In 1984 real GDP grew by about 4.1 percent owing to the recovery of the agricultural sector from the floods that ravaged the countryside in 1982-1983, substantially higher petroleum production, and the positive effects of policies and actions taken by the Authorities as far back as 1982. Ecuador has both the human and natural resources to emerge quickly from the recession and to enter a period of sustained economic growth. In particular, the country's oil reserves are ample enough to pro- vide the Authorities with a financial breathing spell while they continue to implement policies to re-orient the economy tnward exports and away from inefficient import substitution. Ecuador can effect this process without a major economic or financial disruption, but there is nothing inevitable about the outcome and the transition period will require very careful management of the economy. 1.02 This report, based on findings of a mission that visited Ecuador at the request of the Government during November 1984, analyzes the likely future investments of the Ecuadorian Government. In addition to providing a macroeconomic framework which estimates the probable resources available, the report takes a detailed look at the major investment projects to be carried out by the public sector and assesses which of these correspond more closely to the Government's social and economic objectives. 1.03 Ecuador's growth prospects will depend critically upon petroleum exports and international petroleum prices. In 1984, petroleum accounted for about 72 percent of all commodity exports, about 15 percent of the country's GDP, and 50 percent of Central Government revenues. The country is so dependent on oil that whatever happens to the volume of oil production, or to international oil prices, overshadows developments in the rest of the eco- nomy. For example, since the 1950s, Ecuador has been the world's number one banana exporter, with about 20 percent of world market share. If Ecuador were to double its exports of bananas and thereby increase its share of the world market to 40 percent, the gains from such a heroic undertaking would be wiped out by a USS2 drop in oil prices. A careful assessment of petroleum export prospects, therefore, is essential to estimating overall resource availability. 1.04 But the country's growth will not only be subject to external events; the economic policies adopted by the Authorities will also greatly influence it. During the 1970s, the sucre appreciated in real terms, but through successLve de7aluations, in September 1984 it stood at a level which made it as at:ractive to exporters as it was in 1970. Between then and July 1985, the Ecuadorian consumer price index rose about 22 percent, while infla- tion--adjusted for exchange rate fluctuations-in Ecuador's main non-oil export markets has been practically nil. This real appreciation of the sucre was reversed in September 1985, when virtually all trade was unified at the depreciated, intervention rate. Nevertheless, the adoption of future policies which ensure that the sucre does not appreciate in real terms is the most important ingredient in the Authorities' careful economic management. Together with the exchange rate, the interest rate, and the quality of the  public sector investment program will determine how quickly the country's per capita income can recover to the 1982 level and for how long it can sustain the modest rate of the growth enjoyed in 1984. 1.05 The next five years will differ in many ways from the past decade. Despite the country's abundant petroleum resources, growth will be con- strained by scarce foreign exchange and the weight of an external debt whose interest payments will take up at least 25 percent of the country's exports and as much as one-tenth of its GDP. Private savings will also be a con- straint. The slow recovery from the income contraction of the early 1980s will place a premium on private consumption to keep the standard of living from falling and will make savings less attractive. Foreign savings, which accounted for about 7 percent of GDP in the 1970s, may fall by more than half to about 2.5 percent of GDP in 1985 and to even less in 1986-88. 1.06 The savings constraint will require substantial modification of the public sector's behavior. As in the past, the public sector will play an important role in defining the macroeconomic framework in its traditional role as policy maker. In addition, its behavior as an economic agent will have a crucial impact on the funds available for investment to the private sector and on the country's long-term economic prospects. In a complete reversal of behavior of the recent past, the public sector will have to gene- rate a volume of savings high enough to finance its own investments and still have sufficient funds left over to provide resources for non-inflationary monetary expansion to the private sector and thus partially compensate for the virtual disappearance of the generous foreign borrowings of the late 1970s and early 1980s. Otherwise, not only will funds for private investment be scarce, private economic activity-and the exports it could create-will remain depressed. To control inflation, the monetary system's credit expan- sion will have to be minimal; it may not be until about 1987 that credit to the private sector may expand in real terms and even then only if the public sector generates an overall surplus on the order of 3 to 4 percent of GDP. 1.07 This enhanced role of the public sector will be possible because of the State's status as the country's main exporter. The devaluations of the sucre and the recent unification of the exchange rate are expected to bring about a major shift in relative prices, increasing the relative importance of petroleum in the economy and with it the role of the public sector. 1/ 1.08 The Authorities also plan to continue increasing domestic petroleum product prices until they are comparable to international prices. This will shift income from the private to the public sector, further enhancing fiscal receipts and the importance of the public sector in the economy; its current receipts will jump from about one-quarter of GDP (1970s and early 1980s) to over one-third of GDP. To the extent that the Authorities succeed in main- taining the real exchange rate (a key assumption in this report) the shift will enhance the public sector's position in the economy. The efficiency 1/ Petr3leum exports in 1985 may be equivalent to 19 percent of GDP. The same -olume of exports (at 1982 prices) would have been equivalent to only 14 percent of GDP in 1982. The difference is due to the devaluation.  -3 - with which the public sector handles this income will determine to a large extent the economic well-being of the Ecuadorian population in the years to come. These conclusions rre based on detailed projections of the balance of payments, the public sector accounts, and the monetary and private sectors. The rest of this chapter presents the basic assumptions, the resulting resource availability for both public and private investment, and the most likely growth rates. The discussion also pinpoints some of the most important decisions required to attain the desired goals. Basic Assumptions Petroleum Production 1.09 According to recent projections of the Ministry of Natural Resources and Energy, annual petroleum production will average about 97 mil- lion barrels in 1985-1988, peaking in 1986 at 99 million. This level comt- pares with the 86 million barrel level of 19t3. In the opinion of the mis- sion, this projection is within the country's reach and could even be sur- passed with appropriate investments and institutional changes, as discussed in Chapter III. Petroleum Consumption and Lbports 1.10 Domestic consumption of petroleum derivatives rose at annual average rate of 14 percent during the 1970s, owing to rising income and declining real prices. As a result of the slowdown of the economy in the early 1980s and higher domestic prices for petroleum products, domestic con- sumption in 1983 was slightly lower than 1980. Low GDP growth and rising domestic real prices in 1985-1988 point to a very slow growth of demand during the coming years. Petroleum exports, consequently, may increase com- mensurate with production, peaking in 1986 and dropping thereafter, as shown in Table I.1. If international petroleum prices stay constant in real terms, Ecuador can expect to receive about US$2 billion per year from crude petro- leum and fuel oil exports in 1985-1988. With the investment suggested in Chapter III, these projections could be surpassed and, if petroleum prices hold, exports could be higher. Table I.1: ECUADOR - PROJECTED PETROLEUM PRODUCTION, CONSUMPTION AND EXPORTS, 1985-88 (Million Barrels per Year) 1985 1986 1987 1988 Production 96.5 99.0 96.2 96.9 Domestic Consumption 39.6 40.7 39.7 40.6 Net Exports a/ 56.9 58.3 56.5 56.3 a/ Excludes exports of crude exchanged for refined petroleum products. These amount to about 8-9 million barrels per year of crude equivalent. Source: CONADE and Ministry of Energy and Natural Resources.  -4- Traditional Exports 1.11 World demand for three of Ecuador's four main non-oil exports- bananas, coffee and cocoa-is expected to grow somewhere between 1 and 2.5 percent per year. If the sucre does not appreciate in real terms during the next five years, Ecuador may keep its shares of the world market and even increase them moderately. The country's export earnings from these three products could reasonably be expected to range between US$450 and US$500 mil- lion in 1985-1988. Other Exports 1.12 Fishery exports are Ecuador's fourth major non-petroleum export. These exports grew from 42 thousand metric tons in 1977 to 66.6 thousand metric tons in 1983, for an average annual rate of growth of about 12 per- cent. By 1983 Ecuador had become the second largest shrimp exporter in the world (after Mexico) and total fishery exports were second in value only to petroleum. It may be possible to sustain these annual growth rates through the next five years and Ecuador's export earnings might increase from US$240 million to US$360 million in 1985-1988. Other exports might provide Ecuador with some US$130 million per year in 1985-1988 and in total, commodity exports might average about US$3 billion per year. 1.13 A necessary, although not sufficient, condition to reach these export levels is an adequate exchange rate. The real appreciation of the sucre until September 1985 was worrisome. If this were to recur, even the modest growth projections of this report might not come to pass. ForeiLgn Indebtedness amd Direct Foreign Innestmmt 1.14 Ecuador's external debt management is also an important considera- tion. In the latest renegotiation of its external debt in late 1984, the Ecuadorian Authorities successfully arranged for a multi-year rescheduling of the country's commercial bank debt. However, no new commercial money was asked for 1985 and virtually no new commercial money was committed. This was a sound decision on the part of the Authorities. Even after the 1985 Paris Club rescheduling and with only a moderate increase in foreign indebtedness, Ecuador's foreign interest payments alone now absorb about one-quarter of the country's exports, over one-third of its domestic savings, and about nine percent of its GDP. With careful management, Ecuador's interest payments may drop to 22 percent of exports by 1987 and the country could again become creditworthy for commercial bank voluntary lending. The projections thus assume that by 1987 Ecuador is again able to borrow from commercial banks, albeit only modest amounts. Direct foreign investment is another possible source of foreign exchange. With a continuation of present incentives for foreign investment, Ecuador may receive some additional US$120 million per year. Limited access to foreign borrowing, depleted international reserves, and modest direct foreign investment imply that the current account deficit of the balance of payments will be necessarily low, i.e., that foreign savings will not play as important a role in the second half of the 1980s as in recent years.  Foreign Exchange Availabilty 1.15 All told, foreign exchange available between 1985 and 1988 might be about US$3.7 billion per year. Of this total, about 23 percent is already committed for interest payments on the external debt, leaving about 77 per- cent available for imports and for replenishing international reserves. Even with only a minimal increase in international reserves, the foreign exchange available for imports through 1988 would be severely restricted. Thus, in nominal terms, the foreign exchange available in 1988 may be about equal to the level available in 1981; in real terms it may be only about 65 percent (see Table 1.2). Economic growth will be constrained by the scarcity of foreign exchange; activities and projects which promote exports, therefore, are extremely important. Table 1.2: ECUADOR - SOURCES AND USES OF FOREIGN EXCHANGE, 1985-88 (Million US$) 1985 1986 1987 1988 Sources Exports (G+NFS) 3,120 3,512 3,678 3,791 Net Borrowing 135 72 186 147 Direct Foreign Investment 75 100 120 140 Uses Net Factor Payments 808 882 874 858 Imports (G+NFS) 2,545 2,692 3,011 3,095 Inerease in Reserves -3 130 118 150 Memorandum Item: Imports of Goods at 1983 prices 1,512 1,547 1,477 a/ 1,510 a/ Imports decline mainly because petroleum products are substituted with domestic production as the Esmeraldas refinery expansion begins to pro- duce. Source: Statistical Appendix Table 1.2  -6- Economic Growth 1.16 Given the foreign exchange constraint, prospects for economic growth for the next five years appear modest indeed. GDP may be expected to increase just under 3 percent per year, barely above the 2.5 percent rate of population growth, as shown in Table [.3. Table I.3: ECUADOR - ECONOMIC GROWTH, 1984-90 (Percentages, Annual Averages) 1984 1985 1986 1987-1990 (Preliminary) GDP 4.1 3.2 2.8 2.8 Agriculture 6.7 8.0 4.0 4.0 Petroleum 11.9 3.7 2.6 -4.2 Manufacturing -1.4 2.4 4.0 4.0 Other -3.0 4.0 3.0 4.5 Source: Mission estimates Private SaviLngs and Investment 1.17 The decline in per capita income that has taken place since 1982 makes prospects for private sector investment appear gloomy. First, private savings are likely to be low, as in recent years, owing to declining (or stagnant) per capita income. Second, foreign savings are also likely to be low, as discussed in para. 1.14. Unless the public sector generates a sur- plur that serves as a basis for monetary system credit expansion, private investment could be extremely low. Both the IMF 1985 Stand-by arrangement and these projections are predicated on the assumption that the public secto- generates an overall surplus. The Stand-by assumes that there will be a sur- plus in 1985; these projections assume that there will be a surplus every year in 1985-1988. It is this surplus that serves as a basis for monetary system credit expansion to the private sector, partially su.zstituting the generous foreign borrowings of the 1970s and early 1980s. Credit Expansion 1.18 For 1985, the Stand-by arrangement with the IHF incorporates a pri- vate sector credit expansion target of 23 percent with respect to the 1984 level, compared to an inflation rate of 25 percent. This target in essence calls for no real credit expansion. Modest as it is, the target is predica- ted on public sector savings of 12 percent of GDP and an overall public sec- tor surplus of 3.5 percent of GDP that provides the basis for most of the  Table 1.4: ECUADOR - PRIVATE SECTOR ACCOUNT, 1984-88 ------- (As a percent of GOP) 1984 1985 1986 19B7 19BE Current Account Factor Income (GDPIcI 89.0 B8.7 88.0 86.7 84.9 Transfers from Budget 3.6 3.3 3.1 3.4 3.5 Balance of Payments Flows 0.2 0.2 -0.6 -0.5 -0.5 Net Factor Income 0.0 0.0 -0.8 -0.7 -0.7 Net Current Transiers 0.2 0.2 0.2 0.2 0.2 Direct Taxes & Transfers -24.5 -24.4 -22.6 -21.5 -20.0 Disposable Incoae 69.1 67.8 69.0 68.0 67.9 Private Consumption 65.0 62.5 62.5 62.5 63.3 Private Savings 4.1 5.3 5.5 5.5 4.6 Capital Accodnt Sources of Capital Private Savings 4.1 5.3 5.5 5.5 4.6 Monetary System Credit 8.8 7.1 4.9 6.B 7.7 Balance of Payments Flows -0.2 0.9 1.1 1.1 l Capital Transfers from Budget 0.0 0.0 0.0 0.0 0.0 Uses of Capital Real Investment 8.2 10.0 7.9 10.4 10.7 Claims an Government 0.9 0.6 0.5 0.4 0.3 Claims on Monetary System 3.7 2.7 3.0 2.5 2.5 Money & Quasi-Honey 4.3 3.5 3.0 2.5 2.5 Net Other Liabilities a/ -0.7 -0.8 0.0 0.0 0.0 a/ Exicudes foreign borrowing by monetary authorities Sources: Central Bank of Ecuador. direct information, and mission estimates. credit expansion to the private sector. Although a 3.5 percent surplus may be too ambitious (the projections in this report estimate a surplus of 2.1 percent) and credit to the private sector, consistent with the inflation ta.get of 25 percent, may be even tighter in 1985, the basic elements of this program are likely to be repeated in 1986; i.e., the public sector may have to generate an overall surplus, increase its deposits in the Central Bank and  - 8 - thus provide the resources for non-inflationary credit expansion to private investors. Even then it may not be until 1987 and 1988 that credit to the private sector expands in real terms. The projected credit expansions of 1987 and 1988, moreover, are predicated not only on overall surpluses of the public sector, but also on renewed Central Bank borrowings from foreign com- mercial banks (Statistical Appendix Table 1.2). If for any reason-e.g., the sucre appreciates in real terms and the volume of projected exports does not materialize-Ecuador is not deemed creditworthy for commercial bank lending, the flow of resources to the private sector would be lower. If for any reason the overall surpluses of the public sector do not materialize either, credit to the private sector and hence private investment would suffer. This underscores the point made earlier, that the program, although feasible, will require very careful economic management. Table I.5: ECUADOR - MONETARY SYSTEM ACCOUNTS STOCKS, 1984-88 (As Percent of GDP) 1984 1985 1986 1987 1988 International Reserves .0 .0 1.4 2.3 3.2 Net Domestic Credit 34.7 30.3 27.8 26.6 25.0 Claims on Government -8.5 -9.9 -10.8 -13.8 -17.8 Claims on Private Sector 43.2 40.2 38.6 40.4 42.8 Net Others -15.3 -11.9 -10.8 -10.4 -9.6 Assets=Liabilities 19.4 18.4 18.4 18.5 18.6 Money 14.2 13.7 13.8 13.7 13.6 Quasi-Money 5.2 4.7 4.6 4.8 5.1 Memorandum Items: Inflation Rate (X) 23 25 15 10 10 Exchange Rate (S/US$) 80 112 118 121 124 Sources: Central Bank of Ecuador, mission estimates. 1.19 The public sector surplus that serves for monetary credit expansion to the private sector stems partially from higher domestic petroleum prices. The logic of increasing domestic prices of petroleum products to channel funds to the public sector only to funnel them back to the private sector via the monetary system may be appropriately questioned. Why not simply lower the ta, burden and hope that the private sector will use the funds for investment? There are two main arguments that can be adduced in defense of the approach suggested in this report. First, increasing domestic prices of petroleum derivatives would have a positive effect on the balance of payments by reducing domestic consumption of an exportable good. Second, channeling  - 9 - the funds through the monetary system would improve the likelihood of increasing investment rather than consumption. If in addition interest rates are positive in real terms, efficient resource use in the private sector would be more likely. 1.20 The full implications of financial reform to stimulate both savings and saving deposits in the financial system were not fully explored in these projections, although they assume that interest rates on deposits are posi- tive in real terms and that they succeed in mobilizing resources. Previous World Bank work 2/ suggests that quasi-money could increase faster than pro- jected in this report with a financial reform that not only brings interest rates on deposits to real levels but that also fosters mobilization of long- term resources through variable interest rate instruments. 1.21 The scarce credit flowing to the private sector will have to be used efficiently if economic growth is not to be jeopardized. During the 1970s the sheer volume of petroleum-generated resources and the large share of income devoted to investment practically assured high rates of economic growth independently of the efficiency with which these resources were used. Scarcity will place a premium on the efficiency of resource use. Many of the decisions affecting the allocation of investment in the years 1985-88 will be done by the public sector and this report attempts to provide the guidelines to allocate public savings. But the private sector will also play a role that will gradually become more important in the future. A financial reform, of which positive real interest rates for loans and deposits have to be an integral part, would be essential both to stimulate savings and increase the likelihood of allocating resources properly. This point needs to be stressed. Ecuador's present standard of living is sustainable only because the present generation is consuming the country's oil reserves (i.e., the country's capital). To avoid a sudden reduction in the standard of living when oil runs out, the present generation of Ecuadorians needs to invest a high proportion of the perceived revenues efficiently, underscoring the need for high real interest rates throughout the monetary system. Public Sector Revenues 1.22 If the private sector is to take a more active role in generating exports and economic growth, the public sector might best serve the Ecuadorian population assisting in this process, but reducing its role as an economically productive agent. Given the credit needs of the private sector, resources available to the public sector may now be estimated. Petroleum Export Revenues 1.23 Petroleum has provided the bulk of public revenues since the coun- try became a net oil exporter and will continue to be the main source of funds in the future. Mission estimates, based upon expected production levels, point to revenues from petroleum exports on the order of US61.6 bil- lion. These are conservative estimates because they do not take into account the considerable increase in volume that investment in secondary recovery 2/ IBRD Report No. 5270-EC, Ecuador: Brief Review of the Financial Sector,- April 1985.  - 10 - could bring about, as discussed in Chapter III. Nevertheless, they are sub- ject to considerable uncertainty stemming from possible fluctuations of petroleum prices. Table 1.6: ECUADOR - EXPECTED PUBLIC REVENUES FROM PETROLEUM EXPORTS, 1985-89 1985 1986 1987 1988 1989 Billion US$ 1.5 1.6 1.6 1.7 1.6 Billion Sucres 159.9 184.7 191.7 203.0 199.4 As Z of GDP 17.0 16.5 14.8 13.4 12.0 Source: Statistical Appendix Table 2.1 Domestic Sales of Petroleum Products 1.24 Revenues from domestic sales of petroleum products will provide another major source of Government funds. By mid-1985, the average domestic price of petroleum products was about 40 percent of world prices. The income from domestic sales accrues to the public sector almost in its entirety- either to CEPE, the Ecuadorian State Petroleum Corporation, by way of sales revenues, or to the rest of the public sector by way of taxes. The Authori- ties intend ultimately to move domestic prices closer to international prices, but do not yet have a firm plan. Moreover, because price increases are legally tied to CEPE's cost increases, the Authorities do not have total freedom to set them. For this reason, the mission assumed that domestic prices move towards international prices gradually, attaining equality in a period of five years and only after the legal impediment is overcome. Domes- tic sales were projected accordingly. 3/ 1.25 Domestic consumption, of course, will be affected 'y the projected price incrcases. Econometric analyses indicate that gasoline and diesel have very low mediumr-term price elasticities (about 0.15) but high income elasti- cities (about 1.75). Other products failed to indicate any price-responsive- ness. Experience in other countries indicates that demand becomes more elas- tic at higher prices. 4/ The projections in this report assume that price elasticity remain constant as the Authorities move domestic prices towards 3/ The price increases assumed appear in Statistical Appendix Table 1.3. 4/ Indeed, more recent estimates, based on information that became available only after this report's projections had been finished, indicate that price elasticity of gasoline has gone up to 0.35, while price elasticity of diesel is up to 0.17.  - 11 - international levels. Projected sales appear in Table I.7. But even if demand remains price inelastic, owing to the low rates of economic growth likely to prevail in future years, the growth of domestic demand will be largely determined by the Authorities' decisions concerning domestic prices. Table 1.7: ECUADOR - PROJECTED DOMESTIC SALES OF PETROLEUM PRODUCTS 1984-88 1984 a/ 1985 1986 1987 1988 (Preliminary) Billion Sucres 25.9 38.3 56.8 83.3 122.1 Million US$ 326.0 340.0 480.0 690.0 1,000.0 As Z of GDP 3.6 4.1 5.1 6.5 8.2 Average Price (USt per gallon) 28.9 32.0 43.9 63.3 91.6 a/ Estimated. Source: Mission estimates Non-Petroleum Revenues 1.26 Non-petroleum revenues declined relative to GDP, from 17 percent in 1973 to 10 percent in 1983. Some of the reasons behind this relative decline have been explored in a recent Country Economic Memorandum and need not be repeated here. 5/ The Authorities i-atend to improve tax collection and to that effect have engaged the services of consultants, including those of the US Internal Revenue Service. At the same time, they have also stated to the mission that some tax reforms (most notably affecting imports for industrial use) are in the offing. These policies are likely to increase the total tax burden relative to GDP, but the actual amounts are uncertain at this point. If the tax burden were to rise even slightly with respect to GDP, say from 10 to 11.5 percent of GDP through 1988, public savings could become as much as 14 percent of GDP in 1988 as interest payments on the external debt decline in relation to GDP. The public sector could attain an overall surplus of some 9 percent of GDP and deposit the funds in the monetary system to provide the basis for non-inflationary credit expansion to the private sector. Alternatively, the Authorities could lower the effective tax burden through tax credits (for exports, for example) and eliminate -nuisance taxes--taxes that do not raise much revenue, but that take up time and effort to collect and pay. The identification of nuisance taxes and of possible tax credits 5/ See IBRD Report No. 5094-EC, -Ecuador: An Agenda for Recovery and Sustained Growth, October 1984.  - 12 - was beyond the scope of this mission, but a special mission to carry out this task would be highly recommended. For purposes of this report it was assumed that measures are taken to lower the non-petroleum tasi burden and that a sys- tem of tar credits is adopted. Table 1.8 shows these estimates. Table I.8: ECUADOR - NON-PETROLEUM TAX INCOME OF THE PUBLIC SECTOR 1983-88 (Percentages) Item 1983 1985 1986 1987 1988 Total (Billion Sucres) 56.6 105.5 118.6 135.1 152.8 Direct Tases 43.7 38.3 37.6 37.8 38.2 of which: Social Security (26.1) (23.2) (24.5) (24.8) (25.2) Indirect Taxes 56.3 61.7 62.4 62.2 61.8 of which: Imports (21.0) (31.3) (32.5) (32.4) (32.1) Non-Petroleum Tares as Z of GDP 10.0 11.3 10.6 10.5 10.3 Source: Statistical Appendix Table 1.5, direct iuformation. Otber Income 1.27 There are two remaining sources of income for the public sec':or, non-tax income and the current surplus of the State Owned Enterprises (SOEs). The former income has been about 2.3 percent of GDP, the latter about 0.5 percent. With the exception of INECEL, The Ecuadorian Electrifica- tion Institute, time constraints prevented the mission from making detailed projections of the SOEs; these two sources of funds are projected at their relative historical shares. Detailed projections for INECEL, appear in Sta- tistical Appendix Tables 4.5 and 4.6. 1.28 Some of the future current expenditures (e.g., interest payments and social security pension payments) are contractual obligations to which the Authorities are, for the most part, already committed. These expendi-- tures account for about one half of total projected expenditures. The remaining expenditures-wages and salaries and purchases of goods and services-are discretionary. From 1973 to 1980, discretionary expenditures rose relative to GDP, from 8.6 to 14.4 percent. The steepest increase took place in 1980, as a result of the doubling of the minimum wage and ensuing wage escalation of better paid positions. Since 1980, however, the Authori- ties have succeeded in reining in these expenditures; by 1983, they had fallen to 11.5 percent of GDP. But it will be estremely difficult to main- tain them at this level, if political pressures to raise the minimum wage mount again. In fact, Congress considered a bill which would have increased the minimum wage by 40 percent; the Executive increased it by 30 percent.  - 13 - This report projects public consumotion at about 12 percent of GDP-the average level of the past five years. It should be emphasized that a 10 per- cent increase in the Government's wage bill is equivalent to 0.8 percent of GDP. A 10 percent increase in wages combined with a 10 percent increase in the number of public emp]oyees would wipe out the projected public sector surplus of 1985 and 1986 and cut in half the projected surplus of 1987 and 1988. 1.29 Transfers to the financial public sector (the latter excluded from the consolidation) and to the private sector are the last major current expenditure item. The most important sub-item in this category is the pay- ment made by the social security system to its pensioned members. Another component is made up of earmarked, legally mandated petroleum income trans- fers. Additionally, as will be discussed in Chapter XI, the Government wants to undertake an ambitious housing program for which BEV, the Ecuadorian Housing Bank, will require Budget support. The additional amounts to be transferred to BEV are discretionary and have been assumed to hover around the S/1.4 billion per year mark in the period 1985-1988. Table I.9 shows the percentage composition of the petroleum income and budget transfers by reci- pient and as a percent of GDP. Table I.9: ECUADOR - DISTRIBUTION OF TRANSFERS FROM PETROLEUM REVENUES TO THE NON-FINANCIAL PUBLIC SECTOR, 1985-88 (Percentages) 1985 1986 1987 1988 BEDE 68.2 65.3 62.2 64.8 CBE 0.1 0.1 0.1 0.1 BEV a/ 18.0 20.9 24.4 21.0 BlF 10.9 10.9 10.8 11.0 Private Universities 1.2 1.2 1.2 1.2 INFA 1.7 1.6 1.6 1.6 As % of GDP b/ 1.0 0.8 0.7 0.6 a/ Includes about S/1.4 billion per year in addition to earmarked oil transfers. b/ These transfers decline re...ative to GDP because GDP increases and revenues stagnate. Source: Statistical Appendix Table 2.1  - 14 - Public Sawings 1.30 Public savings might reach about 10 percent of GDP in 1985 and rise gradually to about 13 percent in 1988, as interest payments on the external public debt fall relative to GDP (Table I.10).6/ The issue likely to con- front the Authorities in the next five years, then, will not be one of scarce resources (at least not in relative terms), but one of efficient utilization 3f resources. The next Chapter deals at length with the institutional pro- blems which may make it difficult to allocate resources efficiently within the public sector. The remainder of this Chapter will deal with another important issue entailed in these projections, namely the allocation of resources between the public and private sectors. a21e .lI: ELU4DR- PuItC SECD . ACCUtUlU, I94-89 ---------- AsK a percent of ECPt :594 : 1;S 5 196 S ;967 !999 t3.F e:;:;ix szuresv; 0 ; 115 :9 1, :u.;AEiJ7 .CCCJUT ;,-ren- Recewt-s L7.; 5.7 34.6 ;4.9 -5.1 :'trect itaes :e ; i:.0) : .; : rlErCt Ta:es '. ftlier inco3e 24.5 4.1 .e ..5 'D.t' CLrren: E-em-ltures Capsapt;1.n. 1'.o Io 5 12.4 1.2 Eovertaent -rarsfers 1 t1.", 1:.' 10.9 4.a Interest E. 9.7 9.5 7.5 h.; Transier Payments a.b . ;.1 3.4 3.5 kcuetar1 Saning 9.5 :o.i 1;.4 ;1., :;.O 2APITAL AECOUW! Ca3ttal Exuenaitures e;l Investaent *. E.l .4 9.4 XLI J.erall iur;16s ;.7 2.1 2.. ; .2 I, E.ternil Fsancirg NEet -t:ernal Brrrowino J.5 (.7 0.& e.' ha Domestic Financing *on-3ani Borrotinq o, 8 a 1 5 0..4 M.; t.metar' Syste -;. -K. -2. -X; -5.c Source;: entra: Bank ef Eciadcr, IzsIlcA est;sates. 6/ These volumes of public savings would not be unprecedented in recent history, but high savings have always been associated with quantum jumps in either the volume of petroleum exports (1972) or international petro- leum prices (1979). In 1973 and 1974 public savings were equivalent to about 10 percent of GDP. Since then, however, public savings have declined relative to GDP; the average in the period 1975-1982 was about 5.5 percent of GDP.  - 15 - Public Investment 1.31 Chapters 3-13 of this report provide a justification for selecting certain projects from the Government's Public Investment Program and for dropping others. Table I.10 (real investment line) shows the monies required by these projects and compares them with resources available. It is obvious that if domestic petroleum products prices increase as shown in Table 1.7, the public sector could not only have enough resources to finish these prio- rity projects, but in fact, could generate a modest overall surplus even during 1985 and 1986. With the decline of interesr payments to foreigners relative to GDP and the completion of these projects, the public sector sur- plus could become substantial, even if new projects are undertaken in 1987- 1988. Despite the relative abundance of resources, public investment would still be lower in real terms in each year throughout the period considered than in 1980, as shown in Graph I.1. The public sector, then, would have a larger share of a smaller investment pie. For this reason, with very few exceptions, the mission only considered projects in execution and recommends that no new projects be undertaken until 1987 or 1988, lest there be crowding out of the private sector. Indeed, the case could be made that crowding out is already occurring. GRAPH I. 1: ECUADOR - PUBLIC AND PRIVATE INVESTMENT, 1988-88 c I 989-199)3 129- - PUBLIC SECOR 1t07 / \ - --PRIVATE SECTOR \\ // I / 00- \\ ~~~~~/ , I\ 1969 1981 1962 1963 96 t966 18 198 988 x~~  - 16 - 1.32 Chapters III-XI provide an analysis of the public investment pro- gram and select only those projects which are either so far advanced that it would be uneconomical to stop them, or those necessary to sustain economic growth and improve social conditions. In the productive sectors those pro- jects with high rates of return, high contribution to exports and quick pay- off were selected. Selection criteria for projects in the social sector vary according to sectoral priorities and are spelled out in the discussion of each sector. Table I.11 shows the distribution of the recommended invest- ments projects. Table 1.11: ECUADOR - RECOMMENDED PUBLIC INVESTMENT PROGRAM 1985-88 Annual Annual Average Average Million Million Distri- As X of As Z of 1984 1984 bution 1980-82 1980-82 Sucres Dollars (M) Average Peak Petroleum 65,900 829 25.6 139 109 Electric Energy 38,900 489 15.1 55 44 Agriculture 30,300 381 11.8 100 73 Transportation 37,900 476 14.7 82 68 Education 20,200 254 7.8 75 60 Health 9,900 124 3.8 89 66 Water Supply & Sewage 11,300 142 4.4 n.a. n.a. Telecommunications 7,600 95 2.9 n.a. n.a. New Projects 35,600 448 13.8 n.a. n.a. TOTAL 257,600 3,237 100.0 Source: Mission estimates Sensitivity Analysis 1.33 As stated in para. 1.03, Ecuador's growth prospects depend to a large extent on international petroleum prices. The basic projections in this report assume that these prices will stay at present levels in real  - 17 - terms. This section of the report explores the possible consequences on the balance of payments, economic growth and the public investment program of an alternative hypothesis, namely constant petroleum prices in nominal terms. 1.34 If international petroleum prices remain constant in nominal terms, Ecuador's export earnings would fall by about US$745 million in the three years 1986 through 1988, as Table 1.12 shows. Although Ecuador could adjust to this shortfall by accumulating US$400 million fewer international reserves, economic growth would eventually have to suffer. The mission esti- mates that growth could decline by about 2 percentage points in the three years, or about 0.7 percentage points per year, preventing per capita increases in GDP. 1.35 The impact on public investment would be even more noticeable. Petroleum revenues would fall by approximately 9 percent in 1986 and by about 20 percent in 1988. Public revenues would fall by about the same dollar amount as exports and, if the entire shortfall is absorbed by lower invest- ment, public investment would have to fall by about one-fifth in the four years. If the lower scenario comes to pass, a possible adjustment would be to defer all new projects until 1989. A faster devaluation than assumed in these projections might be another required adjustment that, if undertaken, would increase public revenues in sucre terms, partially offsetting the dollar decline. Table I.12: ECUADOR - TOTAL COMMODITY EXPORTS, 1985-88 (Million US$) 1985 1986 1987 1988 Scenario I a/ 2,709.9 3,070.1 3,208.2 3,295.6 Scenario II b/ 2,709.9 2,914.6 2,941.3 2,938.6 Shortfall - 155.5 266.9 357.0 a/ Petroleum prices constant in real terms. b/ Petroleum prices constant in nominal terms. Source: Mission estimates.  - 18 - II. INSTITUTIONAL ISSUiS 2.01 The previous chapter's discussion indicates that Ecuador's main challenge during the coming years will be the efficient allocation of resources both between the private and the public sector and within the public sector. Efficient allocation of public revenues often depends on the agility and efficiency of the institutional framework. The purpose of this chapter, therefore, is to examine the main institutional obstacles to effi- cient public resource use and to recommend policy changes to improve the pro- cess. Core Development Policy and Economic Management Agencies 2.02 The core agencies dealing with development policy and economic management are the Ministry of Finance, the Central Bank, the Monetary Board, the National Development Council (CONADE) -whose secretariat serves as the planning agency-and the National Development Bank (BEDE). The Ministry of Finance and CONADE are jointly responsible for planning and monitoring public development projects, while the Central Bank and the Monetary Board manage foreign exchange and financial and monetary policies. BEDE was created in 1979 as a private, autonomous bank-like institution to channel funds to public sector development program- and projects. BEDE does not capture deposits; its funds come from petroleum revenues, its own lending operations, and foreign credit. It lends exclusively to the public sector. Budget Preparation 2.03 The National Budget is the principal instrument for programming and implementing public sector activities. Its formulation is a complex and fragmented process. In reality, there is no single budget for the entire public secto;-; rather a series of budgets are prepared in pr-allel by various agencies and for different purposes. Moreover, the National Budget repre- sents only about 64 percent of tax revenues and, excluding transfers to other public sector entities, only around 45 percent of public expenditures. Remaining revenues are directly allocated among the budgets of autonomous entities and local governments through the widespread practi e of earmark- ing. Nevertheless, the National Budget covers a major share of the current and capital expenditures of the ministries and of most auton-mous agencies. 2.04 The National Budget is prepared by the Ministry of Finance almost in isolation from the rest of the public sector. For each ministry, the Ministry of Finance's budget department has a specialized analyst who con- sults with the relevant agency when particular problems arise, but these con- sultations are occasional, normally on matters of detail, and links seem to depend more on personal relations than on a structured consultation system.  - 19 - 2.05 Budget preparation follows different courses according to the nature of the expenditures (current, capital) or institutions involved (Cen- tral Government, autonomous agencies, or public enterprises). Budgeting of current expenditures by the Ministry of Finance follows the traditional incremental approach. In a parallel and independent process, each ministry prepares its own current expenditure budget with practically no guidelines from the Ministry of Finance, although in the end their final figures have to conform to those dictated by the Ministry of Finance. Based on requests from the executiag agencies, CONADE programs the capital expenditures and forwards them to the Ministry of Finance. A draft budget is prepared and presented before Congress. Autonomous agenries and public enterprises prepare their budgets only after they know the amount of transfers they will receive, i.e., afteL Congress approves the Central Government's budget. 2.06 In Congress, a five member committee studies, modifies the proposal and finally approves the modified b-aIget proposal. The proposed budget is sent to the full Congress only if the Budget Committee fails to approve it-a rare event in recent years. 2.07 The congressional Budget Committee usually increases the original budget proposal, creating inconsistencies in the process. Although the Budget Committee cannot increase budgetary appropriations unless it also finds financing for the additional expenditures, it usually circumvents this requirement. For example, in 1983 the Executive sent a budget with a S/2 billion provision for transfers to local governments. The Budget Committee doubled the transfer amounts and, to balance the budget, cut the provision for public debt service almost entirely. Because the public debt had to be serviced in any case, the Executive had to secure the additional financing. 2.08 Congressional approval of the budget does not end the budgetary process. Although the Ministry of Finance may not exceed the budget by more than 5 percent, this limit is not binding if the additional amounts are for public debt service, salary increases, or national defense. The Ministry of Finance may also change the composition of the budget, shifting funds within programs, between programs, and between ministries. It has no legal con- straint on its ability to change the composition of budget authorizations; it only has to follow procedural rules. Finally, Congress can add to the already approved budget as long as it explicitly states how the new expendi- tures are to be financed, a requirement that has often led to earmarking. 2.09 Weak teclhnical capacity in macroeconomic forecasting has resulted ic consistent overestimation of revenues (ranging from 10 to 30 percent for non-petroleum revenues, with an average of 17 percent in 1979-1983). Similar weaknesses in the recording and analysis of overall public debt, especially with the complications introduced by rescheduting, limit the Ministrv :f Finance's ability to analyze options for financing the capiral butdget- tough foreign borrowing. 2.10 Although the National Budget is prepared in program budgeting for- mat (i.e., expenditures are stated explicitly in support of program objec- tives), in practice it is not used as a programming tool. Programs are tou aggregated and goals too generally stated. The absence of quantitative indi- cators does not permit an evaluation of goals accomplished.  - 20 - Budget Execution 2.11 Execution of the National Budget is a continuous process of nego- tiation in which program managers experience a high degree of uncertainty. Lack of consultation during the budget preparation phase, disregard for the budget as a programming tool, complicated expenditure approval procedures, and shortfalls in expected revenues lead the ministries to request budgetary changes frequently. Current expenditures are then authorized according to allotments (Ccupos") by the Ministry of Finance's Budget Directorate as funds become available. If funds are inadequate, cuts are often made across the board or in programs that are disbursing slowly; authorizations are often paid at the discretion of the Treasurer. This cash-management approach often yields results different from those originally planned in the budget docu- ment. 2.12 Capital expenditures require detailed documentation to support each request for funds. Execution of the capital budget suffers substantial delays owing to weak managerial capacity, a complicated bidding system, and complex approval and management of public works contracts. 2.13 The Authorities have tried to improve the budget process in recent years. Constitutional reforms approved in 1983 make it mandatory to include in the National Budget all types of income and expenditures and to cover all public sector entities, except those belonging to local governments. Also, the Government's accounting system was revamped and a new legal framework adopted in 1981. But these reforms are still being 4mplemented. At present, fiscal management is difficult because information about budget execution is scattered, untimely, and not comparable among institutions. While it is relatively easy for the Ministry of Finance to keep track of spending autho- rizations-the monitoring of which has been computerized since 1983-informa- tion about actual expenditures arrives very late, sometimes six months after the close of the fiscal year. In sum, using the present system, the Ministry of Finance can effectively monitor neither budget execution nor progress on particular projects. 2.14 A radical departure from the present practice of incremental and non-participatory budgeting is well advised. Fully embracing zero-based budgeting may be too ambitious at the moment, but moving towards that approach and adopting some of its basic ideas would be appropriate. In addi- tion, it would be advisable to improve resource estimates. Although computa- tion of revenue projections are detailed enough, projections of macroeconomic variables are inadequate. CONADE's macroeconomic forecasting and project evaluation capabilities could be improved. Other important steps that would substantially improve the budgetary process include: a) requiring each public sector agency to define in as much detail as possible, its goals and targetr, and delegating to them more responsibility in the preparation of their individual budgets. Strengthening the agencies' budget preparation capabilities would be prior step;  - 21 - b) improving consultations and discussions between the MOF and each of the agencies. These consultations could take place frequen- tly during the preparation of the budget. Introduction of some of the elements of zero-based budgeting would be appropriate at this planning stage. With an adequately structured discussion, agencies could be induced to introduce sensitivity analysis and to appraise the consequences of different funding levels on the two or three most important targets; and c) at a later stage, involving the program managers of the major public agencies in the preparation of the budget. National Project Selection System 2.15 A system to select priority projects was established by law in 1975. According to the system, each executing agency is to have a program- ming unit to identify, formulate, and evaluate investment projects. FONAPRE, a CONADE associate (entidad adscrita) established in 1973, is responsible for the preparation and financing of prefeasibility and feasibility studies and for training programming units and facilitating project execution. CONADE is to provide the macroeconomic and sectoral framework to select and rank pro- jects. The Ministry of Finance is to finance the investments within resource availabilities, and BEDE is to complement budgetary allocations by supplying additional funds for development projects. 2.16 Actual procedures vary from this theoretical framework. Macroeco- nomic projections for planning purposes are made separately by MOF, CBE, and CONADE. CONADE, which heads the planning process, concentrates on public sector investment; it prepares a medium-term plan which serves as a basis for annual operating plans (planes operativos). The latter are supposed to esta- blish a global economic framework and define annual investment plans for the entire public sector, but linkages are loose between these plans and macro- economic policy design, the budgeting process and the executing agencies. No single entity within the public sector has a complete inventory of the pro- jects to be executed nor an assessment of the funds required to complete them. Sectoral coordination is almost non-existent. Each ministry is repre- sented on the board of directors of autonomous agencies, but they do not have direct and decisive influence on the agencies' decisions. There is no regular, formal consultation mechanism among entities within an area. The Ministry of Agriculture's planning office, for example, has no influence on other agencies working in the sector. Finally-and most importantly-no institution in the public sector has the power to veto undesirable projects. Since CONADE's role as coordinator is minimal, the public sector does not have an investment plan. The "investment plan' which the mission evaluated is more an exercise in costing out the intentions of the various public sec- tor institutions than an evaluation of a formal plan. It was compiled by the mission from information provided by CONADE and the differeat public sector agencies executing projects and sifted according to the mission's appraisal of the country's priorities.  - 22 - 2.17 Important reasons for the weak linkages between CONADE and the exe- cuting agencies can be found in CONADE's political isolation from the rest of the public sector in recent years. In addition, the short-term macroanalyti- cal framework is weak; it does not adequately take into account the monetary sector and is not handled with the necessary flexibility for regular adjust- ments in line with changing developments, particularly changing resource availabilities. Also, the operating plans come out too late, sometimes after half the year is gone. In Ecuador, as in any other country, an effective public sector planning process must have strong political backing, but CONADE's technical capabilities must also be strengthened in order for it to command the respect of the institutions whose investment plans it is to supervise and coordinate. 2.18 The programming units are the second most important link in the project system; they are also the weakest. Practically all public sector entities have a programming unit, which not only vary in size, but also in quality, importance given within the agency to which they belong, and in their links with CONADE and MOF's budget unit. As a result, project identi- fication is deficient--most agencies respond mainly to political pressures or to immediate needs created by a particular crisis and, with few exceptions, prefeasibility studies are done only when projects are financed with external sources or BEDE funds. Perhaps one of the reasons why these units are weak is because they are understaffed. The programming unit within MOP, for example, is made up of only four engineers and one economist, yet MOP manages one of the largest capital budgets in the public sector. 2.19 FONAPRE was established in 1973 to facilitate and expedite the pre- paration of development projects. The institution, however, has lacked the necessary coordination with BEDE, CONADE, and MOF. It carries out feasibi- lity studies, but its priorities are established by CONADE on a project-by- project basis without reference to a larger framework. 2.20 Although BEDE is an efficient development bank, its role is questionable: it works as a parallel budgeting and planning operation. BEDE itself does not perform a comprehensive evaluation of the projects that it finances, but usually requires its clients to do so. Once BEDE approves a project, Government officials can be fairly certain that disbursements will occur when needed and, since BEDE requires alL economic evaluation, BEDE- financed projects are less likely to be unsound. The requirement that clients prepare an economic evaluation of the projects, however, discrimi- nates against poor local governments with weak staff. In addition since pro- jects are considered individually, there is no opportunity to rank alterna- tives. In reality, then, there is virtually no project selection at a macro- economic level and no ranking according to a clear set of priorities. Monitoring Project Execution 2.21 Monitoring project execution is left up to the initiatives of the executing agencies; there is no public sector institution charged with this responsibility on behalf of the entire public sector, and, as a result, what- ever information exists is fragmented and scattered throughout the public  - 23 - sector. CONADE has recently begun developing a project monitoring system which has been tested on one or two projects. This system, however, is not a true management information system with a hierarchy of data aggregation. BEDE has been charged with parallel responsibility for monitoring progress of many major investments. A special inter-ministerial committee has been set up to facilitate execution of externally financed projects. It is chaired by the Ministry of Finance; CONADE, BEDE and the Central Bank are represented. These steps may improve project selection and execution in the future, but at present the Government's tools to ensure efficient utilization of resources and to monitor progress in the execution of projects are quite deficient. 2.22 Ecuador has the appropriate legal framework and most of the ingre- dients needed for a good project evaluation and monitoring system, but the programming units and CONADE need to be strengthened. Programming units should be organized in all agencies, adequately staffed, and positioned closer to the higher decision levels within their organizational structures. Training alone would do little to solve their weaknesses. 2.23 Each programming unit should be responsible for coordinating internal plans within the agency or ministry in which it operates. Its work should be focussed on the review and evaluation of projects and on the prepa- ration of the agency's capital budget. They should also participate in dis- cussions with CONADE and MOF's Budget Office at national budget preparation time. FONAPRE is a very useful mechanism within the National Project System and perhaps the institution best prepared to contribute to upgrading the pro- gramming units. 2.24 Aside from preparing a more comprehensive macroeconomic framework, CONADE should also issue uniform project evaluation guidelines to the pro- graming units, including opportunity cost pricing for at least the most important inputs (foreign exchange, labor, and capital). Although the evalu- ation of each individual project is best left up to the programming units, CONADE should be responsible for adapting basic general project preparation and evaluation methodologies and for reviewing and preparing the methodolo- gies in each specific area in consultation with the programming units. 2.25 Continuous monitoring of project execution is also necessary. Bud- getary control and an appropriate information system regarding disbursements would take care of the most immediate needs. But a comprehensive follow-up and evaluation of project rexecution is also desirable. Finally, an ex-post project evaluation would be a useful addition to the project system. Ea 2.26 Earmarking is a traditional way of allocating public sector revenues among institutions and regions in Ecuador. It is also the most serious obstacle to efficient resource use and one of the most intractable public finance problems that the economic Authorities are likely to face during the next five years. Earmarking is not only widespread, it is also deeply ingrained in the Ecuadorian psyche and its modification requires poli-  - 24 - tically difficult legislative changes. Yet, the country's future economic growth will be influenced in great measure by the Authorities' ability to modify earmarking laws. 2.27 Fully 47 percent of the total tax revenues expected for 1985 are already earmarked for specific uses or institutions. In addition, the Cons- titution earmarks 30 percent of current Central Government revenue for educa- tion, bringing the total to 67 percent (Statistical Appendix Table 2.1). The economic Authorities, therefore, have control over only one-third of revenues and there is little that they can do to ensure efficient utilization of the rest. 2.28 Revenues are earmarked for particular sectors or programs by law through complicated schemes. Rules for revenue distribution follow many patterns. In most cases resources are allocated based on a simple percentage of revenues received; in other cases the law earmarks fixed amounts, in yet others, earmarking is done relative to a floor price or to a particular value of the exchange rate. For example, FONAPAR receives S/3 billion from fuel oil exports and past increases of domestic petroleum prices, and S/1 billion from import tariffs. Local institutions (e.g., the Therapy Center of Manabi, the Cancer Society of Ecuador) receive fixed amounts from the 1 percent semi-yearly tax on domestic credit. The rural roads program, introduced in 1983, is funded from a tax on oil export revenues. This tax is computed as the difference between an exchange rate of 44 sucres per dollar and the offi- cial exchange rate prevailing at the time exports are made. When introduced, the tax raised S/2.6 billion in revenues; in 1984 it raised S/10.3 billion; 1985 revenues have been estimated at S/30 billion.l/ As discussed in Chapter V, these funds far exceed transport sector needs. The rural roads tax, the epitome of allocative inefficiency, illustrates the main shortcoming of earmarking-amounts are allocated to recipients according to the develop- ment of the revenue source and not necessarily according to the country's priorities. Examples of similar inefficiencies and inequities abound. There is a tax for urban phone calls which finances water supply expenditures in the city of Guayaquil; there is a tax levied on specific cantons to finance works for an entire province. 2.29 In addition to allocating revenues independently of the country's priorities, earmarking introduces incentives for waste, as recipients, assured of an income, have little incentive to control expenditures rigorously. Earmarking also renders tax calculation particularly difficult because as revenues fluctuate accordirg to changes in international and domestic conditions, recipients' shares must be recalculated. Finally, ear- marking makes budgetary programming practically impossible, as it allocates funds before the Authorities have an opportunity to set goals and priorities. 2.30 Ecuador's earmarking must be changed. Ecuador underwent a signifi- cant simplification of its tax system several years ago when a large number of taxes applied by local governments were replaced by a more flexible system of tax collection and distribution. The Fondo Nacional de Participaciones (FONAPAR) was the result. A radical revisicn of earmarking is once again 11 A law introduced after the projects were made reduces this earmarked amount by about one-third.  - 25 - called for. As long as there is widespread earmarking, there will be little hope of achieving an efficient allocation of resources within the public sec- tor. Pricing of Publicly Supplied Goods and Services 2.31 The Ecuadorian Government owns three of the most important enter- prises in the country: CEPE, INECEL, and IETEL. CEPE is charged with exploration, production, refining, and marketing of oil and oil products; INECEL with electric power generation and distribution; and IETEL with tele- 3mmunications. The state is also involved in marketing agricultural commo- dities through ENAC and EMPROVIT. Finally, there are numerous other munici- pal and local entities which provide water and sewage services, irrigation, etc. With few exceptions, most of the goods and services provided by the public sector are subsidized. Although these subsidies benefit the lower income groups in a small way, they are regressive and encourage inefficient resource use and consumption by higher income groups. 2.32 The most serious case of subsidization takes place in the energy sector through CEPE and INECEL. As mentioned in Chapter I, the price of petroleum products in Ecuador today stands at about 40 percent of interna- tional prices. This pricing scheme entails a subsidy to consumers of petro- leum products equivalent to about 6 percent of GDP. The two highest income groups, comprising about 16 percent of the population, receive about 60 per- cent of the subsidy; 2/ the subsidy has little if any social justification. It also aggravates the foreign exchange constraint because it encourages domestic consumption of an exportable good. The mission calculated that even if price elasticities of demand remain as low as they have been estimated (0.15), Ecuador could increase its exports by about US$230 million during the next five years if it gradually raises domestic prices to international levels by 1990. Because price elasticities are likely to rise concomitantly with prices, the foreign exchange savings would probably be even greater. 2.33 Richer Ecuadorians also receive a subsidy through electricity prices. The same two upper income groups that receive the bulk of the petro- leum derivatives subsidy are the main beneficiaries of the electricity sub- sidy and in about the same proportion (they receive about 60 percent of the subsidy). The two lower income groups, which comprise about 27 percent of Ecuadorian households, receive about 8 percent of this subsidy. As in the previous case, the subsidy cannot be justified on social grounds. 2.34 If INECEL had to bear the burden of this subsidy by itself, it would have gone bankrupt long ago. But part of the earmarked petroleum reve- nues go to INECEL, allowing it to survive and even grow. For 1985, this cash subsidy is estimated at around US$160 million. In addition to this subsidy, there is an additional implicit subsidy equivalent to the difference between INECEL's actual tariffs and the tariffs that it would have to charge in order to earn an adequate rate of return, say 8.5 percent, on its revalued 2/ IBRD Report No. 5094-EC, -Ecuador: An Agenda for Recovery and Sustained Growth," October 1984.  - 26 - assets. The total subsidy is about US$200 million, equivalent to about 2 percent of GDP, or twice as much as INECEL's total income from operations. INECEL's customers are paying for one-third of the cost of electricity. Such low prices encourage waste, aggravate the balance of payments constraint, and worsen the distribution of income. Increasing prices of goods and services provided by the public enterprises is another decision that merits the Autho- rities' attention if they are to improve resource allocation.  - 27 - III. PETROLEUM Introduction 3.01 Petroleum initiated and sustained the high rates of growth that Ecuador experienced during the 1970s. As discussed in Chapter I, petroleum exports are also Ecuador's best hope of relieving its medium-term foreign exchange constraint while the economy undergoes the structural changes neces- sary to enter a path of sustained growth less reliant on petroleum. Invest- ments in oil field development, secondary recovery and the ancillary facili- ties that would be required to increase oil exports-storage, pipelines, etc.-are therefore Ecuador's best hope of easing the foreign exchange con- straint. These investments, therefore, obviously deserve a high priority. Energy Sector O anization 3.02 The Ministry of NXatural and Energy Resources (MRNE) is the execu- ting and controlling agency for national energy policy. Under its jurisdic- tion are INECEL, CEPE and INE-the latter a research institute created in 1978 to assess Ecuador's energy resources, develop energy balances, and eval- uate alternative energy technologies. 3.03 CEPE, the largest state enterprise in the country is a state-owned enterprise founded in 1972 for direct Government participation in all hydro- carbon-related activities in Ecuador. CEPE does not have complete adminis- trative autonomy and is subject to MNRE's political decisions and programs on matters related to hydrocarbons. CEPE's budget and major investment deci- sions are subject to approval by a Board of Directors comprised of the Minis- ters of Energy, Industry, Finance, and the heads of CONADE and the Joint Com- mand of the Armed Forces. CEPE holds about one-third of the total 9.4 mil- lion hectares within Ecuador considered as prospective hydrocarbon areas. In 1982 CEPE began producing crude oil in the important Libertador field in the Oriente. CEPE owns 62.5 percent of the CEPE-Texaco consortium that produces over 89 percent of all oil production in Ecuador (Texaco owns the rest), and also owns 50 percent of the Trans-Ecuadorian pipeline and associated storage and export terminal facilities (Texaco owns the rest). CEPE also owns most of the country's refining capacity, all of the gas processing plants, pro- ducts pipelines, and distribution terminals. CEPE has a monopoly on internal trade of petroleum products, but subcontracts most product transport other than by pipeline. CEPE's future role in exploration and secondary recovery has been changing and the Government now envisions a reduced involvement, but no clear definition has yet emerged. This definition is urgently needed in order to establish firm exploration and oil field development plans.  - 28 - 3.04 The National Hydrocarbons Subsecretariat (DNH) is the technical and administrative branch of MNRE responsible for hydrocarbon activities within Ecuador. This organization, in existence long before CEPE, was formed in order to monitor petroleum production by private industry. DNH now controls most of CEPE's activities as well as those of foreign companies. DNH sets the maximum permissible producing rates for each well and each field and ensures compliance through its own staff of field engineers and assistants. All drilling programs, workover programs, and other modifications of downhole installations are subject to initial approval by DNH. Finally, DNH licenses firms involved in petroleum products distribution, prepares analyses on the basis of which the Central Bank withholds royalties and tax payments, and does a variety of technical and economic studies, most of which would normally be done by the state oil company. 3.05 Texaco is the operator of the CEPE-Texaco consortium and of the Trans-Ecuadorian pipeline and related export terminal facilities. A refinery with a capacity of 1,000 barrels per day is operated by Texaco in the Oriente to supply products for the consortium's field development and producing operations. 3.06 City Ecuadorian Production Company (CEPCO) owns, in consortium with CEPE, the production from three fields in the Oriente. CEPCO a US based holding company, is operator of these fields which produce currently about 1.5 percent of total Ecuadorian oil production. CEPE s Investment Program 3.07 As of January 1, 1985, Ecuador's proven and probable reserves were estimated at 1.5 billion barrels (see Statistical Appendix Table 3.4), enough for 20.7 years of production at 1983 production rates. During the 1970s domestic demand of petroleum derivatives grew by about 15 percent per year. Owing to higher domestic prices and lower economic growth, demand has stag- nated since 1980, but is likely to grow again as economic growth picks up. If demand grows twice as fast as GDP (or about 6 percent per year), oil pro- duction would have to increase annually by at least 2 million barrels to pre- vent exports from falling below present levels. Sufficient reserves exist to permit a modest increase of oil production in 1986. After 1988 a rapid decline of oil production could occur unless new production comes on stream through secor ary recovery and oil field rehabilitation. In the medium- to long-run, production declines can only be halted if stepped up exploration efforts are successful. 3.08 At the time the mission was in Ecuador, CEPE had an ambitious investment plan covering practically every aspect of the oil industry, from oil exploration to natural gas, to fertilizer and polypropylene plants. As formulated, the plan would have absorbed about one-half of total public investment in the period 1985 through 1988. Table II1.1 gives a summary of this investment plan. Since then, CEPE's investment program has been pared  - 29 - Table I11.1: ECUADOR - CEPE's INVESTMENT PLAN, 1985-88 (Million 1984 USS) Total Distribution Exploration a/ 92.8 4.8 Development a/ 332.0 17.? Refineries Esmeraldas 123.0 6.4 Amazonas 23.0 1.2 Atahualpa 941.2 48.7 Basic Lube Oil Plant b/ 51.1 2.6 Transport & Storage 97.4 5.0 Petrochemicals b/ 61.5 3.2 Fertilizer Plant b/ 210.0 10.9 TOTAL 1,932.0 100.0 a, 1985 plan projected for four years. b/ Total cost of project, not only funds to be invested in 1984-1988. Source: Statistical Appendix Table 3.1. down. The Atahualpa refinery has been deferred and the lubricant, polypropy- lene and gas projects and fertilizer plant are on hold, waiting for a suita- ble private sector partner without whose participation the projects will not be undertaken. This revision is welcome. The Atahualpa refinery had a nega- tive rate of economic return and the other projects were of dubious economic profitability. The report, then, concentrates on the evaluation of the remaining projects. Evaluation of CEPE's IQvest et Program EXploration 3.09 Although in the long run only new' oil discoveries will provide replacement oil reserves, the Government's policy is to limit CEPE's explora- tion activities to geological structures close to known commercial fields in order to minimize risks and permit quick exploitation following discovery and to open other, more risky, fields to exploration by private companies. The 1985 exploratioin budget for CEPE provides for an investment of US$23 million;  - 30 - it includes drilling one exploratory well with a cost of US$2 million and drilling another well in partnership with Texaco. This is a drastic reduc- tion from the Five-Year 1984-1988 Plan (prepared in O:tober 1983), in which 12 exploratory wells had been projected to be drilled by CEPE during 1985. With the change in Government in 1984, a program for the years following 1985 has not been prepared. The mission prepared Table II1.1 on the assumption that in 1986-1988 a program similar to the 1985 program would be followed. 3.10 Whereas CEPE's previous exploration plan may have been too ambi- tious, its current plan is excessively modest. CEPE has had an excellent success ratio in exploratory drilling in the Amazon region (15 commercial wells out of 24 wells drilled), but it could still profit from working along- side expert exploration specialists. Unless CEPE continues with a reasonable level of exploration activity, it cannot develop and maintain a reliable exploration staff. 3.11 Projected crude oil production from CEPE's own fields during the next five years amounts to 92 million barrels. In its previous exploratory drilling in the Amazon region, CEPE discovered an average of 5.33 million barrels of new reserves per well. At this discovery rate, just to keep oil reserves at present levels, CEPE must drill 18 exploratory wells during the next five years. With some reorganization and adequate contracted assist- ance, CEPE could effectively conduct an exploration program 4 to 5 times larger than its 1985 plan. 3.12 An active exploration program in the Amazon region (drilling 14-15 exploration wells each year) would be necessary to add 90 to 100 million barrels of new reserves per year and keep the present reserves/production ratio constant during the next few years. If CEPE's exploration program can be upgraded to 4-5 exploration wells per year, then the remaining 10 explora- tion wells per year could be drilled by private companies. 3.13 CEPE is spending most of its 1985 exploration costs on seismic surveys in areas where it is not likely to drill soon. If this investment were concentrated in the north Amazon region where CEPE has considerable experience and infrastructure, 4-5 exploratory wells could be drilled without increasing the budget significantly. In the opinion of the mission, CEPE's exploration program needs to be increased by about US$20 million per year and redirected to the north Amazon region where CEPE's previous efforts have been successful. Oil Field Development 3.14 Development of existing oil fields is clearly the most profitable investment that the Government can undertake. A previous Bank mission inves- tigated three possible investment scenarios and estimated the possible bene- fits associated with each one.1/ Total investments for each of the three cases, together with expected production for every year from 1985 to 1990, appear in Statistical Appendix Tables 3.2 and 3.3. The cash outlays of the 1| IBRD Report No. 5094-EC 'Ecuador: An Agenda for Recovery and Sustained Growth, October 1984.  - 31 - low case amount to US$245 million (1984 prices); the expected output to 541 million barrels. The total outlay of the high case amounts to US$716 million (1984 prices), the total production of the high case to 779 million barrels. At US$27 per barrel, each additional dollar of investment would increase exports by US$13 in 1985-1990. The additional cost of producing a barrel of oil in Ecuador is about US$2; the net additional profit to be derived in the four years 1985-1988 from each dollar of additional investment would be about US$11. This is by far the investment that in Ecuador has the highest expec- ted rate of return, the quickest pay-off, and the most dramatic impact on exports. 3.15 Development investments budgeted by CEPE for 1985 total US$83 mil- lion. Included in this amount are provisions for drill'ng twelve development wells by CEPE and participation by CEPE in drilling nine development wells by CEPE-Texaco. CEPE has not prepared a development program beyond 1985. Were CEPE to continue investing in oil field development at the 1985 planned pace, its investment over the period would be about 70 percent of the investment estimated by the Bank to be necessary to achieve the -maximum production" scenario. Preliminary estimates indicate that the maximum production scena- rio could be achieved if investment in oil field development is stepped up to about US$120 million per year. Storage and Transportation 3.16 The Trans-Ecuadorian pipeline has a rated capacity of 245,000 barrels per day (bpd). in 1983, planning was initiated to expand its capa- city to 293,000 bpd nearly Ecuador's present production rate. Another expan- sion of the Trans-Ecuadorian pipeline system must begin in 1985. Final expansion to the maximum capacity of 400,000 bpd is projected for 1988. These expansions must be undertaken if exploration and oil field development efforts are successful. Present plans are adequate and the mission fully supports them. Expansion of storage capacity is also necessary. The total accumulated investments in crude oil pipelines and terminals during the period 1984 through 1990 is estimated to be US$37 million (1984 prices), of which CEPE's portion is likely to be US$30 million. Refineries 3.17 Four refineries process crude oil in Ecuador. The largest and newest refinery, Esmeraldas, has a capacity of 45,000 bpd. Two refineries located on the Santa Elena Peninsula, Anglo and Gulf, have capacities of 29,000 bpd and 7,000 bpd, respectively. The small refinery operated by the CEPE-Texaco consortium at Lago Agrio has a capacity of 765 bpd. Thus, the total installed refining capacity is about 83,000 bpd, but the mix of refined products does not correspond to the mix of products required by the country; there is excess production of residual fuel oil (which must be exported at below crude prices) and a shortage of gasoline, diesel, kerosene and turbo fuel, all of which must be imported.  - 32 - 3.18 CEPE is well advanced with the program of expansion for the Esmeraldas refinery to a processing capacity of 90,000 bpd and plans to have the expansion in operation by 1987-1988. In addition to this expansion, a proposal is being evaluated for the construction of a new refinery to be located in the Oriente for providing that region with petroleum products, thereby avoiding most of the transport problems and costs now being incurred. This new refinery, whith could begin operating by 1986, would have a processing capacity of 9,700 bpd. Estimated investments required for the Esmeraldas refinery expansion and optimization, and the new Oriente refinery are estimated at US$146 million. Both refineries are readily justifiable. The Zsmeraldas expansion has an economic rate of return of 17 percent; the Oriente refinery has an economic rate of return of 41 percent. Assoclated Natural Gas 3.19 Natural gas produced in association with the production of crude oil is called associated natural gas. In Ecuador, associated natural gas production takes place in two areas, the Santa Elena Peninsula and the Oriente. Currently, the national production is approximately 45 million cubic feet per day (cfd) of natural gas. The Santa Elena Peninsula contri- butes about 1 million cfd of natural gas, with production declining. 3.20 Historically, natural gas produced in the Oriente has been flared, with only nominal volumes utilized as fuel gas and for gas lift operations associated with crude oil production. Due to the low gas/oil ratio and extremely remote production areas lacking any processing infrastructure, full utilization of available natural gas is not economically viable. Of total natural gas production in the Oriente, 23 million cfd have been produced in the area of the Shushufinde-Aguarico gas processing plant. CEPE's current program is to maximize recovery of LPG and condensate from gas. This plan would fully utilize the capacity of the existing gas plant in the region, and represents the most rational method of achieving benefits from natural gas production in the Oriente. In fact, implementation of an effective liquids recovery program would allow Ecuador to beceme self-sufficient in the production of LPG. At this point there is a good prima facie case for the investment. 3.21 The Amistad field, located in the Gulf of Guayaquil, estimated to have between 280 and 440 bcf of natural gas, is another source of energy that Ecuador would exploit. CEPE is currently considering a program tu bring the gas into production and using it to manufacture fertilizer. The investments required to bring the gas into production are estimated at US$228 million; the fertilizer plant would be additional. Although there is no economic feasibility study of the project, there is a prima facie case against it lxcause of the reduced market for fertilizer. An alternative use, as a substitute for petroleum in electric power generation, does not look attrac- tive either, as Ecuador has more than enough generating capacity at the moment to satisfy internal demand (see Chapter IV).  - 33 - Reco mudations 3.22 In sum, the deferrals already undertaken by CEPE are welcome. The missiou recommends that CEPE continue iTith its exploration efforts, but place more emphasis in the north Amazon region, where its undertakings have been successful. Secondary recovery and oil field development should receive more emphasis and an additional US$40 million per year. The plan to construct ancillary facilities for transport and storage should also be implemented. The refinery in the Oriente is fi-lly justified; the expansion of the Esmeraldas refinery is attractive, but not so attractive as to be an unequi- vocal decision. The latter could be deferred if the funds are not tied and could be put to better uses. Plans to maximize recovery of associated natural gas in Oriente need a feasibility study, but there is a good prima facie case for the required investment. On the other hand, none of the uses identified so far for the Amistad gas seem justified. Table III.2 provides a summary of the recommended investments. Table III.2: ECUADOR - RECOMMENDED INVESTMENTS IN PETROLEUM SECTOR, 1985-88 (Million 1984 USS) Distribution of Recommended Recommended as Recommended Investments Z of Proposed i%) Exploration 170.0 19.0 205.0 Development 494.0 54.0 145.0 Refineries 146.0 16.0 13.0 Transport & Storage 97.0 11.0 100.0 Studies 0.4 - a/ - a/ 907.4 100.0 47.0 a/ Negligible Source: Mission estimates. Other Sector Issues Production Rates 3.23 DNH establishes allowable production rates for each well and field with a criteria that in effect restricts oil production so as to make reserves last 20 years, independent of technical and economic considera- tions. There are some instances where oil production could be increased without damage to the fields or with little additional investment.  - 34 - 3.24 The Cononaco field, a new field operated by the CEPE-Texaco con- sortium, currently has a maximum allowable production rate set by DNH of 20,000 bpd. Production could be easily increased to 30,000 bpd without damage to the field. The Shushufindi-Aguarico field has a maximum allowable production rate set by DNH of 110,000 bpd, but oil production could be increased to at least 120,000 bpd by drilling 4-6 new wells .long the reservoir. 3.25 CEPE has 34 wells which have been drilled but are not producing, mainly because the reservoir pressure is too low for naturai flow. In cer- tain wells, repairs, stimulation, or other facilities are lacking, but arti- ficial lift equipment is the major constraint. CEPE could have these wells producing within nine months and increase production by 23,000 bpd. All told, these three large fields could produce 43,000 bpd and increase export earnings by about US$400 million. Organizational Problems 3.26 CEPE's production departdent, which plans and directs all explora- tion and production activities appears too large, dispersed, bureaucratic, inexperienced and subject to too many interests out of CEPE's control. Many of the key staff are in Quito; close, qualified supervision of people in the field is difficult. The Quito staff could be reduced, with most profes- sionals and technical personnel working in the Amazon area. To the extent possible, a cost control center should be implemented for this department, and full authority for decisions and actions, within approved annual budgets and programs, should be delegated to those assigned positions of responsibi- lity. 3.27 The organization of DNH, the technical and administrative branch of MNRE responsible for hydrocarbon activities within Ecuador, is essentially a miniature CEPE. In effect, the DNH has technical groups needlessly duplica- ting CEPE's studies and technical investigation. Those individuals with DNE that are more experienced, and/or more qualified than their CEPE counter- parts, could be absorbed by CEPE to help improve CEPE's technical capabili- ties. A very clear distinction should be made by MJRE between national hydrocarbon policies, and the actual operations by CEPE and other companies. Exploration Contract 3.28 The coastal and offshore regions are very risky from an exploration standpoint, and private capital should be encouraged by all possible means to participate in exploring these regions. CEPE, along with other companies, has invested substantial amounts of money in these regions without rnew com- mercial discoveries being made. The service contract permitting private capital companies to explore for and produce new discoveries of hydrocarbons should be expanded to more areas and calls for bids issued without delay.  - 35 - IV. ELECTRIC POWER SECTOR Introduction 4.01 Ecuador made substantial progress in providing electric energy to its population during the past 15 years. Per capita installed capacity and consumptien more than doubled, and the electrification rate (the number of inhabitatrx with access to electricity relative to the country's population) increased from 28 to 43 percent. Nevertheless, owing to the low levels pre- vailing in 1970, before the oil boom, per capita installed capacity and eccess to electricity are still among the lowest in South America (see Table IV.1). Also, the benefits of the electrification effort were unequally dis- tributed; Quito and Guayaquil (with about one-quarter of the population) account for about three-quarters of total electric energy consumption. Table IV.1: ECUADOR - ELECTRIFICATION RATES IN SELECTED SOUTH AMERICAN COUNTRIES Per Capita Consumption Electrification (KWh/year) Rate (M) Argentina 1,444 80 Brazil 1,167 62 Chile 1,203 88 Colombia 873 63 Peru 619 40 Uruguay 1,205 91 Ecuador 438 43 Source: IBRD reports, 1984 Power Sector Organization 4.02 The Ministry of Natural and Energy Resources is charged with the formulation of national electrification policy. The Ecuadorian Electrifica- tion Institute (INECEL), under the Ministry's jurisdiction, is responsible for power sector regulation and supervision. Ecuador's 1961 Electricity Act stipulates that the Government, through INECEL, has the monopoly on electri- city generation, transmission and distribution, but is empowered to authorize private operations. At present there is only one privately owned company: the Electric Company of Ecuador, Inc. which operates in Guayaquil under a  - 36 - under a municipal concession. The contract expires in 1985. On contract expiration, the municipality of Guayaquil will have the option to purchase the company's facilities at a fair price after giving appropriate advance notice. There are 16 other power companies organized as private corpora- tions, with INECEL as the largest shareholder and the balance of shares owned mainly by the local municipalities. In a few cases, private individuals are also shareholders. All power companies are required to submit their capital budgets to INECEL, inform INECEL about external borrowing plans, allow INECEL to inspect their facilities and audit their records, and abide by the regula- tions approved by INECEL's Board. Dem2md 4.03 Electricity sales in Ecuador increased steadily at an average annual rate of over 13.5 percent, from 791 GWh in 1970 to 2,930 GWh in 1980 (see Statistical Appendix Table 4.1). Concomitantly, uaximum demand increased from 224 MW in 1970 to 767 MW in 1980-equivalent to an annual rate of growth of about 13.2 percent. Since 1980, consumption has grown at a slower pace (7.5 percent per year) owing to the general slowdown of the eco- nomuy. INECEL's latest demand forecast, predicated on the expected slow growth of the economy and rising real prices for electricity, points to a growth rate somewhere between 5 and 7 percent per year through 1990. Table IV.2: ECUADOR - ESTIMATES OF DEMAND FOR ELECTRIC ENERGY 1985-95 Generation Demand (GWh) Peak Demand (MW) Avezage Average Annual Annual Growth Growth i985 1990 Rate (Z) 1985 1990 Rate (Z) High Estimate 4,489 6,179 6.6 863 1,231 7.4 Most Likely Estimate 4,473 5,931 5.8 860 1,181 6.6 Low Estimate 4,447 5,757 5.3 855 1,147 6.1 Source: Statistical Appendix Table 4.2  - 37 - Existing Power Facilities 4.04 Since about 1978, INECEL has been investing according to an aggres- sive Master Plan whose main objectives have been Ci) to meet demand require- ments; (ii) increase efficiency in generation and distribution by integrating all of INECEL's subsidiaries and some municipal systems to the national interconnected system; and (iii) extend service to some 250,000 new cus- tomers. As of December 1984, Ecuador's installed power generating capacity was about 1,680 MW, of which 955 MW (or 57 percent of the total) was thermal and the balance hydroelectric. About 57 percent of total installed capacity is currently interconnected. SOEs (through INECEL, its subsidiaries, and the municipalities) account for about 92 percent of total power supply. Private generation (self-producers, mostly industrial and agricultural undertakings) acccunt for the remaining 8 percent (about 150 MW capacity, of which 137 MW are diesel generators and 15 MW are hydroelectric plants). Installed capa- city is expected to increase by 156 MW, to about 1,800 MW, when the Agoyan hydropower plant enters into operation in 1988. 4.05 Neither INECEL's main transmission ring nor the integration of iso- lated system into the national system are complete. System losses have increased in recent years and were estimated at 16 percent of total energy generated in 1984. This compares with losses only 15 percent in 1978. Although part of these losses are attributable to deficiencies in recording methods, the incomplete transmission and isolated inadequate distribution systems alao contribute. The Power SE r Investment Program 4.06 INECEL is one of the few public sector institutions with a compre- hensive expansion plan. In order to meet energy demand, take advantage of economies of scale in generation and reduce distribution losses during the coming years, INECEL and its subsidiaries have prepared generation, transmis- sion and distribution construction programs for 1985-1995. These are based on the short-term optimization studies which constitute the first part of a three-stage Master Plan. The 1985-1992 expansion program is being drawn up on the basis of the master plan's medium-term studies. The sector's needs in the 1990-2000 period are being examined within the context of the Master Plan's long-term studies. 4.07 The more specific objectives of INECEL's power sector expansion plan for 1985-88 are (i) to finish the Agoyan Hydroelectric Project; (ii) to initiate construction of the third phase of the Paute generating complex (Paute C-) and the Daule-Peripa hydropower component; (iii) to add transmis- sion and subtransmission lines; and (iv) to conduct feasibility studies. As proposed, the plan would amount to about US$800 million (1984 prices)-and would absorb about 20 percent of available public sector investment funds.  - 38 - Evaluation of INECEI. s Investment Program Generatior_ 4.08 E:uador has twice the installed generation capacity that it needs to meet present peak demand. Once Agoyan Project is finished, there will be enough generating capacity to satisfy demand until 1993 (see Graph IV.1). Ecuador, therefore, does not need more generating capacity to meet demand; INECEL's generation investment program aims at saving fuel by substituting hydro for thern-t generation thereby reducing imports (or increasing the exportable surplus) of diesel and fuel oil. Fuel savings, then, must pay for the investment planned in hydrogeneration during the next five years. INECEL's investrcent plan appears in Table IV.3. GRAPH IV. 1: ECUADOR: ELECTRIC ENERGY BALANCE, 1984-96 PEAK DEMAND VS. FIRM CAPACITY 2.,208- - _ _ _ _ _ _ _ _ _ _ a-wI~RM APACXTY 2,W9-h- M DEKMN ----L W DEBM / I-' - i P I-2W 1.48489 888-N|Stj *1 - I IYE 1964 1966 1966 1998 1992 1994 1996 YEARS  - 39 - Table IV.3: ECUADOR - INECEL'S PROPOSED DISTRIBUTION OF PUBLIC INVESTMENT IN THE POWER SECTOR, 1985-88 (Percentages) Total Installed Firm Costs Cost Construc- Capacity Capacity (Million Distribution tion (MW) (MW) 1984 US$) (X) Period Generation 960 725 345.7 44.4 Agoyan 156 125 78.8 a/ 10.1 1982-88 Paute C- 500 430 183.3 23.5 1985-91 Daule-Peripa 130 75 60.5 7.5 1988-90 Paute Mazar 174 95 23.1 3.0 1988-95 Transmission & Substations n.a. b/ n.a. 119.2 15.3 ongoing Subtransmission & Distribution n.a. n.a. 202.8 26.0 ongoinr Studies n.a. n.a. 95.3 12.2 ongoing Other n.a. n.a. 16.2 2.1 ongoing TOTAL 779.2 100.0 a/ Costs to finish the project. Total costs estimated at US$250 million. b/ n.a. stands for not applicable. Source: Statistical Appendix Table 4.3; mission estimates. 4.09 The Agoyan Project, started in 1982, is scheduled to be finished in 1987. The civil works are substantially advanced and the equipment has already been ordered. The mission estimates that to finish the project would require about US$80 million (1984 prices). The economic rate of return on funds yet to be disbursed is extremely high-the payback period is only about four years; the mission considers that this high-return project should be finished.  - 40 - 4.10 Paute -C" is the third phase of a hydropower complex constructed in the Paute River. This complex consists of an existing 160 meter dam--the Paute-Amaluza Dam-and a 500 MW hydropower station that is already in opera- tion. The Paute -C project would consist of an additional tunnel and another hydropower plant, using the existing Paute-Amaluza Reservoir to feed the new plant. Because the project makes better use of an existing dam, it appears extremely profitable, as it would cost only about US$250 million and would have an installed capacity of 500 MW, for a cost of US$0.5 million per MW. The Paute-Amaluza Dam, however, is silting at about 4 million M3 per year; the dead storage volume of the existing Paute-Amaluza Reservoir is about 30 million M3 and would silt in about 5 or 6 years, after which turbine operation might become difficult. INECEL is now studying feasible alterna- tive solutions to the siltation problem with the assistance of international experts. One of the solutions is a geolidro--a device that would suck sedi- ments from the reservoir. 4.11 The construction of another dam upstream-Paute-Mazar-is another solution. This solution would entail building another 160m high dam with a much larger reservoir and the capacity to accumulate sediments for up to 40 years. Unfortunately, sedimentation is taking place so fast that even if Paute-Mazar were started today, it would not be ready in time to prevent silting of Paute-Amaluza. Moreover, the cost of Paute-Mazar would be very high (around US$900 million) and it is not obvious that it would be economi- cally justified. INECEL has been studying the construction of a sediment trap and a diversion tunnel that would take the sediments from upstream of the reservoir and carry them to a place located downstream of the Paute- Amaluza Dam. If feasible, this tunnel would obviate the need to construct Paute-Mazar and would cost only about US$40 million. INECEL has ample time to assess the sediment problem, start construction of Paute -C" in 1986 or even in 1987, and still finish the project before 1994, when it might be needed. 4.12 Daule-Peripa is a multiple-purpose project with a hydroelectric component (see Chapter V). As is discussed in Chapter V, the project as a whole has a low rate of return, but is so far advanced that to postpone it would be uneconomical. Once the dam is built, the additional hydroelectric component would be attractive. Its cost would be about US$108 million (1984 prices); it would have an installed capacity of 130 MW (75 MW firm capacity) and an average energy output of about 400 GWh per year. This energy output, if produced in a thermal power plant, would require about 663,000 barrels of bunker "C. At a price of US$28.37/bbl (1984 average price), fuel cost savings could be about US$19 million per year. In view of (i) the present resource constraint; (ii) the likelihood that oil prices may decline; and (iii) the fact that installed capacity would still suffice to meet peak demand through 1991, it would be advisable to defer construction of the hydropower component two years and start construction in 1989. Results of economic analysis have shown that the economic disadvantages of such a deferment would be marginal.  - 41 - Transmission and Substations 4.13 The first major link of the national interconnected system was com- missioned during August 1980 and ties the two biggest consumption centers, Guayaquil and Quito, through a 654 km 230 KV transmission line. This line will be extended during the construction program 1980-85 from Guayaquil to Paute and from Quito to Ambato. The last section of the 230 KV line between Paute and Ambato is part of the expansion program 1985-89. 4.14 Considerable transmission improvements are expected from this last 300 km transmission line section because it will close the 230 KV trans- mission ring which covers the central part of Ecuador. The 1985-89 expansion program includes also some 300 kms of 138 KV transmission lines which are expected to provide the links between the main transmission ring and remote centers of consumption. 4.15 INECEL plans to invest US$120 million during 1985-88 in the expan- sion of its transmission facilities. In view of the importance for further electrification, improvement in system operation and for loss reduction, these investments can be considered as reasonable and should be maintained, although some slight deferral is recommended in view of the recommended post- ponement of the hydrogeneration investments. ubtrannsussion and Distribution 4.16 Plans are to integrate all isolated systems into the main network through subtransmission lines of 69 and 34.5 KV. The responsibility for carrying out the expansion and connection of the cubtransmission and distri- bution systems, including rural electrification, ts mostly with the regional electric companies under INECEL's supervision. "e amount of investment allocated for subtransmission, distribution and rural electrification during the years 1985-88 is estimated to be in the range of about US$;.00 million, a reasonable amount taking into consideration the low electrification rate in Ecuador. However, the mission recommends deferring installation of distribu- tion lines in the costly rural electrification programs by one or two years. Studies 4.17 INECEL's investment plans include various feasibility studies mostly for new hydroelectric projects. Most of these studies are already under preparation or committed. They would also provide the basis for planning. The mission considers that the amounts budgeted are appropriate. Because of the geothermal potential in Ecuador, the mission considers it desirable to continue with studies for geothermal power plants which could be an attractive alternative to hydropower. An amount of about US$40 million, to be invested in studies during 1985-1988, would be adequate.  - 42 - Reco mendations 4.18 The recommended investment program for 1985-88 is shown in Table IV.4. Compared to INECEL's investment program, the mission's proposal recom- mends reducing the program by over one-third. In proposing this reduction, the mission has taken into consideration that Agoyan will enter into opera- tion in 1988 and that new generating capacity will not be needed before 1993. Paute C should be deferred (one or two years) until more information on sediments and ways to handle them is available. Both a sediment trap and a geolidro could contribute to protecting the Paute-Amaluza Dam and have been included in the investment program. While the sediment trap would be able to control the bed load and larger sediment particles in suspension, the smal- ler, floating particles might not be trapped in the silting basin and might reach the reservoir. The geolidro could deal with the smaller particles in the area near the intake. Table IV.4: ECUADOR - RECOMMENDED INVESTMENT PLAN IN THE POWER SECTOR, 1985-88 (Million 1984 US$) Recommended Distribution as X of Project Recommended (Z) Proposed Generation 156.1 31.9 45 Agoyan 78.8 16.1 100 Paute -C" 58.4 11.9 32 Daule-Peripa 11.5 2.4 19 Paute-Mazar 0.0 0.0 0 Rehabilitation Thermal 7.4 1.5 - Transmission & Substation 93.1 19.0 76 Subtransmission & Distribution 135.3 27.7 67 Studies 43.5 8.9 46 Protection Paute 51.5 10.5 Sediment Trap 33.4 6.8 Geolidro 18.1 3.7 Other 9.3 1.9 57 TOTAL 488.8 100.0 63 Source: Statistical Appendix Table 4.4  - 43 - Other Sector Issues Financial History and Present Situation 4.19 INECEL and its subsidiaries have been facing serious financial pro- blems for a number of years. These problems only became apparent at the beginning of the 1970s, after INECEL started its ambitious hydroelectric investment program. At the time, the country was enjoying unprecedented prosperity arising from high oil prices and ensuing favorable terms of trade, and its incipient role as an oil exporting country. In such a context it was decided that costs of the investment program were to be funded by oil revenues. Indeed, since 1975, earmarked petroleum revenues have been equiva- lent, on average, to about 65 percent of total capital expenditures (Table IV.5). The recent decline in oil prices, and the concurrent Latin American debt crisis, found the sector ill-prepared to face financial realities. Table IV.5: ECUADOR - INECEL: EARMARKED PETROLEUM REVENUES RECEIVED RELATIVE TO CAPITAL EXPENDITURES, 1975-83 (percentages) i975-79 1980 1981 1982 1983 Earmarked Revenues as a Z of Capital Expenditures 78.8 63.3 60.2 79.7 163.9 Source: Statistical Appendix Table 4.9; mission estimates. 4.20 Subsidies encouraged inefficiency at all levels: technical (high levels of system losses and poor maintenance of some regionai systems), administrative (long and bureaucratic decision-making procedures, poor management information systems) and financial (absence of financial planning, cumbersome accounting systems, late and inadequate reporting). INECEL was not selective in its borrowings, and many of the loans it obtained were with short maturities causing heavy debt-servicing requirements for the present. Financial Structure 4.21 Thanks to these subsidies, INECEL's financial structure is sound, despite its poor financial evolution. On a consolidated basis, the ratio of total debts to equity as of December 31, 1983 was 34:66, which is quite low by normal sector standards. Assets have been fully revalued. Yet, INECEL would be in a desperate situation were it not for the pretroleum subsidies.  - 44 - 4.22 In 1983 and 1984, the low level of tariffs resulted in a negative operating income. The slight improvement in operating income in 1984 came from reduced fuel expenses associated with the initiation of operations of the Paute Hydroelectric Project. Net internal cash generation has become increasingly negative; by 1984 the shortfall was US$67 million and would have been even larger, but for the rescheduling of a portion of INECEL's debt amortization. TarIffs 4.23 Electricity tariffs today stand below the 1970 level. The average tariff level is US3.4 cents/kwh (see Table IV.6), which is lower than in most countries in the region and in those developed countries for which recent information is available. Table IV.6: ECUADOR - INECEL: ELECTRICITY TARIFFS, 1970-84 Tariff in sucres Tariff in US cents Current Constant Current Constant sucres 1970 sucres US cents 1970 cents (Sucres per kwh) (cents per kwh) 1970 0.56 0.56 2.72 2.72 1975 0.78 0.42 3.12 2.25 1980 1.28 0.38 5.12 2.34 1984 (Dec.) 3.32 0.36 4.96 at 1.78 a/ 3.42 b/ 1.23 bl a/ At -official' exchange rate of S/67 - US$1. b/ At exchange rate of S/97 US$1. Source: INECEL, mission estim-tes. 4.24 Little has been accomplished to introduce economic logic to the tariff schedules of the utilities: residential tariffs have an initial block (usually 60 to 120 kwh) with frozen tariffs, a second block (30 to 60 kwh) with low -promotional' tariffs, and ascending tariffs per block thereafter. Energy charges are subject to a ceiling which now stands at Sf4/kwh, so that in fact the present policy of increasLng tariffs by 3 percent per month, adopted in January 1985, actually implies that, on average, tariffs are increasing 2.3-2.6 percent per month, i.e., more or less at the same pace as the 1985 target for internal inflation. It also means that at the rate of tariff increases underway in early 1985, the average tariff reached the ceiling around July 1985.  - 45 - Operating Costs 4.25 The Government has already made public its decision not to fire any public-sector employees, and fuel prices will have to be increased signifi- cantly over the next few years. This leaves limited room for savings through reduction of operating costs. INECEL has studied distribution planning and system losses in the regional systems and is also engaged in a program of organizational and managerial improvements. Although it may be worthwhile to review operations, fuel efficiency and maintenance policies at the thermal plants, especially in the small regional systems where technical expertise is limited, it is doubtful that the economies that could be achieved in the next few years from all these programs would have a measurable impact on INECEL's finances. Without rescheduling in 1985, debt service requirements would have been US$151 million. Fuel costs, however, will be only US$20 million and all other operating costs texcluding depreciation) will be US$60 million. Financial Prospects 4.26 Future prospects for financial independence are dim, unless there is a major increase in electricity prices. For illustration, the mission prepared the financial projections reflected in Table IV.7 which set finan- cial independence from the Government as the target. These projections assume a tariff increase averaging 50 percent effective January 1, 1985, fol- lowed by monthly tariff increases averaging 2 percent until the sector achieves such level of cash generation that financial support from the Government is no longer required. This would take place in 1988, with an average tariff level of US8.9 cents/kwh. Under the assumed tariff policy, the funding mix would change from a negative contribution to investment through 1987 to 50 percent self-financing by 1988. Table IV.7: ECUADOR - PROJECTED INECEL INCOME STATEMENT, 1985-89 (As Percent of Revenues) a/ 1985 1986 1987 1988 1989 Revenue from Operations 100.0 100.0 100.0 100.0 100.0 Operating Expenses 91.2 91.5 72.9 56.6 63.9 Operating Income 8.8 8.5 27.1 43.4 36.1 Financial Charges 36.1 25.6 20.9 14.4 10.8 Net Income -29.8 -19.3 4.3 27.5 23.7 Rate of Return (%) 0.7 0.7 2.7 5.0 4.0 Memorandum Item: Net Internal Cash Generation (million US$) -81.0 -56.7 -8.4 61.0 63.3 a/ Assuming 50 percent tariff increase in January 1985, followed by 2 per- cent monthly increases. Source: Statistical Appendix Table 4.6  - 46 - 4.27 As an alternative scenario, the mission also prepared projections based on slower tariff increases: 25 percent on January 1985, followed by 2 percent thereafter. In this scenario, financial independence from the Government would require that tariff increases not only be continued for a long,er time (until 1989), but also end with a higher tariff level (US 9.5 cents/kwh instead of US8.9 cents/kwh) in order to service the higher level of debt that inevitably would be picked up along the way (Table IV.8). Table IV.8: ECUADOR - INECEL: KEY FINANCIAL INDICATORS, 1985-89 (AS A FUNCTION OF 25 PERCENT AND 50 PERCENT TARIFF INCREASE) 1985 1986 1987 1988 1989 50% 25Z 50% 25% 50% 25% 50Z 25% 50% 25% Govt. contributions CUS$ millions) 140 140 135 135 113 113 - 71 - - Gross borrowings (USS millions) 109 135 143 184 88 142 74 74 89 89 Average tariff (US cents/kwh) 4.9 4.1 5.9 4.9 7.3 6.1 8.9 7.6 8.9 9.5 Source: Statistical Appendix Tables 4.5 and 4.8 ReconmendatJous 4.28 The present pricing policy adopted for INECEL has no economic justification and is inconsistent with the Government's goal of ending subsi- dies and making consumers pay for benefits received. Even if earmarking had a justification during the halcyon days of high petroleum prices, the country's present and foreseeable stringent resource constraint argues strongly against subsidies that encourage inefficiency and that do not con- tribute to improving the distribution of income. For these reasons, it would be advisable to review again INECEL's tariffs and adopt a plan to free INECEL from Government subsidies. In addition to revising the overall level, it would also be desirable to revise the tariff schedules and accelerate present efforts to improve INECEL's internal efficiency.  - 47 - V. ALT Introduction 5.01 Agriculture was Ecuador's engine of growth until the advent of oil in 1972. Although agriculture's importance has diminished since then, the sector still accounts for over a tenth of GDP, over a quarter of export earnings, and employs almost one-half of the economically active population. The sector's potential has not been fully exploited and it could play an important role in generating foreign exchange and employment, alleviating two of Ecuador's most pressing problems. 5.02 Government intervention in agriculture occurs through pricing, tax, exchange rate, and trade policies. The Government also invests in agricul- ture to provide irrigation and accelerate development in rural areas through integrated rural development programs, but the most influential participation of the state in agriculture is through the policy framework that it defines. 5.03 Agriculture did not prosper in the 1970s. In fact, it was a lag- ging sector, growing at about 3 percent per year in 1970-82, about half as fast as the rest of the economy and barely ahead of the 2.5 percent estimated population growth rate. [uring this period, Government policies did not favor agricultural development. First, owing to abundant foreign exchange generated by petroleum exports, the exchange rate appreciated in real terms, making it difficult for Ecuadorian farmers to compete in both domestic and world markets. Second, farmers had to pay export taxes during a good part of the 1970s, compete with subsidized imports (e.g., wheat), and bear the onus of protection granted to industry by having to buy fertilizers and agrochemi- cals at highly inflated domestic prices. Partly as a result of high protec- tion to industry and low protection to agriculture the internal terms of trade turned against agriculture forcing farmers to exchange more of their production for an equal amount of goods. Deficient marketing channels, low levels of technology, and poor agronomic practices also held output down. 1/ Finally, the land reform initiated in 1964 shifted relative prices, making labor relatively more expensive and inducing both a structural change in agriculture towards more land-intensive agriculture and abandonment of marginal lands. 2/ / See IBRD Report No. 5094-EC 'ECUADOR: An Agenda for Recovery and Sustained Growth, October 1984. 2, The agrarian reform had an indirect effect in labor costs. In esse ce, it altered-indeed, maybe eliminated-the feudal structure of Ecuadorian society, particularly in the Sierra. Erstwhile serfs, occupying small parcels on large farms in exchange for labor services that were not fur- ther remunerated either in cash or goods, became free men as a result of the agrarian reform. Today, the land-owner has to negotiate payment in kind for labor services. Labor costs, therefore, have become an out-of- pocket expense for the land-owner, rather than a hidden indirect cost.  - 48 - 5.04 In recent years the Ecuadorian authorities have tackled many of the policies which have held agricultural output down. Not only have export taxes been virtually eliminated, but the sucre has undergone several devalua- tions and is now at a level which makes agricultural exports very attrac- tive. Moreover, maximum consumer prices on practically all agricultural pro- ducts have been eliminated and substituted with minimum farmgate support prices, and the subsidy granted to imported wheat, through a preferential exchange rate, has been eliminated. In sum, most of the factors militating against agricultural expansion have either disappeared, or are much less important now than a year ago. 5.05 There are, however, some bottlenecks which could still impede the proper development of the sector. First, marketing facilities are still ina- dequate. To the extent that new policies succeed in stimulating production, marketing channels will become an even more important constraint and the Government is attempting -to break this bottleneck through credit, to the private sector, for building marketing facilities. Second, the technological level is stlll very low, as evidenced by overall low productivity and yield disparities oetween the best farmers and national averages (ranging anywhere f:om 1.5 to 4 times). Sectoral Organization 5.06 The Ministry of Agriculture is charged with the responsibility of defining agricultural sector policies. These include price control for agri- cultural goods and overall invest-"ent levels in the sector. The Ministry also provides research, marketia, and extension services. Some of the most important policies affecting agriculture, however, lie outside the Ministry's reach-excha.g,e rate and trade policies for example. 5.07 A number;of regional development organizations are charged with the execution of most of the major irrigation works, in addition to other devel- opment-related undertakings. The Agrarian Reform and Colonization Institute has the responsibility of supervising and implementing colonization and agra- rian reform. The Hydraulic Resources Institute (INERHI), an agency of the Ministry of Agriculture, supervises the execution and management of irriga- tion works, occasionally overlapping functions with the regional development organizations. The National Institute of Agricultural Rese:rch (INIAP) is the Ministry's research arm, while extension services are _ ivered by 15 different agencies each with responsibilities for specific commodities or activit'-es. Finally, there are two state-owned enterprises attached to the Ministry-ENAC charged with enforcing farmgate prices and smoothing out seasonal fluctuation, and ENPROVIT charged with marketing staples for lower income groups, although both are in the process of being phased out and sub- stituted with private marketing channels. The Integrated Rural Development Secretariat (SEDRI), attached to the Presidency of the Republic, is legally and financially independent of the Ministry of Agriculture and is charged with executing integrated rural development projects. xt  - 49 - Public Investment in Agriculture 5.08 Total public investment in agriculture has been modest. With res- pect to total public investment it averaged less than one-ninth in 1975-1983; with respect to GDP it averaged about seven-tenths of 1 percent. Investments by the semi-autonomous agencies, most of which are regional development corporations dedicated to building infrastructure for irrigation and potable water supply, have on average taken aoout 80 percent of total investment in the sector. Investments in production-related activities, i.e., investments made mostly by product-specific programs, (national banana program, national coffee program, etc.) have been about 3 percent of total investment in agri- culture. 5.09 There is no good economic reason, however, why the public sector should be involved in agriculture other than in the definition of policies and, perhaps, investment in major irrigation works. Ecuador, however, has a high potential for rainr-fed agriculture and does not need much investment in irrigation, the most costly of all agricultural investments. In the absence of irrigation works, public investment in agriculture could be justifiably small; the justification for a particular level must be done on specific pro- ject grounds and not on global considerations, as might be the case with health and education, for example. 5.10 As Table V.1 shows, almost 80 percent of total planned investment in agriculture is for irrigation and about 16 percent is for rural development projects. Forestry and ongoing programs account for virtually the rest. Of the total investment in irrigation, the Daule-Peripa Project would absorb the vast majority of the funds. Table V.1: ECUADOR - PROPOSED INVESTMENT PROGRAM IN AGRICULTURE, 1985-88 (Million 1984 US$) Totals Distribution z Projects in Execution Research & Extension 27.9 7.0 Forestry 16.3 4.1 Rural Development 65.1 16.4 Irrigation 288.4 72.5 Daule-Peripa 213.8 53.8 Tahuin 31.0 7.8 Medium Irrigation 38.5 9.7 Small Irrigation 5.1 1.3 Total 397.7 100.0 Source: Statistical Appendix Table 5.2; mission estimates.  - 50 - Evaluation of Public Investment In Agriculture Ir,rigation 5.11 The Daule-Peripa Project is a CEDEGE-mnaged multiple-purpose pro- ject with the following components: (a) irrigation and drainage system for approximately 50,000 hectares on the Daule River, 17,000 hectares along the right bank and 33,000 along the left, both mainly for rice production; (b) hydroelectric power plant with a capacity of 130 MW; (c) irrigation and drainage system on the Santa Elena Peninsula, to bring approximately 50,000 hectares of land under irrigation by means of a diversion system for the Daule River; and (d) diversion works to provide additional water for the Poza Honda and La Esperanza reservoirs in the Pro- vince of Manabi. 5.12 As a consequence of construction of the dam, other benefits would include: Ci) regulation of the river to supply water for urban consumption to Guayaquil and the river-bank cities of the Daule River; (ii) maintenance of the necessary flow to control salinity and decrease contamination of the river; and (iii) retention of a volume of water equal to flooding levels of 25 years of recurrence for the purpose of controlling flooding in the lower Daule valley. 5.13 Given the resources and execution capacity that the project requires, CEDEGE has subdivided the activities of the program into three stages. The first stage consists of the construction of the Daule-Peripa Dam and drainage system for 17,000 hectares along the right bank of the Daule River. The second stage is the construction of the 130 MW hydroelectric plant. The final stage is the construction of the irrigation and drainage system for the 33,000 hectares on the left bank of the Daale River. At this time the project is in its first stage and the project costs shown in Table V.1 refer to costs necessary to complete the dam and the irrigation works on the 17,000 hectares and initiate works on the 33,000 hectares component. Final designs for the hydroelectric plant are being completed. Construction of the irrigation infrastructure for the 33,000 hectares (with an estimated cost of US$105 million, 1984 prices) in the Daule valley is scheduled to be started in 1987 and completed in 1991. Construction of the Santa Elena com- ponent has no time-table yet; its cost is estimated at US$300 million (1984 prices). To reap the full benefits of the project, the Poza Honda and La Esperanza diversion would have to be constructed; their cost would be about US$160 million. All told, total project cost would be in the neighborhood of US$1 billion.  - 51 - 5.14 The mission did not carry out an economic evaluation of this pro- ject. The following comments and conclusions are based on a study conducted by the IDB, which is financing the project. This project (defined as irriga- tion of 50,000 hectares consisting of the 17,000 hectares along the right bank and the 33,000 hectares on the left bank, and the hydroelectric compo- nent, but excluding the diversion works for Santa Elena, Poza Honda, and La Esperanza) is one that perhaps never should have been started. Expected agricultural benefits are mainly increased rice production; those of the hydroelectric component are fuel savings until 1993 and satisfaction of demand thereafter, as discussed in Chapter IV. Aside from the fact that agricultural benefits are subject to a considerable element of risk because the incremental rice production could not all be consumed internally and an export market has yet to be identified, the costs of the project are too high in comparison to the benefits; the economic rate of return is about 8.8 per- cent (discounted at 12 percent, the net present value of the project's cash flow is a negative US$124 million). The project, however, is far advanced and a'-out one-third of the costs have already been incurred. The relevant question at this point is whether the present value of the costs incurred in stopping the project is higher or lower than the present value of continuing with it. The economic rate of return of the funds yet to be disbursed is still low-11.7 percent; the present value (discounted at 12 percent) is still a negative US$8.5 million. 5.15 Costs of stopping the project would include compensation to the contractors for income foregone, contractual obligation to purchase the equipment and machinery that the contractor has on site, and demobilization. These costs are estimated to be far greater: than US$8.5 million. Further- more, the river has already been diverted to permit construction of the dam and may need to be rediverted; there may be other costs that would have to be incurred if the project is stopped. Because the cost of stopping the project would be greater than the cost of continuing it, the IDB recommended that it be continued. The 33,000 hectares irrigation component on the left bank of the river is not under construction yet and financing is not in place. It would be advisable to study whether scaling it down might be economically justified. Finally, given the costs and uncertain benefits of the additional components (diversion system from Daule River to Santa Elena and diversion works for Poza Honda and La Esperanza reservoirs), a permanent deferral of these components should be considered. Although the mission has included the project in the list of the recommended projects, it has done so only because it appears that by now it would be more costly to stop it. The opportunitv costs of this project may be appreciated considering that the US$270 million that it will cost to finish it could have increased exports of oil in the next four years alone by about US$2.5 billion if invested in secondary recovery. The estimated present value of Daule-Peripa's gross benefits for the next 50 years amount to about one-fifth of this total. 5.16 Tahuin is the second major multiple purpose project in execution. The purposes of the project include (i) irrigation of 80,000 hectares, 10,000 in a first phase and 70,000 in a second phase; (ii) provision of potable water to three cantons (Arenillas, Huaquillas and Santa Rosa); and (iii) flood control. Only US$2.5 million are yet to be disbursed to finish the dam; PREDESUR, the executing agency, estimates that the dam will be finished by June 1986; the irrigation works are at an early stage. Given the advanced stage of the dam, the mission considers it preferable to finish the project.  - 52 - 5.17 Of the 22 planned medium irrigation projects 17 are already in exe- cution. To complete the latter, the Government would have to invest an addi- tional US$25 million (1984 prices) in the next four years and, according to CONADE, all but five will be finished in 1985. Other than the Integrales Loja, these are rather small projects with a cost of under US$3 million each. The Integrales Loja has a cost of about US$8 million, but is a set of smaller projects under one name. Only some of these projects are backed with a feasibility analysis, and time constraints prevented the mission from doing a feasibility analysis of each. Returns are generally acceptable, ranging from 9 to 30 percent, with an average of 19. Given their small size, and their generally high returns, the mission does not recommend suspending them. Of the only two projects with rates of return below 12 percent (Alumis and Quimiag), Alumis has not yet been started and should not be; Quimiag is a US$1.5 million proposition. Rural Development 5.18 Investments under the aegis of rural development account for the second largest share of total investments in agriculture. The budget of the eigh.t rural development projects in execution includes, in addition to capi- tal expenditures, credit components and provision for recurrent expendi- tures. For purposes of this report, only the capital expenditures components were considered. 5.19 As planned, capital expenditures in rural development emphasize road construction (66 percent) and irrigation (21 percent). Socially oriented components-sanitation works and school construction-account for another 10 percent. 5.20 Implementation of all rural development projects has proceeded at an agonizingly slow pace. In general, execution of the social component has proceeded faster than the rest, with the road component lagging behind all others. The three projects which the World Bank has helped finance are illustrative of the slow execution pace. The Tungurahua Project loan became effective on September 28, 1979; the original completion date was mid-1985. As of end-July 1984, no more than 13 percent of the expected disbursements had been realized. As a result of the inability to implement the project, it was restructured and turned essentially into an irrigation project. The Puerto Ila-Chone Project experienced similar delays; implementation of the road component had been hampered by lack of cooperation on the part of the Ministry of Public Works. The Esmeraldas Project also suffered similar delays. Aside from the poor overall execution, it is important to note that implementation of the individual components has not proceeded apace, indica- ting that the synergism, which was the raison d'etre of integrated rural development projects has not taken place. Finally, the Ministry of Public Works has not built the feeder roads and the Central Bank's cumbersome and time consuming reimbursement procedures have slowed credit disbursements. This lack of component integration is most patent in the Puerto Ila-Chone Project where the credit component has lagged partly because the construction of the Daule-Peripa Dam has rendered one-third of the area under the project  - 53 - ineligible for credit. Because the individual components have not interacted synergetically, their priorities are no different from the priorities of similar components in other areas of the country and their relative merits are better assessed within the general discussions of the respective sec- tors. At this point, only a cursory review of the recommendations will be offered. 5.21 In general, feeder roads have a high priority (see Chapter VI), but present plans for the country as a whole are overly optimistic and beyond the Ministry of Public Works' implementation capacity. Moreover, experience up to 1984 indicates that the Government did not devote the necessary resources to fulfill plans to construct feeder roads and consequently execution has lagged. On the other hand, feeder roads are probably the most important bottleneck in the integrated rural development projects. If these projects are to increase income, farmers must have easier access to inputs, technical assistance, and markets. The present institutional arrangement is not con- ducive to success. Although no separate economic feasibility analysis exists for the feeder road components, this is such an important component that it should not be cut. It would be preferable to first try a new institutional arrangement. For this reason, the mission recommends finishing feeder roads already in process or already designed. Both rural health and primary educa- tion are urgent necessities and these components should continue as planned. In sum, save for some minor buildings, the mission considers that the rural development projects should be given one last chance but under a different institutional arrangement. If execution lags, as it has so far, all but the social components should be dropped altogether. Research and Forestry 5.22 The last items in agriculture-related investments are research and forestry. Capital expenditures related to these activities account for US$18 million and were only summarily examined by the mission. Planned capital expenditures on research amount to less than US$2 million in the four years 1985-1988. Reforestation has considerable support from the Ecuadorian, American, Belgian, Canadian and German Governments. The Belgian Government is even participating in the reforestation of the Palmira desert with venture capital. The mission did not evaluate the reforestation investments. Recoendations 5.23 The mission recommended investments, include (i) finishing the first irrigation phase of Daule-Peripa, but delaying the hydroelectric compo- nent by at least two years; (ii) finishing the Tahuin dam and the irrigation channels; (iii) finishing the ongoing medium and small irrigation projects, but not starting new ones for at least three years; (iv) concentrating on the productive and social components of the integrated rural development pro- jects, postponing new feeder roads and finishing only those that are already designed; and (v) continuing with the research programs. A summary of the proposed investments appears in Table. V.2.  - 54 - Table V.2: ECUADOR - RECOMMENDED INVESTMENTS IN AGRICULTURE, 1985-88 (Million 1984 USS) Recommended TOTAL Distribution as Z of (%) (X) Proposed Research & Extension 27.9 7.3 100.0 Forestry 16.3 4.3 100.0 Rural Development 63.2 16.6 97.1 Irrigation 274.0 71.8 95.0 TOTAL 381.4 100.0 95.9 Source: Mission estimates. Other Sector Issues 5.24 Although there are many institutional issues that affect agricul- tural development, these have been addressed in previous Bank documents and need not be repeated here. 3/ Given the importance of irrigation, however, a few cursory comments on water charges are appropriate. As with many other goods and services provided by the public sector, irrigation is highly subsi- dized. INERHI has a two-level tariff, a basic charge supposedly to amortize the capital investment and a 'complementary charge- to pay for recurrent costs. In 1983 total annual income from water charges amounted to S/28 million, while operation costs were S/22 million. The -basic tariff- is calculated so as to amortize 75 percent of the investment in 75 years at a zero discount rate. The implicit subsidy embodied in this tariff is at least 92 percent of the total investment. 4/ 3/ See IBRD Report No. 4522-EC -Agriculture: An Assessment and Direction for Development, August 22, 1983. 4/ To the extent that INERHI fails to revalue the capital costs in accordance with inflation, the tariff becomes even more heavily subsi- dized.  - 55 - 5.25 The implications of these tariffs can be clearly seen in the case of Daule-Peripa. The first phase of the project will cost about US$300 million. Even assuming that recurrent cos:s are fully covered and that the 'basic tariff is adjusted according to inflation, project beneficiaries would pay only about US$28 million. The remainder would have to be paid out of taxes contributed by the population at large or from funds diverted from other uses. An appropriate water tariff is a complex subject beyond the scope of this report. The subject is an important one, however, and the mission recommends that these tariffs be revised.  - 56 - VI. TRANSPOEl AND CUNICAIONS Introduction 6.01 As in many other areas, Ecuador made impressive progress in the expansion of its transport network during the 1970s. Between 1970 and 1980 the total length of paved roads more than doubled, from 2,850 kms to almost 6,000 kms; gravel roads increased by about 50 percent, from 8,200 kms to 12,200 kus, and some 5,200 kms of earth roads were added to the system. This expansion was accomplished with road investments averaging about 1.4 percent of GDP over the period (see Statistical Appendix Table 6.1). Ecuador now has an adequate primary network. 6.02 Ecuador also made substantial progress in providing for adequate port facilities, and there are now three major ports, Guayaquil, Esimeraldas, and Manta. Owing to a 20 percent drop in derand in 1983, these ports in fact are now underutilized. 6.03 The Ecuadorian railway, extremely deteriorated to begin with, was damaged extensively by floods caused by the Nino Current in 1982 and 1983. This was not a grave economic loss. The present good coverage of road infrastructure and the relatively short traveling distances for freight render rail transport uncompetitive with other transportation modes. Beyond transporting passengers to a few isolated areas not served by roads, the railway has little economic role in Ecuador's transport system. 6.04 Air transport plays an important role in the system given Ecuador's geographical diversity and the lack of good transport lines with the more remote zones of the country. Domestic airport infrastructure is still under- developed, however, particularly in the Oriente region. Sectoral Organization 6.05 Responsibility for planning, policy-making and administration is fragmented among ministries, regional and local authorities. The Defense Ministry is responsible for planning and managing the sea and aviation modes. Responsibility for land transport infrastructure is divided between the Ministry of Public Works and the regional and local authorities. The Ministry of Public Works is responsible for the national road network and for rail infrastructure; the regional and local authorities for planning and building secondary and feeder road projects. Road transport regulatory policy lies chiefly within the jurisdiction of the Ministry of the Interior. CONADE is responsible for setting national goals and objectives and for determining relative investment priorities within the sector. As discussed in Chapter II, CONADE does not provide leadership in the formulation of pro- grams and policies; it reacts to initiatives from subsectoral agencies and  - 57 - its role is limited to making adjustments to investment programs as part of the annual budgetary exercise. These 'institutional arrangements do not pro- vide a coherent framework for determinLng relative investment priorities, nor for defining policies that affect the efficiency of the sector, such as pri- cing and regulatory policies. 6.06 The Ministry of Public Works' Transport Planning and Coordination Unit (DPCT) is charged with the development of medium- and long-term trans- port investment plans. This unit, established in 1978, completed its first plan in 1980 and updated it in 1982. The plan has had little or no impact on investment decisions. Economic criteria are often disregarded in investment planning and the Ministry of Public Works prepares feasibility studies only for those projects to be financed by international agencies. Public Investment in Transportation 6.07 The Government's public investment program for transport-including projects underway, and those either mandated by law, or proposed by the exe- cuting agencies and/or CONADE--would absorb about 3 percent of GDP in 1985- 1988. As Table VI.1 shows, about 70 percent of the investment program is slated for roads, about 17 percent for airports and 10 percent for rehabili- tating the railway. The program entails a massive and unprecedented shift of resources in favor of the sector-if implemented it would more than double estimated 1980-83 transport sector expenditures relative to GDP. It would also place excessive emphasis on primary road construction, airports and the rehabilitation of the railway. As mentioned in Chapter II, this massive shift stems from the Rural Poads and Employment Act of 1983 (Ley de Vialidad Agropecuaria y Fomento de la Mano de Obra) which stipulates that, with the exception of revenues earmarked for the National Defense Board, the universi- ties and the technical schools, all revenues from oil exports actually liqui- dated at an exchange rate above 44:1 with respect to the US dollar shall go to finance the construction of a list of specific rural roads and sections of rural roads. Table VI.1: ECUADOR - PROPOSED TRANSPORT INVESTMENT PROGRAM, 1985-88 (Million 1984 US$) Total Percent of 1985-88 Total Roads 888 70 Ongoing 275 22 New 613 48 Railway 124 1C Ports 52 4 Airports 218 17 Total 1,281 100 Source: Statistical Appendix Table 6.3.  - 58 - Evaluation of Public Investment in Transportation Investment Priorities 6.08 The Ministry of Public Works' maintenance capability has not grown as fast as the primary road network and, as a result, mans roads are now in need of rehabilitation. In the late 1970s, budgetary resources for road maintenance increased dramatically and, with them, the quantity and quality of maintenance. Yet, not enough resources have been devoted to road mainte- nance; actual expenditures were only about 77 percent of the required levels in 1981 and 1982; 58 percent in 1983 and only 39 percent in 1984 (see Appendix Table 6.8). 6.09 Road rehabilitation is another area in need of more attention and resources. In addition to roads that have deteriorated owing to normal use and poor maintenance, the floods that were provoked by the Nino provoked caused extensive road damage. 6.10 Finally, Ecuador needs to upgrade and extend its secondary and feeder road network in the Costa and Sierra regions. The Oriente, because of its sparse population and scant economic activity, would be better served with air transport for the time being. Roads 6.11 Over a quarter of the Government's investment program in ongoing roads is for roads that are either not economically justified or overdesigned (see Table VI.2). By lowering design standards and stopping uneconomic investments, the road program could be reduced by some S/6 billion. If in addition, ongoing projects of lesser priority are deferred two or three years, the emphasis of the investment program on ongoing projects would be about right, as it would automatically fall on road rehabilitation and feeder road construction. 6.12 New road projects total some S/48.8 billion (US$613.3 million in 1984 prices) over the 1985-88 period (Statistical Appendix Table 6.6). The list of projects places too much emphasis on new primarv roads between cities already served by reasonable road links (such as Cuenca-Quayaquil), urban by- passes, and areas not associated with regional economic development programs, such as the Selva and the Colombia-Ecuador border. The program does not pro- vide either for continuation of road rehabilitation efforts beyond 1986. Projects totalling some S/12.9 billion (US$162 million in 1984 prices) of new construction and improvement projects are not economically justified, based on the pre-feasibility analyses prepared by DPCT. Another S/4.7 billion (US$59 million in 1984 prices) of new construction (mainly penetration roads) have not been analyzed, but are considered to be of doubtful justification and low priority.  - 59 - Table VI.2: ECUADOR - PROPOSED EXPENDITURES ON ONGOING PROJECTS NOT JUSTIFIED OR OVERDESIGNED (Millions) Expenditure 1985-88 Project Name 1984 Sucres 1984 US$ A. DPCT Evaluation Available Not Economically Justified Jipijapa-Montecristi 680 8.5 Alamor-Rio Puyango 129 1.6 Catamayo-Gonzanima 653 8.2 Esmeraldas-Quininde 123 1.5 San Clemente-B. Caraquez 230 2.9 Hollin-Loreto-Coca 156 2.0 Subtotal 1,971 24.8 B. No Evaluation Available but Justification Doubtful Jipijapa-Manglarito 680 8.5 Cumbe-Pasaje 550 6.9 Subtotal 1,230 15.5 C. Lower Design Standards Appropriate Pinas-Zaruma 210 2.6 Cuenca-Loja 2,125 26.7 Balbadanera-Zhud 1,100 13.8 Sua-Muisne 600 7.5 Ibarra-San Lorenzo 1,335 16.8 Subtotal 5,370 67.5 S_urce: Mission estimates, based on DPCT evaluations. 6.13 Economic evaluations of feeder roads have shown that they have very high economic rates of return. In a sample of 14 roads done in connection with the World Bank's Sixth Highway Project for example, the lowest economic rate of return was 14 percent, the highest 160 percent, the average (weighted by cost) was 54 percent. Nevertheless, the mission considers that the Government's new feeder roads program is not economically justified and pro- bably beyond the country's capabilities. The program calls for the construc- tion or improvement of 3,000 kms over fonr years with a total cost of S/19 billion (US$239 million in 1984 prices). The roads to be constructed under the auspices of this program have not been justified with feasibility studies; the average cost per kilometer (US$79,000) is so high as to suggest  - 60 - that the projects are not the least-cost solutions to the problem of pro- viding year-round access. Furthermore, the Ministry of Public Works and Ecuador's construction industry do not have the capability to execute the program. The Ministry of Public Works is four years behind in implementing the Bank-financed Sixth Highway Project. Of the 1,050 kas planned, only 130 are in execution and not one road has been completed. Until the Ministry of Public Works's ability to plan and build feeder roads is demonstrably better, additional resources will only further strain an already overburdened con- struction system. The mission recommends reducing the investment program in new roads by 70 percent. 6.14 In 1982, the DPCT developed an investment program that took into account the carrying capacity of the present network and possible future demand. The investment required to meet future demand was about US$100 mil- lion per year. While the program is now somewhat dated, in the process cf revision, and, therefore, only indicative at this point, it still provides the only economic criteria for deciding reasonable investment levels. Based on this evaluation, an appropriate level of investment in roads would amount to no more than one-third of total planned investment in the sector, or about 1 percent of GDP. Coincidentally, relative to GDP, this was the average level of investment devoted to roads in the period 1979-82. Table VI.3: ECUADOR - RECOMMENDED ROAD INVESTMENT PROGRAM, 1985-88 (Million 1984 Sucres) Total 1985 1986 1987 1988 1985-1988 New Projects Improvement 0 0 1,467 3,743 5,210 New Construction 0 160 580 1,310 2,050 Rehabilitation 380 367 2,000 2,000 4,747 Feeder Roads 0 0 1,416 1,417 2,833 Total New Piojects 380 527 5,463 8,470 14,840 Ongoing Projects 7,633 7,800 3,200 525 19,158 TOTAL 8,013 8,327 8,663 8,995 33,998 USS Million equivalent 100.7 104.7 108.9 113.0 427.3 Source: Statistical Appendix Table 6.7.  - 61 - 6.15 As Table VI.3 shows, this reduced road investment program calls mainly for rehabilitation, with no improvement of existing rocds until 1987, and only minimal construction (as detailed in Statistical Appendix Table 6.7). After 1986, improvement projects could include, if feasible, two pro- jects to increase capacity along the Pan American Highway and along the Quito-Guayaquil Corridor. The litter would require careful studies to determine least cost solutions to provide capacity increases along critical areas. Initiation of these works could be postponed at least until 1988. The remaining improvement projects could be limited to selected upgrading of the secondary network. 6.16 New Construction. The Government's program calls for four new pri- mary links or bypasses (Quayaquil Port access; Ambato bypass; El Guabo- Kasaji; Cuenca-Guayaquil). It is recommended that only the most promising, the Guayaquil port access project, be tentatively included, pending confirma- tion of its economic viability and then only in the last year of the pro- gram. Other new construction projects are limited to four secondary road projects in the Manabi area which have confirmed economic justifications. It is recommended that the Government's rehabilitation program for 1985 and 1986 remains as proposed. In addition, funds sufficient to finance rehabilitation of 200 km/year should be included in the program for 1987 and 19R8. 6.17 No new feeder roads are 4ustified until 1987 (see Statistical Appendix Table 6.7). In 1987 and 1988, funds sufficient to finance improve- ment of about 300 km/year should be included. Ports 6.18 The Government-proposed port investment program would total S/4.2 billior (US$53 million in 1984 prices) between 1985-1988, of which 87 percent is targeted for the port of Guayaquil (Statistical Appendix Table 6.9). Port investment requirements at Guayaquil are currently being analyzed as part of preparation of a proposed World Bank project. Preliminary conclusions indi- cate that (i) only minor dredging works will be required in the access chan- nel; (ii) investments, mainly in the form of technical assistance and compu- ter technology, should be targeted to strengthening port maintenance capa- city, improving cargo control, streamlining customs procedures, implementing a cost-based pricing system, and adaressing port administration issues; and (iii) port equipment investments are not required. This being the case, investments in the range of US$12-18 million only would be justified over the next four years at Guayaquil. Assuming an investment of US$13 million for Guayaquil, plus the relatively small allocations made for the other ports total investment requirements in the port sector are estimated at US$19 million over the 1985-88 period (Statistical Appendix Table 6.11). Aviation 6.19 Pressure to relocate Quito and Guayaquil airports at a cost of US$250 million each is mounting again. On capacity grounds, these new air- ports are not justified. Some case may be made for relocating the Quito air-  - 62 - port which, because of difficult terrain and low visibility approa^hes, is open only to daylight traffic. The complicated analysis required to assess whether the benefits from 24 hour servic. will justify the US$250 million investment has not been made, but it does not appear that these would be of such a magnitude as to make the new airport a high priority investment. Flight restrictions at Quito resulL in time delays for passengers and cargo. The trade-off between high fixed infrastructure costs and time savings, how- ever, has not been assessed. For international traffic, the restrictions are not as serious because passengers generated by Quito can transit through Guayaquil on domestic lines, when necessary. Time delays for passengers transiting at Guayaquil, are of course an additional cost. On the other hand, the new airport location, outside of the Qutito urban area, would result in increased door-to-door travel time. On balance, the Quito airport reloca- tion project should be deferred. In the short- to medium-term, improved navigational aids may be warranted at both Quito and Guayaquil. 6.20 Improvement of the domestic airports would be important in the Oriente region. The Government does not, however, place priority on these types of projects and the current proposed investment program provides for only limited investment at Bolivar, Manta and Coca airports (SLatistical Appendix Table 6.10). 6.21 Recommendation. Statistical Table Appendix 6.11 summarizes recomi- mended levels of investment for the aviation subsector, assuming (i) the new airports at Quito and Guayaquil are postponed; (ii) a navigational aid pro- gram is implemented after appropriate economic studies prepared; and (iii) other investments are implemented as planned. This would mean investments in airports totaling S/2.4 billion (US$30 million in 1984 prices) over the 1985-88 period. Railways 6.22 The Ecuadorian railway is extremely deteriotated and carries little traffic. Because of increasing competition from road transport and the pro- gressive deterioration of the rail system, traffic declined from 82 million ton-km in 1966 to 15 million ton-km (88,000 tons) by 1981e Traffic was interrupted in 1982 and 1983 because of flooc damage. The railway has an operating deficit of about US$11 million (before depreciation) and would require at least US$100 million to rehabilitate. An emergency loan to repair these damages may have deferred an ideal point to close this company which has little economic role Lo play in Ecuador's transport system. 6.23 Current Government plans call for a S/9.8 billion (US$123 million in 1984 prices) investment to rehabilitate the railway. Feasibility studies for the rehabilitation program have not been made. Nevertheless, based on information available in a comprehensive 1975 study of railway traffic poten- tial, the mission made a rough estimate of the economic feasibility of this investment. Neither the rehabilitation of the railway's southern division nor that of the northern division are justified. In the former, traffic forecasts point to an economic rate of return of 3 percent; in the latter,  - 63 - to 2 percent. These estimates, of course, vary according to the volume of traffic that the railway could carry; traffic forecasts could be wrong. But, to achieve an economic rate of return of even 12 percent, the southern division would have to capture 80 percent of the freight cargo between Quito and Guayaquil and their adjacent areas-an extremely unlikely event. The northern leg would have to capture traffic levels 20 times higher than forecast. Given the high cost of rehabilitation relative to the likely traffic potential, it does not appear that rehabilitation of the railway can be justified on economic grounds and the mission recommends against it. Telecom unicatioua 6.24 Planned investment in teleconmunications amount to about 3 percent of total public sector investments. The mission did not evaluate these investments and they appear in the list of recommended investments in exactly the same amounts and disbursement profile as in -ETEL's original plan. IETEL has consistently generated a cash surplus in its operations despite low tariffs (US$0.003 per three minutes) on its domestic telephone calls. Higher tariffs on telex services and international calls have enabled IETEL to generate a cash surplus. 6.25 IETEL's expansion plans include (i) a rural telephone network which the company considers not profitable but socially desirable; (ii) urban telephones which could be profitable with higher tariffs; (iii) a regional network to improve service and link major urban areas; and (iv) telex services. Recomendations 6.26 In summary, the mission recommends cutting the proposed investment program in the transport sector by 63 percent, as shown in Table VI.4. In particular, the mission recommends cutting ongoing roads by 12 percent; new roads projects by 70 percent; not rehabilitating the railroad; and improving navigational aids in Quito and Guayaquil airports, but not building new international airports. The Oriente would be better served by air than surface transport for the time being. Table VI.4: ECUADOR - PROPOSED VS. RECOMMENDED INVESTMENT PROGRAM IN TRANSPORTATION 1985-88 (Million 1984 USS) Distribution Recommended as Recommended (X) Z of Proposed Roads 427 91 48 Ongoing 241 52 88 New 186 40 30 Railway 0 0 0 Ports 20 4 38 Airports 30 6 14 TOTAL 465 100 37 Source: Statistical Appendix Tables 6.3 and 6.11  - 64 - Other Sector Issues 6.27 As mentioned, in para. 6.05, the division of responsibilities among MOP, the Ministry of the Interior, and CONADE do not provide a coherent framework for determining relative investment priorities. Over the years, several proposals toward centralizing responsibility (creation of a Transport Ministry, creation of multi-modal transport planning unit, establishment of a National Transport Council) have been proposed by the Government, but no action Nas been taken. As a first step, it is recommended that road and rail infrastructure planning (now within the Ministry of Public Works) and trans- port regulatory policy (now within Interior Ministry) functions be consolida- ted within the Ministry of Public Works. 6.28 Problems with planning and coordination of feeder roads is a spe- cial dimension within the overall issue of inadequate planning. It is increasingly important, however, given the high priority which has been placed on feeder road development by the current administration. Of the 'Zotal of 34,000 kms of roads, 8,400 kms of trunk roads are administered by -he Miniatry of Public Works; the remaining 26,200 kms are secondary and feeder roads for which the responsibilities are divided by law between MOP and a great number of other Government agencies: 20 provincial councils, an undetermined number of municipal and cantonal councils, five Central Govern- ment organizations for sectoral development and five regional development organizations. Road administration capacity of the provincial councils vaties widely, from a relatively high level in Guayas and Pichincha to almost non-existence in less developed provinces. Performance of the other agencies is also uneven. 6.29 Efforts to introduce some rationalization to the process have been disappointing at best. The Feeder Road Coordination Unit (UCCV) was esta- blished in the Ministry of Public Works in 1980 to coordinate the activities of the directorates within the Ministry of Public Works as well as the numerous institutions involved in feeder road development. In addition, the UCCV was to be responsible for development of a country-wide feeder road pro- gram based on economic planning criteria. This unit has not been effective and the country-wide program has not been developed. Unless attention is paid at the higaest levels to this problem, the unprecedented level of resources currently targeted in feeder road develcpment and the lack of any economic planning are bound to result in uneconomic investments and ineffi- ciencies in execution. The UCCV should be upgraded to a Directorate and should be adequately staffed. Its functions should be expanded to make it an executing uni: specifically charged with streamlining rural road planning, engineering, construction, and maintenance activities within the Ministry of Public Works, and coordinating non-Ministry feeder road efforts. In addi- tion, a country-wide feeder road program should be developed. 6.30 A related issue is the disregard of economic criteria in investment planning and the resulting low priority given to development of planning and investment analysis capacity. This problem is particularly acute in the area of land transport. In response to this deficiency, a land transport planning tnit, the Transport Planning and Coordination Directorate (DPCT) was esta- blished in the Ministry of Public Works in 1978. A major task was the  - 65 - development of a medium- to long-term investment plan. This plan, which was completed in 1980, and updated in 1982 has had little or no impact on invest- ment decision-making within the Ministry of Public Works. Investment analy- sis capacity in the air and maritime modes should also be strengthened. It is recommended that strict economic criteria for investment decision-making be established, and that economic analyses be routinely included in feasibi- lity studies. 6.31 Fuel Pricing continues to be not only a macroeconomic issue, as discussed in Chapter I, but also a major issue in the sector. At present the Ecuadorian consumer can buy gasoline for 68 percent of its wholesale Carib- bean price; diesel for one-half and kerosene for one-fifth. Low fuel prices contributed to the high traffic growth rates of the 1970s and to putting pressure on the Government to increase road capacity, which in turn diverted resources from other priority investments. Subsidized diesel oil prices and inadequate road user charges also contributed to inefficiencies in the road freight industry. The average truck utilization in 19801/ was 56,000 km/ year, a low average for the region. 6.32 Another issue is that of inadequate road user charges. Revenue from these charges, such as fuel taxes (over and above those required to set fuel prices at international levels) and import duties on road vehicles, should provide for recovery from road users of the costs associated with the utilization of road infrastructure. A study carried out in 1981 concluded that the existing system not only did not provide for cost recovery from road users (Statistical Appendix Table 6.2), but was actually subsidizing the use of roads through low fuel prices and that only passenger cars were paying their way. In particular, heavy vehicles that should have been paying some S10.70 per vehicle-kkm, were actually receiving a subsidy of S/1.46 per vehicle-km costing the country some S/2.16 per vehicle-km. This study is being updated by the DPCT to reflect current conditions, and it is recom- mended that, as a result, a comprehensive set of changes in the structure and level of road user charges be implemented. This is not an argument for further earmarking, but rather for higher fuel prices. 1/ The most recent data available.  - 66 - VII. EDUCATION Introduction 7.01 Ecuador has traditionally made education one of its principal social objectives. The Constitution stipulates that -Education is a main responsibility of the State.... [the Central Government] will allocate no less than thirty percent of its revenues to education and the elimination of illiteracy.' Because of this Constitutional stipulation the proportion of public expenditures on education, relative to the Central Government budget and GDP, is one of the highest in the world, as Table VII.1 shows. Education is one sector where public resources have been relatively abundant and likely to continue so. Table VII.1: ECUADOR - PUBLIC EXPENDITURES ON EDUCATION IN VARIOUS COUNTRIES a/ Z of Government Expenditures Z of Regions (1981) GDP World Average 12.1 3.9 Industrial Countries 11.6 4.9 Oil exporting 14.7 4.5 Asia 12.2 2.6 Europe (non-industrial) 15.0 3.1 Middle East 9.6 n.a. Latin America 13.9 3.4 Ecuador 28.0 b/ 5.2 a/ Sample includes 46 countries. b/ Provisional estimate. Source: IMF, Government Finance Statistics, Vol. VI!, 1983. Mission estimates. 7.02 Rapidly increasing fiscal revenmes resulting from the discovery of oil in the early 1970s, combined with the social priarities enshrined Ln the Constitutional provision cited above, permitted an accelerated provision of educational services to a rapidly increasing populatian. Students in primary  - 67 - education increased 65 percent between 1970 and 1984; and those in secondary education 200 percent. Student population in higher education exploded seven-fold between 1970 and 1983 1/ (see Table VII.2). Table VII.2: ECUADOR - STUDENT ENROLLMENT, 1970 AND 1983 (Thousands) Annual Rate of Growth 1970 1983 z Student Enrollment Primary Education 1,016 1,677 3.6 Secondary Education 217 650 8.2 Higher Education 40 285 15.1 TOTAL 1,273 2,612 5.7 Source: C0NADE, mission estimates. Sectoral Organization 7.03 Responsibility for the overall administration of the educational system (excluding higher education) is vested in the Ministry of Education- structured to cover all aspects of the educational system-where a high degree of centralized control is exercised. The School Construction Direc- torate (DINACE) is responsible for all construction in the sector. DINACE has a planning unit of its own which prepares short- and long-range educa- tional construction plans. CONADE's Human Resources Division is charged with the responsibility of coordinating and planning expenditures on education within a macroeconomic framework. The Ecuadorian Professional Training Service (SECAP) is charged with training the urban labor force in non-firm- specific occupations. SECAP 's funded from a 0.5 percent payroll tax / The quality of education statistics is suspect. Data from the 1982 Popu- l.ation Census indicate that there were fewer children aged 6-9 in the country than reported as enrolled in schools by the Ministry of Educa- tion. Part of the reason may be a general tendency of school principals to over-report enrollments and graduates in order to increase budgetary allocations. Still the above figures provide a fairly accurate impres- sion of the rapid increase in enrollments, especially in secondary and higher education.  - 68 - and roughly matching funds from the Central Government's budget. The struc- ture of the formal education system is designed to provide nine years of basic education, three years of a specialized cycle at the upper secondary level, two-year post-secondary institutes for technical/professional train- ing, and undergraduate and post-graduate programs at the uni ersity and poly- technical level. Sectoral Problems Equity 7.04 As in other sectors, the benefits of education have not been equally shared. In general, urban areas have benefitted more from wider coverage and better facilities. Although about two-thirds of children 7 to 14 years '- age reside in rural areas, primary school enrollment in these areas iS v- one-half of the total; and even this proportion results from the large e jers of rural repeaters in the first and second grades. When primary school graduates are compared to the corresponding age group, achievement in urban areas is approximately double that of rural areas. And when graduates are compared to entrants six years earlier, the completion rate is about 75 percent in urban areas, but only about 30-35 percent in rural areas. 7.05 The distribution of classrooms also favors urban areas. The Ministry of Education estimates that there is a deficit of about 8,300 pri- mary school classrooms, and about 9,400 secondary schaol classrooms (Statis- tical Appendix Tables 7.1 and 7.2); three out of every four primary class- rooms needed in the country, are needed in rural areas. quality and Efficiency 7.06 The education system is also characterized by low internal effi- ciency. It is estimated that the dropout rate in the basic cycle of second- ary education exceeds 30 percent, while in the specialization cycle it exceeds 15 percent. For universities, on the other hand, it appears that dropouts are between 40 and 50 percect of initial admissions, although the quality of the data is less reliable than for the other levels. These rates are generally in line with other developing countries of the region. The specific reasons for these dropout rates are unknown, since the schools and universities conduct neither follow-up studies nor any other type of analysis to diagnose the problem. Interviews with educational officials suggest that at the secondary level the reasons are mainly economic. As students attain working age, pressures to find employment and assist the family mount for those who come from economically deprived families, 2/ but there are other reasons as well, as discussed in paras. 7.08 and 7.09. 2/ IBRD Repurt No. 2900-EC -Ecuador: Education Sector Memorandum, March 11, 1980.  - 69 - 7.07 The evaluation of the quality of the education acquired by those students who successfullly complete any level of the educational system is hampered by the lack of testing and other data. Although the Ministry of Education establishes regulations that govern the evaluation of primary and secondary school students, that evaluation is a local school matter, and the direct results are not compiled for analysis at the national level. As autonomous institutions, universities submit student evaluation data neither to the Ministry of Education, nor to any other national agency. Also missing is a formal process by which feedback can be obtained from industry, Govern- ment, and business on the adequacy of training received by those whom they employ. 3/ Nevertheless, there are many indicators which point to deficient educational facilities and achievements. Primary Education 7.08 Many textbooks are not of appropriate quality or content and, because of their cost, cannot be afforded by low-income families. This pro- blem, especially acute in rural areas where incomes are lower, cont ,butes to the relatively larger number of rural dropouts. 7.09. Although the number of teachers, relative to the number of stu- dents, is roughly adequate, their quality is not. A characteristic of rural education in Ecuador is the need for teachers with specialized training at the piimary level in bilingual (Spanish-Quechua) instruction, so that they may provide Indian children witb approp7.riate bilingual instruction during the first four years of school. The majority of the teachers currently teaching in rural schools that serve Indian children are lacking in this type of pre- paration, and this also contributes to the high incidence of repeaters, drop- outs, and low achievement. 7.10 In part, the relative scarcity and inadequacy of classrooms and the poor quality of the textbooks may be traced to inadequate allocation of resources. In 1983, for example, less than 3 percent of the recurrent budget was allocated to school maintenance, utility bills, and school supplies, while teachers salaries absorbed about 90 percent. SecoSdary Education 7.11 Similar problems are present in secondary education. The number of classrooms is insufficient, and neither books nor teachers are of the approp- riate quality. These deficiencies are partially the result of rapid growth of enrollments. The Government has been forced to direct its resources to quentitative rather than qualitative goals; the need for additional class- rooms and teachers has overshadowed attempts to improve the quality of the programs being offered. 3/ IBRD Report No. 2900-EC -Ecuador: Education Sector Memorandum," March 11, 1980.  - 70 - 7.12 School facilities at the pre-university levels are certainly not conducive to the development of a quality educational system. While urban school facilities achieve a high degree of utilization (generally 2 shifts, at times 3 shifts), the resources for their maintenance are extremely limi- ted. Resources for other vital items, such as utility bills, and consumable materials are also too limited. In 1983, for example, less than 3 percent of the recurrent budget was allocated to these categories; in 1984 and 1985, there was no allocat'on. Rural facilities are not as heavily utilized as urban facilities, but they also suffer from deterioration and poor mainte- nance. Specialized facilities (libraries, and physical education facilities) are generally in poor condition or non-existent. Instructional materials, textbooks, and equipment are also in short supply; the.. quality is wanting, their content inappropriate, and their cost too high-only a limited number of students can afford them, especially in rural areas. 7.13 Another shortcoming of the system at the secondary level is its lack of practical, market-oriented preparation of students and its dedica- tion to programs that feed the universities and polytechnic schools. As Table VII.3 shows, at the specialized cycle there is a heavy concentration in the humanities-a specialization that essentially prepares the student for entry into the universities. Although in many countries and many circum- stances this would not be a problem, in Ecuador, university education is deficient and the marker for university graduates is over-saturated (see paras. 7.19 and 7.21). One-quarter of the students opt for specializations in commerce and administration, careers that unfortunately do not hone the student's skills for clerical careers in business. Table VII.3: ECUADOR - STUDENT ENROLLMENT IN SECONDARY SCHOOL. 1984 (Percentages) Enrollment in Careers fc,: Humanities (pre-University) 61 Commerce & Administration 23 Teachers' College 8 Technical Schools 8 Source: CONADE. Higher Education 7.14 It is a generalized opinion among private and public sector leaders that the quality of university education is poor. Free tuition-required by the Constitution for public universities and achieved through subsidies for private universities-plus no entrance examination have created a large demand for university studies by high school graduates who are ill-prepared to enter the labor market. High underemployment and significant unemployment have further fed this demand. Increases in the national budget allocated to  - 71 - higher education have simply met swelling enrollment needs; quality of higher education has suffered. The number of graduates reported by universities currently reaches 12,006 to 15,000 per year and could eventually reach 30,000. On the basis of annual entry of 12,000 new professionals into the labor force, by 1990 fully 7 percent of Ecuador's labor force would possess university degrees-a percentage well above that observed in countries at a similar stage of development. These estimates indicate that the system has exceeded its optimal size. 7.15 This conclusion is further bolstered by the large number of uni- versity graduates who annually flood the market, but cannot find jobs in the profession for which they studied. The case of unemployed medical doctors discussed in Chapter VIII is a telling example. Ecuador has one of the high- est ratios of medical doctors to population among countries at similar stage of development, but they are ill trained and consequently many cannot find employment and have to seek work in other occupations. 7.16 These indicators strongly suggest that the general quality of edu- cation at all levels, from pre-school to the first four years of university, suffers serious deficiencies. Further, within the primary and secondary levels, the problem of quality is worse in the rural zones where economic, social, and geographic conditions all iateract to blunt the edge of the edu- cational delivery system. A major part of the problem has been the alloca- tion of resources which has been directed to meet the needs of quantitative expansion of enrollment rather than to quality improvements. Evaluation of Public Investment in Education 7.17 It is evident from the previous discussion that the main problem with education in Ecuador is not so much the level of public funding--which is higher than in most countries-but the allocation of resources. Past allocation has led to an inequitable distribution, favoring urban centers to the detriment of rural areas. Also, the use of funds has been biased towards quantitative expansion rather than qualitative improvement. Finally, second- ary specialized- and higher education have been favored at the expense of primary, -basic cycle secondary education and institutional development (planning, evaluation, staff training, and studies). The primary task of public investment in education should be to redress these imbalances. Table VII.4 summarizes the Government's proposed public education investment. The Government's proposed investment program places emphasis on higher education, with rural primary education and urban 'specialized- secondary education tied for second place.  - 72 - Table VII.4: ECUADOR - PROPOSED PUBLIC INVESTMENT IN EDUCATION, 1985-88 (Million 1984 US$) Item Total Distribution (X) Literacy Programs 8 2.8 Rural Primary Education 66 23.6 Rural Basic Cycle 3 1.0 Urban Primary Education 24 8.5 Urban Basic Cycle 6 2.0 Urban Specialized C-le 63 22.4 University Education 105 37.3 Sports Complexes 5 1.7 Studies, Research, Teacher Training 2 0.7 Total 282 100.0 Source: CONADE. Prima" Eduation 7.18 The State's school system participation is most pronounced at the primary level, as only 16 percent of all reported enrolled students were enrolled in private primary schools. Coverage is also more widespread at the elementary level, with almost 100 percent of the corresponding age group in -urban and 70 percent in rural areas enrolled in elementary schools. At Ecuador's stage of development, universal primary education, especially in rural areas, should be the highest priority for public sector investment. Although no studies have been done in Ecuador evaluating rates of return to primary education, studies in various countries have consistently shown that investment in primary education has P. higher rate of return than -in secondary and higher education. Conditions in Ecuador are not so different as to invalidate the conclusions of these studies; there is a strong presumption that in Ecuador primary education is among the most socially profitable acti- vities. Universal primary education makes it possible to provide the popula- tion with uniform, basic skills and with access to higher levels of educa- tion. It is, therefore, one of the principal means for opening opportunities to the population at large and improving the distribution of income. Increased access to education, especially in rural Ecuador, could be an important instrument for speeding up the integration of the rural population into the mainstream of national life. In the long run, primary education could also increase the productivity of a series of resources, from land to people, that under the current social structure are underutilized. There- fore, a greater share of funds than in the past should be directed to primary education, with emphasis on the expansion of access to education and quality improvement of primary education through low-cost teaching materials, teacher training and supervision and evaluation.  - 73 - 7.19 The Government's proposed investment in primary rural education would probably cover about 80 percent of the deficiencies estimated in 1982. Since new needs (even if the rural population stabilized at its 1982 level) can be projected for replacing deteriorating classrooms, distributing text- books, and retraining rural teachers, this is an area in which additional investment should be authorized. Indeed, this is one of the two areas within the education sector in which modest foreign assistance would be fully justi- fied by the expected results. Part of the financing required might be secured by reducing the proposed adult literacy programs. 7.20 Proposed investment for primary urban education (US$24 million, 1984 prices) is insufficient. The shortage of classrooms can be expected to worsen in future years with the rapid rural-urban migration. In the mission's opinion, this is another area where the Government needs to allo- cate more resources; it would also deserve the State's full attention as soon as the large deficits in rural areas are brought down to manageable magni- tudes. Secondbry Education 7.21 Secondary education covers six years. During the first three years the curricula are common to all students. These three years are called the -basic cycle." During the last three years-called the -specialized cycle- the students choose either preparation for university education, or a more specialized education with little or no further training. The Ecuadorian Constitution makes secondary education obligatory through the basic cycle. 7.22 At the basic cycle, the student enrollment in State schools is about 75 percent. The Constitutional requirement making nine years of primary education obligatory has been almost complied with in urban areas, but not in rural areas (no more than 20 perceat of the rural students com- plete it). Even allowing for upward bias in the numbers, it is unusual for a middle-income country to have practically at:ained nine years of universal education in its urban areas: this is a formidable achievement. The last three years of secondary education are characterized by a larger concentra- tion of students in urban areas (92 percent of total), higher participation of private schools (31 percent), and lower coverage (70 percent of corres- ponding age group in urban areas). 7.23 Given the unusually high cQverage attained in urban areas, second- ary urban education is an area where the State can relax its efforts, cut resources and transfer them to another area, such as rural primary educa- tion. This is not to say that the public sector should neglect secondary school classroom construction, only that resources should be charnelled pre- ferably to quality improvement of textbooks, teachers, and curricula. Also, school room coastruction should proceed on the basis of DINACE's analytic school mapping in coordination with the Office of Planning of the Ministry of Education. The State could also accept greater participation of private schools and intervene through scholarships, rather than through full  - 74 - provision of services. Also, to facilitate career choices, the State should sponsor labor market ariyses. The latter are an important activity, espe- cially in view of the system's proclivity to encourage university careers rather than market-oriented education, as discussed in para 7.13. Overall investment, however, could be reduced. 7.24 The proposed 1985-88 public investment for rural secondary schools of the basic cycle (US$3 million, 1984 prices) is not only fully justified, but probably insufficient. The mission recommends increasing this allocation and locating schools so as to provide a network easily accessible from most rural areas. Proposed irvestment in the urban secondary basic cycle is also insufficient and should be increased. 7.25 Regarding rural secondary education in grades 7-9 (the 'specialized cycle-), it may be unrealistic for the State to push for a large increase in the number of students because many rural zhildren (at least 30 percent of the corresponding age group) do not currently finish primary school. The ex- tension of the existing network of basic secondary schools is a much more urgent task for the majority of rural area residents. Availability of finan- cial aid would increase the likelihood of providing the best primary school graduates from rural areas with access to higher levels of education. 7.26 The proposed investment in specialized cycle- schools (US$63 mil- lion, 1984 prices) could be reduced until necessary reforms can be put in place. Such reforms are the establishment of a system of vocational guidance, the amendment of curricula to make them more compc.tible with labor market demands, and, most important, careful selection of high school gradu- ates for entry into the universities and polytechnical schools. Higher Education 7.27 Ecuador's university system exploded during the 1970s, with reported enrollment growing from 40,000 in 1970 to around 300,000 in 1983. Accoriing to the 1984 UNFSCO yearbook:, Ecuador places first among Latin American countries and ahead of many European countries, including Germany and Switzerland, in number of university students per inhabitant. In a para'lel development, t te number of universities and polytechnic schools grew to 18. At present, there is one university per million inhabitants, and less thati 500,000 inhabitants per higher learning institution. If anything, Ecuador has far too many institutions of higher learning. The number one priority in this area is quality improvement, not expansion. Quality may be improved through consolidation of campuses and specialization of existing campuses, duplicating careers in different campuses only in extreme cases. For these goals, additional resources are not needed. 7.28 The Government has been reducing its relative allocations to the higher learning institutions. In 1979 higher education received about 30 percent of total public expenditures in education; in 1983 this share had decreased to about 25 percent. Further reductions will prove more difficult because higher learning institutions enjoy the benefits of earmarked  - 75 - revenues. Universities receive 11 percent of income tax revenues, about 1.5 percent of CEPE's oil export revenues, about 1.5 percent of taxes levied on Texaco's profits, and also funds from sundry other taxes of minor impor- ance. Unless the Government tackles earmarking head on through legislative changes, reducing allocation to these institutions will be practically impos- sible. The Govern,ent might explore, together with higher educational authorities, ways to redress the imbalance between the quantitative expansion and the qualitative improvement. Some devices should be introduced to slow the increase in new students entering higher educational institutions. Otherwise, graduates who are ill-prepared to enter the labor force might not find employment upon graduation and become a serious source of social con- flict. To the extent permitted by the Ecuadorian Constitution, the link between reported enrollments and budgetary allocations needs to be broken. Entrance examinations should be introduced. Finally, the Government should consider closing down the less able institutions after an independent analy- sis is undertaken by a commission on the Government's behalf. The saved resources might be directed to improvements in the quality of educational programs at this level or to other levels of education. 7.29 The Government's proposed investment in higher education absorbs the lion's share of the education capital budget (US$105 million at 1984 pri- ces, equivalent to 37 percent of the total education capital budget). In addition, Congress is discussing the creation of five new universities. In the mission's opinion, the proposed investment in higher education is exces- sive and, pending legislative changes, the Government should limit financial assistance only to cases of proven efficient use of investment funds. Not only is the creation of five new universities unjustified, consideration could be given to consolidating those now existing. Adult Literacy 7.30 Adult literacy programs have been typically declared by each suc- cessive Government in Ecuador to be among its highest priorities. Currently, illiteracy in Ecuador is estimated to be about 15 percent of the population over 6 years old. Almost certainly, this figure is a significant underesti- mate of the true situation, given the 'leniency of the literacy test (in most cases, signing the Census questionnaire). Therefore, illiteracy is undoubtedly an important problem with serious social, political and economic consequences, and justly deserves the attention of the State. However, in a ccuntry in which a large number of children drop out of school before attaining literacy, and many of those who become literate receive education of such poor quality that they soon relapse back into illiteracy, the declared priorities of the Government need reexamination. Accordingly, the mission recommends reducing the allocation to this program. Vocational Training 7.31 SECAP, the principal vocational training agency, developed slowly until 1980, when decisive support on the part of the Government and financial assistance through two Bank loans helped it project a new more dynamic image  - 76 - among the country's entrepreneurs. Until then, SECAP had been considered mainly as a source of additional taxation. ^urrently SECAP is in the middle of its second expansion phase, financed through a second Bank loan. More importantly, it has taken in earnest the goal of consolidating its position vis-a-vis urban workers and businessmen by improving its planning procedures, updating the content of its courses, entering into agreements for on-the-job training of the work force of various firms, and establishing consultative committees at each training center in order to receive direct advice from local firms when preparing detailed operational plans. Given the importance of a trained labor force (and the importance of the ability to adapt the skills of this labor force to evolving demand patterns and techniques of pro- duction) in the Government's drive towards more sophisticated production and exports, a strong vocational training agency could be highly instrumental to the country's development efforts in the next few years. SECAP's expansion plans, therefore, should receive full political and financial support. In the next five years, SECAP plans to invest in vocational training about US$15 million through a World Bank Loan and one billion sucres (1984 prices) for counterpart requirements. Table VII.5: ECUADOR - RECOMMENDED PUBLIC INVESTMENT IN EDUCATION, 1985-88 (Million 1984 US$) Distribution Recommended Item Recommended (Z) as % of Proposed Literacy Programs 6 2.4 75 Rural Primary 86 33.8 130 Rural Basic 4 i.6 133 Urban Primary 30 11.8 125 Urban Basic 6 2.4 100 Urban Specialized 50 19.6 80 Higher Education 66 26.0 60 Studies, Research, Teacher Training 4 1.6 200 Sports Complexes 2 0.8 40 254 100 90 Source: Mission estimates. Other Investments 7.32 Additional resources to strengthen the Ministry's planning and evaluation capabilities would be highly desirable. The effectiveness of the Ministry of Education has been weakened by a lack of strong managerial capa- city among key personnel; an excessive amount of legalistic/bureaucratic  - 77 - procedures in daily operations; and a lack of personnel and equipment to carry out functions that reqaire data processing, printing, duplicating and research. The Ministry is also handicapped by its weak links with other Hinistries and agencies that carry out education/training responsibilities. This creates both internal and external problems of coordination. Planning and evaluation are also weak. The Ministry's Office of Educational Planning has neither the material nor human resources to carry out major educational planning tasks effectively. The unit usually accomplishes its planning with- out inputs from CONADE's Human Resources Division, a failing that is indica- tive of the poor coordination between the two agencies and of CONADE's weak- nesses. In evaluation there is no national achievement testing program, nor a system to measure the accomplishment of any set of educational objectives. Student evaluation is conducted on the basis of local teacher-made tests and final examinations. 7.33 Finally, proposed expenditure on studies, education research and teacher upgrading should be considered of the highest priority. Table VII.5 illustrates an allocation of capital expenditures that might correspond more closely to the country's priorities. This allocation should not be interpre- ted in the same light as, say INECEL's or CEPE's recommended investment pro- gram, but more as an indication of the direction which capital expenditures should take if public funds are to be spent in accordance with the country's educational needs.  - 78 - VIII. HEALTh Introduction 8.01 Health conditions have improved considerably in Ecuador in the past 20 years. Life expectancy increased by 12 years, from 51 to 63 years; infant mortality wrs cur in half and fertility fell by about 20 percent. Ecuador now has death rates and infant mortality rates similar to those of Chile and lower than those of Bolivia and Peru (Table VIII.1). These improvements were possible partly because public expenditures on health care increased at a real annual rate of about 13 percent between 1973 and 1982. Ecuador now spends 3.3 percent of its GDP on public health care--only a slightly sualler proportion than its neighbors. Table VII. 1: ECUADOR - S1E[ HENIH lNi)Ca1f IN SIX S>u!n RAMCAN cownuEs, 1982 Eciador Bolivia Chile Colcuia Pem VeUezla Death Rate 8 16 7 7 11 6 Tnfant MDrtality Rate 78 126 72 54 83 39 Health Expense per Capita (US$, 1981) 18 5 44 na. 14 87 Source: Statistical Appendix Table 8.1 8.02 The improvements, however, have not been widely shared. Neither rural nor periurban residents have the population and health services avail- able to urban residents. Infant mortality hardly declined in the less devel- oped provinces, while it fell by more than one quarter in Guayas and Pichincha. In rural areas the infant mortality rate is at least twice the national average. 8.03 Also, despite marked improvements in health status, much remains to be done in delivery of services. For over half the rural population, public health facilities are so far away in terms of time and distance as to be  - 79 - inaccessible. Only a third of pregnant women receive prenatal care, a fifth of births are attended by professionals, and fewer than one child in twenty receives any medical care at all between ages one and five. More than half of all infant deaths in the poorer zones of urban Quito occur without professional medical personnel present. Sectoral Organization 8.04 Public sector intervention in health takes place principally through the Ministry of Public Health and the Social Security Institute (IESS). The Ministry of Public Health sets policy and goals included in development plans; it has residual responsibility for health service delivery to approximately 80 percent of the Ecuadorian population, particularly the poor and those living in rural and periurban areas. IESS provides health services to its 700,000 affiliates and 200,000 peasant beneficiaries who con- tribute to the payroll tax. The private sector provides just over half of all family planning services and, through pharmacies, drugs and informal medical consultations. There are several effective health maintenance orga- nizations in the major cities. Chapter VIII of this report covers the Ministry of Health's investment program; Chapter IX, some selected issues affecting the financial well-being of the IESS. Health Resources and Infrastructure 8.05 Health resources include about 12,000 practicing medical doctors- one for each 700 persons-a quarter of them employed full or part time in the public sector. This many doctors per inhabitant places Ecuador second only to Cuba among Latin American countries. Unemployment among young doctors has become a serious problem suggesting that, indeed, there may be too many. In contrast, there are too few nurses and health promoters. As with other health resources, there is an unequal geographic distribution of doctors in the country: 80 percent of the practicing physicians live in the three more urbanized provinces with 47 percent of Ecuador's population. 8.06 Ecuador has in place about 2,000 physical facilities (385 are hos- pitals) which provide health services. Overall, there are 16,000 hospital beds, that is, about 2 for each thousand inhabitants, which is typical for Latin American countries of a similar level of development. About half of these are operated by the Ministry of Public Health, 1,600 belong to IESS, and the rest are privately-run. Hospitals, like doctors, are concentrated in Quito, Guayaquil and Cuenca. The overall hospital occupancy rate of 58 per- cent is low and signals significant underutilization of resources. There has been overbuilding of hospitals and probably some inefficient duplication of facilities between the Ministry of Public Health, IESS, and the private sector.  - 80 - Stated Priorities vs. AcStul Expeaditures 8.07 The Ministry of Public Health- nominal priority target groups are women of childbearing age and their children, workers, and the aged. But, despite this priority, primary health care for mothers and children has ina- dequate resources. In 1982 only 18 percent of pregnant women and 21 percent of children were attended by Ministry of Public Health service personnel. The Ministry of Public Health delivers only a third of family planning services received by Ecuadorian families. Health services reach no more than half the urban population and extend only sporadically to rural areas. Between 1979 and 1983, the Ministry of Public Health's per capita annual ambulatory visits (consultas) went up from 0.48 to 0.81, this level still falls far short of the World Health Organization norm of two visits per person per annum. Shortcomings of Present Investment Strategy 8.08 Despite the 13 percent real annual growth rate of public health ex- penditures between 1973 and 1982, it was still not possible to extend services to all Ecuadorians-too high a proportion of the Ministry of Public Health's resources were assigned to hospital-based care. Because resources available are projected to grow far more slowly in the next five years, there is an urgent need to shift priorities away from hospital-based care to basic health eare offered through health posts and health clinics that can ef'ec- tively reach the poor majority. Full population coverage for maternal and child health care may be impossible if too much money is spent on keepi,g hospitals open. If the Government expands health services under the princi- ples that prevailed over the past decade, many people could still be without health coverage in 1990. 8.09 Construction and maintenance of the Ministry of Public Health's physical piani. requires more resources than the Ministry can give it. Many facilities have been started but are inoperative because the Ministry or Public Health lacks t-he monies to complete construction and to provide for staffing, equipment, and maintenance. Half the hospital bed-days available through the Ministry cf Public Health go unused for lack of complementary resources; thus additions to the number of beds available could raise recurrent costs by more than the Ministry of Public Health can afford. It is estimated, for example, that completion of 1,500 beds in 12 hospitals now in various stages of completion would raise the Ministry of Public Health's salary costs by about 10 percent over current levels. It seems unlikely that such a large additional burden on the Central Government budget could be easily absorbed. Thus it may not be financially feasible to finish all 12 hospitals in the period 1985 through 1989. Despite present hospital underu- tilization, the Ministry of Public Health has plans for more than S/4,000 million for hospital construction in 1985 alone and many more hospital con- struction projects in the pipeline. The IESS hospital construction program would cost more than S/30,000 million over ten years, and IESS already has equipment import applications for more than US$20 million. None of these investments can contribute as much to public health improvement as can full coverage of basic health care for all Ecuadorians.  - 81 - 8.10 An increase in sector expenditures for hospital-based service deli- very would be tantamount to accepting a far too costly, high-technology model. Continuation of past policies, including the high-technology approach would leave too many Ecuadorians without services; the investments that it would require would raise the national health bill without resolving basic health problems. Unless there are clear signs that resources can be shifted from high-technology, mostly curative to basic health care, the sector's resources should be limited to a maximum of 3.3 percent of GDP, as shown in Statistical Appendix Table 8.11. Recommendations Ministry of Pablic Bealth 8.11 Investment in primary health care offers a feasible alternative for the Ministry of Public Health. Tt would place highest priority on delivery of primary services, particularly immunizations, diarrheal disease control, and maternal and child health preventive care to all families. This model would focus attention on a few health goals: reducing infant mortality, extending life expectancy, and improving nutritional status. Essential service goals would be delivery of primary care to an increasing share of the total population, particularly through the maternal and child health program; greater extension of coverage to rural and periurban areas, and cost contain- ment so that basic health services could be given to all. The principle of operation would be minimum services to all, rather than expensive curative services to a lucky few. 8.12 This option requires investing less in bricks and mortar and expen- sive imported equipment; it does require a major investment in staff training for medical personnel-investments that build human capital in the health sector. The Ministry of Public Health and IESS staff need reorientation of services away from the current pattern. Health management training is essen- tial. If this option is chosen, it would be worthwhile to augment sector resources as shown in Statistical Appendix Table 8.12. Additional resources, if applied to priority, primary health care programs, could speed health improvements. 8.13 Incremental resources available to the Ministry of Public Health and IESS, shown in Statistical Appendix Table 8.13, would be allocated to basic health care. This approach could address three objectives: (a) Make basic health services accessible to all families, espe- cially those in rural and periurban areas; (b) Improve the efficiency of the Ministry of Public Health and IESS by introducing such modern management techniques as pro- gram budgeting, resource control, and goal-setting; and  - 82 - (c) Move toward a specialization of functions between the Ministry of Public Health, IESS, and other providers within a sector- wide planning framework. Reducing the equity gap requires improving efficiency and effectiveness as well. Avoiding duplication in construction and hospital services would help make less costly services feasible. 8.14 The current policy of concentrating on maternal and child health is sound; it is also consistent with the principle of extending services to the rural poor. The Ministry of Public Health priority program, currently being aided by UNICEF and UNFPA, is the cornerstone around which the rest of Ecuadorts public health system could be built. The malaria program, and the rural health delivery system project are also key components of primary health care. 8.15 Table VIII.2 illustrates, for the Ministry of Public Health, the projected total, current, and capital expenditures which could be contempla- ted with a modest increase in the national health bill, as provided in Sta- tistical Appendix Table 8.12. Table VIII.2: ECUADOR - RECOMMENDED MINISTRY OF PUBLIC HEALTH EXPENDITURES ON HEALTH, 1985-88 Recurrent Capital Total As Z of Expenditures Expenditures (Million 1984 US$) GDP (Z) (z) 1985 72.2 27.8 115 1.2 1986 74.6 25.4 117 1.2 1987 75.6 24.4 126 1.2 1988 76.5 23.5 136 1.3 74.8 25.2 494 1.2 Source: Statistical Appendix Table 8.12 These figures assume a modest expansion of recurrent expenditures, leaving funds available for capital expenditures as a residual. In light of the stated priorities of this Government, the next table illustrates a possible distribution of capital expenditures between the priority programs of primary health care, and necessary investments in hospital facilities.  - 83 - Table VIII.3: ECUADOR - RECOMMENDED DISTRIBUTION OF CAPITAL EXPENDITURES BETWEEN PRIMARY HEALTH CARE AND HOSPITALS, 1985-89 Primary Health Care a/ Hospitals b/ Total Year (Z) (Z) (Million Sucres) 1985 50 50 3,200 1986 60 40 3,400 1987 65 35 3,850 1988 70 30 4,400 1989 80 20 4,900 a/ Includes external assistacce from IDB, USAID (integrated rural develop- ment, population, and malaria), UNICEF, PAHO, and UNFPA, as provided in Statistical Appendix Table 8.9 for 1985, and projected forward to future years; local counterpart assumed to equal one-third of total investments. bf Includes S/1,325 million for Eugenio Espejo Hospital in 1985, as provided in Statistical Appendix Table 8.9; other amounts include hospital con- struction and maintenance. Source: Mission estimates These data suggest that it will be possible to finance a considerable expan- sion of facilities for primary health care, provided that it is possible to reduce funds allocated to hospital construction and maintenance. More effec- tive coordination between the Ministry of Public Health and IESS will be necessary to relieve the pressure on the Ministry of Public Health construc- tion budget. lESS Investments In Health Facilitles 8.16 The IESS is the other important public sector institution involved in construction of health facilities. IESS plans call for an investment of about US$133 million (1984 prices) in hospitals, clinics and equipment (see Statistical Appendix Table 9.12). The geographical distribution of this investment follows previous patterns, as one-half is for Quito and Cuenca, cities that have the highest social security coverage and the best health facilities. 8.17 Besides the equity issue of providing more health facilities to provinces that already are relatively well endowed, there is also an effi- ciency issue. The health facilities in the provinces where Quito and Cuenca are located have low overall occupancy. Better coordination of facilities  - 84 - and more efficient use of available resources could easily meet the needs in the immediate future without doubling the number of hospital beds through the addition of 1,000 new ones, as IESS present plans call for. 8.18 The remaining half of IESS' investment is assigned to provinces with both a social security coverage and health facilities lover than the national average, but with low occupancy rates. It would be preferable to first coordinate and increase the efficiency of existing facilities before quintupling the number of beds with 1,350 new ones. 8.19 The mission recommends halting IESS hospital construction during 1985 and 1986 (except those close to completion) and taking the appropriate steps to coordinate and increase the efficiency of existing facilities. The construction of rural posts and small ambulatory care units; the maintenance of all existing facilities; and the re-equipment of old facilities, should all be of high priority. Reorganizing the health Sector 8.20 The separate management of the Ministry of Health and of the health services of IESS has led to duplication of effort and inefficiency and left millions without services. Coordination is essential to achieve efficiency and it may be necessary to bring the two services under a single management. The National Health Council provides an adequate forum for discussion, but it needs to be used more actively to formulate and pursue a unified health policy to guide the investments and program activities of the Ministry of Public Health and IESS. Other Sector Issues 8.21 Maintenance of health facilities is almost universally inadequate. The Ministry of Public Health may wish to consider reallocating part of its resources away from new construction to rehabilitation of existing facili- ties. The very large investment in new construction for the Hospital Eugenio Espejo might have been reduced if plans had been developed to save the existing excellent buildings. An overall review of architectural decisions for hospital construction would be useful. 8.22 There appear to be too many medical doctors in Ecuador, yet there are large public subsidies for their training. Free tuition for university medical students has far less priority from this perspective than free health services for the rural poor. 8.23 Family planning services are provided in the main by the private sector. The Ministry of Public Health is responsible for 36 percent of fami- lies who use family planning; IESS for only 3 percent. Both these public health institutions could expand family planning within the context of the key ingredients of primary health care: immunization, breastfeeding, oral rehydration therapy, and growth monitoring for children. There is no need to  - 85 - push- these services, since surveys demonstrate that about one-quarter of women want services but cannot get them for lack of physical and financial access. 8.24 The severity of nutritional problems is somewhat in doubt for lack of a recent survey. However, a new nutrition survey will begin soon, and public health managers will need to consider policy initiatives in light of its results. The limited evidence which exists suggests that more vigorous nutrition prograns, in conjunction with the maternal and child health pro- gram, are needed in rural and periurban Ecuador.  - 86 - It. SOCIAL SECURM Introduction 9.01 The social security system in Ecuador has achieved much progress in the last 20 years: coverage of the total population nearly tripled and coverage of the work force more than doubled; insured members are covered against practically all social risks, and the social security system has con- sistently generated a cash surplus. Benefits, however, are unequally distri- buted. Not only are certain groups legally excluded, but coverage among groups legally included is uneven, and the geographical distribution of bene- fits favors urban areas. The stability of the system, moreover, is in jeopardy owing to negative real yields on the Social Security Institute's investment portfolio, a large debt owed by the State, high overhead, and overly generous benefits. These problems not only impede an accelerated expansion of IESS services, they are gradually decapitalizing the pension fund. Social Security Investments 9.02 IESS investments are virtually all in portfolio investments, mainly loans to insured workers, equIty in private firms, and other financial assets. In the past IESS has also invested in real estate, including housing developments for its insured, and in hospital construction. Although finan- cial investments are of signal importance to IESS, they are not the subject of this report and are discussed only in passing. IESS hospital investments are evaluated in Chapter VIII, its investments in housing in Chapter XI. This Chapter's main concern, then, is with issues that affect the distribu- tion of benefits and the long-term viability of the system. Equity Considerations Coverage 9.63 Despite accelerated expansion, the coverage of the social security system is still low. With only 11 percent of the total population and 23 percent of work force covered by social security, Ecuador ranks in 16th and 13th place, respectively, among Latin American countries. Most agricultural wage earners, temporary workers, and the unemployed are legally excluded 8 om IESS coverage. The self-employed may join voluntarily. Although peasant insurance was established in 1968, it still embraces only 9 percent of the rural population.  - 87 - 9.04 Coverage is not only low, it is uneven as well. In general, coverage is higher in the more urbanized provinces, among the higher income groups, and among Government employees (Statistical Appendix Tables 9.1 and 9.2). With few exceptions the poorest are excluded from the system. Benefits and Entitlement Conditions 9.05 Those insured by the IESS enjoy more benefits and easier conditions for entitlement than in most countries of the Latin American region. The pension program covers old-age, disability and death risks, seniority pen- sions, three extra monthly pension payments, and for some groups, a supple- mental pension program. The overall age of retirement-55 with 30 years of work-places Ecuador among the four Latin American countries with the lowest retirement age. Furthermore, one can retire in Ecuador with 35 years of work at any age, and a dismissed insured employee with 25 years of work can retire at 45. 9.06 Although the health-maternity care does not cover dependents (as in most Latin American countries), the insured enjoys unusual benefits, such as dental prosthesis, part of the cost of contact lenses, and the cost of travel and treatment abroad when specialists or services are not available domesti- cally. Insured members have the right to request a variety of loans from the LESS at such low interest rates that in practice they receive a gift as well as a chance to participate in housing programs. 9.07 Benefits and entitlement conditions are unevenly distributed among members. Those entitled to less benefits are usually those with lower income and less influence: domestic servants, artisans, peasants, the self- employed. The better organized obtain more benefits. For instance, communi- cation workers can retire with 10 years less work (at any age) than those insured in the general system; teachers receive 33 percent more than the average pension and can retire three years earlier; military pensions are 56 percent over the general pension (see Statistical Appendix Table 9.4). Health facilities are also unevenly distributed. Military hospitals have a ratio of hospital beds per insured 3.4 times higher than public hospitals. The most developed urban provinces have the highest social security coverage and the highest rates of physicians and hospital beds per inhabitant. Con- versely, the poorest, most rural provinces have the lowest coverage and ratios (see Statistical Appendix Table 9.2). Contributions 9.08 The IESS is financed with wage contributions from the insured and the employer, state subsidles, and investment yields. There are no special taxes (other than the wage tax) earmarked for social security. Nominally, the combined insured/employer wage contribution for social security in Ecuador averages 20 percent of the wage (or income), the sixth highest in  - 88 - Latin America despite Ecuador's 16th place ranking in coverage. however, supplemental income (transport subsidies and other fringe benefits) do not enter into the base of the social security tax, making direct comparisons difficult. The five countries with higher rates-Argentina, Brazil, Chile, Costa Rica, Uruguay-have programs with a much wider coverage and, with the exception of Costa Rica, their programs are much older than those of Ecuador. Furthermore, these countries have aging populations and 8 to 13 years longer life expectancy (except Brazil) than Ecuador, making the pension plans more burdensome and justifying higher contribution charges. 9.09 Social security contribution rates in Ecuador are uneven-rates ranging from 30 to I percent (of wages or income) among the various insured groups, as Table IX.1 shows. Variations among groups are linked to varia- tions in benefits received. For example, teachers and print shop employees, who receive higher pensions, pay higher rates; domestic employees and arti- sans pay lower rates. But the variations in rates are not necessarily com- mensurate with the variations in benefits received. For example, neither artisans nor professionals are eligible for workmen's compensation, severance pay, or health-maternity cash benefits, but their contributions are not reduced in the same proportion. Table IX.I: ECUADOR - TOTAL LEGAL CONTRIBUTIONS TO SOCIAL SECURITY, SELECTED GROUPS OF INSURED - 1984 (As a Percentage of Wage or Income) Insured Group Insured Employer Total Public School Teachers (Highest) 16.4 13.9 30.2 Peasants (Lowest) 1.0 0.0 1.0 Average 11.4 7.9 19.1 Standard Deviation 4.4 6.3 8.3 Source: Statistical Appendix Table 9.3. 9.10 The state is obligated to pay 40 percent of the cost of pensions. This provision has its roots in a law established in response to an actuarial deficit found in 1941 in the public employees pension fund. To cover the deficit, the State was forced to subsidize the cost of all pensions. A tax on the general population, then, was levied in order to favor less than one- quarter of the work force and only about one-tenth of the population. In addition, the State pays military and police pensions, as well as special pensions for communications, railroad, printing workers, and teachers.  - 89 - Efficiency Considerations 9.11 There are many indicators that point to an urgent need to increase the internal efficiency of the IESS as well as its coordination with the Ministry of Public Health. The IESS health program is administered by two geographic units, the National Division and the Coast Region Sub-Division. There is no integration or coordination between these two units or between them and the programs for occupational risk and peasant insurance. Moreover, because of lack of coordination between IESS and the Ministry of Public Health there is often duplication of facilities. HeaLth Care 9.12 IESS' health orientation is incongruous with the health situation described in Chapter VIII. The emphasis is on curative medicine, rather than preventive medicine and mainly on urban groups 20 to 55 years old with the lowest health risks. In 1981, 86 percent of the Ministry of Public Health and 98 percent of IESS expenditures went to the urban sector. Little is spent on preventive medicine and the IESS covers very few pregnancies and children below one year of age. Despite the peasant insurance program, coverage of the rural population is mininal. 9.13 Several indicators suggest overbuilt capacity, underutilization, and inefficient use of health facilities. Ideally, efficient hospital operation is characterized by high occupancy rates (about 85 percent) and short stays. Sometimes inefficient operations achieve high occupancy rates through long stays. In Ecuador, the national rate of hospital occupancy declined from 71 percent in 1971 to 58 percent in 1979, together with a decrease in the average days of stay, from 13.1 to 8.2. IESS hospitals have the highest-although declining-occupancy rates in the nation: 85 percent in 1979 and 82.7 percent in 1981, but their average stays are lengthier than the national average (Statistical Appendix Table 9.13). The number of annual per capita consultations is also another indicator of efficiency. For IESS it was 3.3 in 1981, high for an insured population with low health risk. In contrast, annual per capita consultations in the Ministry of Public Health and peasant insurance program -both of which cover populations with a higher health risk-were significantly lower (1.4 and 0.58, respectively). The cost of the IESS health care program is also excessively high: S/3,309 per person in 1980, compared to S/482 for the peasant insurance program and S/342 for the Ministry of Public Health's. If the IESS model of health care had been extended to all the Ecuadorian population in i981, its costs would have been equal to 55 percent of the Central Government expenditures or almost 10 per- cent of GDP. Finally, the lack of integration between IESS and the Ministry of Public Health facilities also increases costs through needless duplication of facilities. In many provinces occupancy rates in IESS facilities are nearly double those of the Ministry of Public Health. Aduinistrative Expenditures 9.14 Administrative costs are another indicator of efficiency. IESS' administrative expenditures are among the highest in Latin America: in 1983 they reached 17.4 percent of current expenditures and set a record for the hemisphere. In 1977, administrative expenses in the region ranged from 3  - 90 - percent to 13 percent of total expenditures and in two-thirds of the countries were below 9 percent, while in developed countries in North America, Europe and Asia they ranged from 2 to 3 percent. The number of employees per 1,000 insured has steadily climbed to 13.9, and is now one of the highest in the region. Cumbersome administrative procedures, such as complex bidding, are a stumbling block which also pushes prices of goods and services up; a triple auditing system delays decisions. Also, IESS in fact runs the most important housing finance bank in Ecuador. The costs of running this 'bank- are paid by the pension plan, inflating IESS administra- tive costs. Low Yield Xnvestoeots 9.15 Because of the relative youth of the population insured by the IESS and the growth in the number of insured in recent years, the IESS has had a substantial cash surplus throughout its history which it has invested in various activities. In 1983 three-quarters of this portfolio was invested in personal and mortgage loans at an average interest rate of 8 percent, com- pared to an inflation rate of 48 percent. About one-fifth was invested in bonds and stocks; real estate holdings accounted for 2 percent, hospital con- struction and equipment for 1 percent and bank deposits for the rest. The average yield on this portfolio has been consistently below inflation since 1974, but in 1983 it fell to minus 26 percent as inflation soared and yields remained fairly constant. Inflation, of course, has eroded the value of IESS' portfolio. The mission calculated that S/100 invested in 1974 at IESS' average annual yield during 1974-1984 would now be worth about S/45 (1974 prices). If the yield on IESS' portfolio had merely kept pace with inflation in 1974-1984, it would now be worth S/51.4 billion instead of S/27.7 billion; at a real interest rate of only 3 percent (below the growth rate of its obli- gations) it would be worth S/71.2 billion. Since 1982, IESS members have been entitled to 30 year mortgage loans with an initial interest rate of 4.8 percent (first five years) that gradually increases to 22.8 percent (last five years) for an average annual interest rate of 6 percent; to qualify, members do not have to pass a medical examination. 1/ The mission estimated that the implicit subsidy received by IESS members through low interest rate amounted to S112 billion in 1974-1984 in constant 1984 sucres, or 45 percent of IESS 1984 portfolio. 2/ While the portfolio has been eroded by infla- tion, IESS pensions have not, as Table IX.2 shows. I/ IESS intended to charge a higher rate, but a mistaken calculation resulted in an effective annual rate of only 6 percent. 2/ Estimate excludes 1979, a year for which the requisite data was not available.  - 91 - Table IX.2: ECUADOR - INDEX OF REAL VALUE OF ANNUAL IESS PENSIONS, 1970-82, SELECTED YEARS 1975 1980 1981 1982 Index of Real Value of Pension (1970 = 100) 113.5 173.8 159.4 139.1 Source: Statistical Appendix Table 9.4 State Debt 9.16 As in most Latin American countries (e.g., Costa Rica, Panama, Peru) the state systematically delays its contribution to social security. Obligations are eventually honored, but by notes and bonds with interest rates much lower than market rates. Since 1970 the State has not paid its obligations on time, either as an employer or as a contributor. S/225 million were paid in 1970 but almost nothing in 1971-1972; S/333 million in 1973 but nothing in 1974-1975; S/810 million in 1976 but nothing in 1977- 1978; and S/1,312 million in 1979. The State paid nothing in 1980-1983 and in 1984 only partly fulfilled its obligation as an employer. The cumulative State debt to the IESS by the end of 1983 was officially set at S/14.5 billion but an estimate from the Economic-Financial Division of the IESS put it, in November 1984, at S/22 billion (US$280 million at the 1984 exchange rate, or about 3 percent of 1984 GDP). Payment of this debt was recently negotiated. It is the tenth such agreement between the State and the IESS since 1956. Since 1973 the interest rate set in each agreement has been about three percentage points below the inflation rate of the year in which the agreement was signed. Part of the referred State debt has been for obli- gations incurred by the Military and Police Funds with the IESS. IESS acts as treasurer of the armed forces, but delays in contribution payments often result in lags between revenues and expenditures, forcing lESS to deploy its own funds. By the end of 1984, the lag had grown to S/5 billion. Private employers also evade payments; during 1981-84 almost 12,000 trials were held and S/4.4 billion collected from past due obligations. Neither the state nor private employers pay fines or interest rates high enough to compensate for inflation. 9.17 Inefficient management, overly generous benefits, difficulties in collecting from the State, and unsound investment practices have taken a financial toll that is becoming evident: IESS' current surplus, as a per- centage of current income, has declined from 43 percent in 1976 to less than 10 percent in 1983. If this trend continues, a cash deficit will occur before the end of the decade. In the last ten years, as the pension program matured, the percentage of benefit expenditure going to that program increased from 53 to 63 percent. Since 1983, pension income has been used to cover a significant portion of health investment. In the future, there might  - 92 - be a need to subsidize current health expenditures as well. An actuarial balance of the pension fund with data up to the end of 1980 estimated an actuarial deficit (i.e., the difference between expected payments and expected contributions) of 457 billion sucres in the next 20 years (an amount equivalent to one-half of projected 1985 GDP). Although this balance has been criticized within IESS as being flawed in many respects, there is no denying the existence of a major deficit, a deficit that has been aggravated in the 1980s by negative real yields and liberalization in expenditure poli- cies. The cost of social security (including health care administered out- side of IESS) reached 5.6 percent of GDP in 1984, the seventh highest in Latin America, despite Ecuador's very low coverage. At the same rate of expenditures, universal of coverage would have taken 45 percent of GDP in 1984. 9.18 IESS financial structure is in dire need of reform. The overall contribution burden is excessive, differences in the insured's and employer's contributions among various groups are significant and seldom justified, and the State's 40 percent contribution to the pension fund is unjustified. An increase in contributions is not advisable because the global rate is already too high, but unification of contributions is strongly reco ended. On the income side, it is necessary to establish a realistic contribution from the State and assure its punctual payment. Computerization of individual accounts and better control should reduce private sector employers' evasion; detected evaders should be charged with an interest rate well above infla- tion. On the expenditure side, it is necessary to cut privileged special pension programs, increase the age of retirement, eliminate seniority pen- sions, and make other conditions for entitlement tighter and more uniform. Administrative expenses must be drastically reduced. The orientation of the costly health care program should be changed in favor of a more efficient and coordinated program oriented towards preventive medicine and primary care. 9.19 IESS is considering introducing measures to increase interest rates on its signature and mortgage loans, and to diminish risks in the latter by re-introducing prior medical examinations. It is also considering reducing the number of new mortgage loans by closing this window in March of every year, and the number of signature loans by opening this window only part- time. Finally, it is also considering recalculating interest rates on mort- gage loans outstanding to compensate for the previous mistake. Although these measures would increase somewhat the investment yield, they would not stop the decapitalization process. To correct this problem, IESS investment should move away from loans (particularly personal) towards more profitable investment. The capital in mortgage loans should be indexed to inflation, or a system of flexible interest rates during the life of the loan should be introduced. Investment in short-term bank deposits should increase if those deposits pay interest rates above inflation rates. Ideall,, investment funds should be channeled to the capital market, but the latter's small size and uncertainty are serious obstacles, as experience in Chile and other Latin American countries has shown. But an efficient investment policy in finan- cial instruments will ultimately depend upon the development of sound national financial policies.  - 93 - K. WA3ZR SUPPLY ANM SEUR&CGE latroductian 10.01 Between 1960 and 1982 water supply and sewerage service levels improved considerably in Ecuador, from 37 percent of the population served by water supply to 45 percent; and from 15 percent to 28 percent of the popula- tion served by public sewerage. Despite these considerable improvements, service levels are still among the lowest in South America and the benefits have not been equally shared between urban and rural areas. Moreover, the systems are highly inefficient, with 40 to 60 percent of water unaccounted for. Quality of service is generally very poor, and intermittent service is the rule. It is the purpose of this chapter to evaluate water and sewage investment plans in urban areas; investment plans in the rural areas were not evaluated. Table X.1: ECUADOR - WATER SUPPLY AND SEWERAGE IN SELECTED LATIN AMERICAN COUNTRIES 1981 Service Levels Water Sewage Urban Rural Rank a/ Urban Rural Rank a/ (,Z) (Z) (%) (Z) Chile b/ 90 40 1 70 7 2 Peru 57 2 12 55 2 6 Colombia b/ 83 18 6 65 10 4 Ecuador 47 14 14 36 4 9 a/ Position in a sample of 21 Latin American and Caribbean Countries. b/ Service levels for 1983. Source: IBRD Report No. 4168-6, 'Water Supply and Wastes Sector Strategy Paper,- 1985. Sectoral Organization 10.02 The Ministry of Public Health's National Water Authority (IEOS) has responsibility for sector planning and determining investment priorities in coordination with CONADE. IEOS prepares water, sewage and storm drainage  - 94 - projects and operates hospitals, health care centers and 21 water supply sys- tems. IEOS may also construct, set tariffs and promote and participate in the organization of autonomous water supply and sewerage companies, but only at the request of the municipalities. 10.03 IEOS suffers from political interference, budgetary limitations and low quality of staff. It is a highly centralized institution with more thuan 700 employees, most of them residing in Quito. The low level of planning, due to IEOS' weakness, has led to stop-and-go policies resulting in a large number of works being initiated but not completed. In addition, because of the current economic recession, approximately 60 percent of IEOS' works in the urban areas have been brought to a temporary standstill for lack of financing. In the rural sector, the proportion of works halted has been lower, about 30 percent, as active community participation has kept many pro- jects underway. 10.04 At present, only the eight largest cities have autonomous munici- pal water and/or sewerage companies. Most of the other municipalities do not segregate water supply and sewerage services from other municipal activi- ties. Municipal sanitation services are characterized by a lack of qualified manpower and a limited revenue-earning base. Sector Financing 10.05 BEDE authorized water supply and sanitation sector loans amounting to over S/2.8 billion between 1979 and 1983. Water supply projects financed by .EDE must have IEOS' approval and CONADE's assigned priority. 10.06 The 1980-1984 National Development Plan allocated S/10.9 billion, or 8.6 percent of total planned investment, to the water supply and sewerage sector. The Plan amounts did not fully take into account investments by major municipalities and regional agencies. Plan targets were highly opti- mistic. The actual investment including major municipalities and regional entities was Sf700 mlIl"on. The total estimated investment for 1984 was about S/600 million, one-half of the annual investment needed to achieve the Water Decade Targets.1! Sectoral Efficiency and Equity Efficiency 10.07 Efficiency of investment in the sector has been adversely affected by poor project design criteria, lack oi capital cost recovery and condi- tionality of suppliers' loans. Investments in the sector are not subjected I/ The Government of Ecuador's Water Decade targets established under the auspices of PAHO in 1982 are: 80 percent of the population served with water house connections and 95 percent with some kind of sanitation by 1990.  - 95 - to least-cost solution examinations. The present design period for some peripheral urban areas 2/ is uneconomically long, ranging from 20 to 40 years. Projects, as a result are overdesigned. Moreover, the selection cri- teria applied by IEOS is based on 'a first-come, first served basis." Con- struction in stages, designed to meet demand for shorter periods, say 8 to 12 years, would normally optimize economic returns for projects in high growth urban areas. These shorter periods would help stretch funds considerably and ease the financial burden on the communities. Also, the future extensions could be more realistically based on actual urban settlements. A simple per capita cost criterion should be used as a minimum. This will be the first step toward integrating financial and economic analyses with IEOS' technical designs. 10.08 The second problem affecting investment efficiency in the sector is the conditionality of suppliers' loans. These loans are tied to promoting imports from the suppliers' countries and in many cases, lead to the use of inappropriate technology when highly capital-intensive investments are required. An example of this problem is the supplier's loans for compact water treatment plants, which in the case of Manta will cost twice as much as plants already designed by local consultants and reviewed by IEOS. In addi- tion, Ecuador often has no spare parts for such plants and has no trained personnel to operate and maintain them. 10.09 A final problem which affects both equity (and, occasionally, efficiency), is the fact that there is no recovery of capital costs. IEOS suggests tariffs according to the Municipal Law, which states that tariffs can only cover operating and maintenance cost, but even these legally limited tariffs are not being I-mplemented by the municipalities. In a sample of 50 systems, total income in 1983 covered only 45 percent of operating expenses. The resulting operating deficits are covered by municipal budgets and debt service by the Central Government. In contrast, most rural systems cover at least their operating expenses, with many accumulating a surplus for future extension. The disparity between cost recovery levels in urban and rural systems is illustrated by the town of Ambato, where consumers pay a tariff of Sf0.50 per m3 while those in nearby rural areas, whose incomes are generally lower, pay S/2 per m3. The fact that capital costs are not recovered from users promotes project overdesign, water waste, and lax management prac- tices. Recomendations 10.10 Unlike sectors such as electricity and transportation, where there is some information concerning rates of return about the various projects under consideration, in the water and sewerage sector, IEOS has no such 2, Number of years during which capacity of the facilities will meet or exceed demand.  - 96 - information. The mission could not evaluate each project within the time limits allowed, but another approach to project selection was adopted. In general, the projects selected addressed both equity and efficiency issues, but also practical considerations. Water supply was ranked above sewerage because the former is more effective in preventing disease. In particular, the mission accorded high priority to projects that (i) redress service level disparities, especially in communities where individual low-cost sanitation solutions can be used; (ii) improve the service level in the low-income and high density population areas of Guayaquil and Quito because of the public health threat; (iii) are located in municipalities with a strong commitment to adequate operations, maintenance and cost recovery practices; (iv) are based on realistic demand forecasts; (v) foster mawimum investment efficiency by integrating project components, i.e., if the production capacity is expanded, the distributUon system should be expanded accordingly; and (vi) complement other public investments. 10.11 Based on the above criteria and giving special weight to the per capita cost and the percentage of population served, on-going projects in urban centers which lack financial resources and deserve first priority are the following: Water Supply Project Z of Physical Cmpletion Guayaquil exrpansion of the first stage of the system 25 Mendez 50 Tabacundo 55 Puyo 50 Salitre 37 Macara 43 Corazon-Moraspungo 15 Polara 10 Sanitation Arenillas 70 Huaquillas 53 Santa Rosa 35 Macara 31 Quevedo 25 10.12 New projects which lack financial resources and deserve first prioritv because their benefits will e,xceed costs and improve services in urban centers with continued rapid urbanization and industrial/commercial growth appear in Statistical Appendix Table 10.1. 10.13 Based on IEOS' estimates, the total cost of the recommended 1985-88 program would be about S/1o billion (1984 prices) or about US$127 million, as shown in Table X.2.  - 97 - Table X.2: ECUADOR - RECOMMENDED PUBLIC INVESTMENT IN WATER SUPPLY & SEWERAGE, 1985-88 (Million 1984 USW) Recommended as Total 2 of Proposed Water Supply 126.6 98 Sewerage 35.8 82 Technical Assistance 3.5 Source: Mission estimates. Otber Sector Issues 10.14 In additior, the mission strongly recommends an immediate institu- tional development program for IEOS with special emphasis on sector planning financial policies, review of project preparation and design standards, and technical assistance for the municipalities to improve their operation. The cost of this program would be about US$3.5 million. 10.15 The rural water supply and sanitation projects (not evaluated by the mission, as mentioned in para. 10.01) have available financing from the Fondo Nacional de Saneamiento Ambiental' (FONASA) created on August 10, 1984. It would be necessary for IEOS to triple its execution capacity in order to carry out this ambitious program. This will be a very difficult goal to achieve if IEOS does not improve its internal organization consider- ably.  - 98 - X1. HOUSING Introduction 11.01 Approximately 45,000 new families are being formed in Ecuador every year. About 40 percent (or 600,000) of the existing dwelling units are deficient in one way or another, be it that they lack sewerage, water, or electricity connections. It is in this sense that there are both quantita- tive and qualitative housing deficits in Ecuador. 11.02 During its electoral campaign, the present Administration promised to address this problem and provide -pan, techo y empleo (bread, roof, and employment) to the Ecuadorian population. Since taking office, the Govern- ment has been formulating a plan to fulfill its electoral promise and made substantial progress in defining what type of dwelling units it wants to build, for whom it wants to build them, and how it is going to finance them. The purpose of this chapter is to assess whether the plan is feasible and in accordance with the Government's social objectives of providing dwelling units to lower-income families. 11.03 Public intervention in the housing market has traditionally taken place through two institutions, the Social Security Institute and the Ecuadorian Housing Bank (BEV). IESS has clearly the lion's share of the housing market with about 60 percent of all loans outstanding (see Table IX.1). Of the public sector institutions IESS grants the largest loan amounts (up to US$16,000) at the longest terms (30 years) and at the lowest interest rates (6 percent per year). IESS is funded entirely from its own resources. Table XI.1: ECUADOR - HOUSING FINANCE AND ILLUSTRATIVE MARKET SEGMENTATION, 1984 Private BEV IESS S&L Cooperat