Mozambique - Second public expenditure review

FILE COPY CONFIDENTIAL: Report No. 11524 - MOZ Report No.:11524-MlOZ Type: (SEC) Title: SECOND PUBLIC EXPENIDITURE REVII Author: PEREIRA DA SILVA. L Ext.:342461 Room:J11031 Dept.:AFbCO GREEN COVER Mozambique - Second Public Expenditure Review December 31, 1992 Country Operations Division Southem Africa Departnent FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   CURRENCY EQUIVALENT TO THE USD (Local Currency Unit is the Mozarnbique Metical -plural Meticais-- MZM) Value of 1 USD in MZM in year. 1975 27.24 1980 32.40 1981 35.35 1982 37.77 1983 40.18 1984 42.44 1985 43.18 1986 40.43 1987 289.44 1988 528.60 1989 819.71 1990 1038.15 1991 official rate 1845.40 1991 secondary market 2033.00 1991 parallel market 2247.00 MOZAMBIQUE - INFLATION (CPI) RATES AND NOMINAL DEVALUATIONS 609 PERCENT NOMI AL^ 190 DEVALUATION IN ADJVSMENT PERIOD 140 n inlao(CPI) LUNE OF 10 PERCENT OF INFLATION 40 - 19S0 1991 1982 1983 1984 1985 19 1987 1988 1989 1990 1991 ABBREVIATIONS BDM Banco de Mocambique BOP Balance of Payments BPD Banco Popular de Desenvolvimento CAD Current Account Deficit CCCE Caisse Centrale de Cooperation Economique CF Counterpart Funds CG Consultative Group CGE Central Government Expenditures CIDA Canadian International Development Agency CNE National Executive Comission for Emergencies  CNP National Planning Commission CPE Centrally Planned Economy DEO Department of Budgetary Execution DNIA Direc,o Nacional de Impostos e Auditoria DPCCN Department for the Prevention and Combat of Natural Disasters EC European Community EDM Electricity of Mozambique EPI Primary Level Education ERP Economic Rehabilitation Program ESAF Enhanced Structural Adjustment Facility ESRP Economic and Social Rehabilitation Program FFP Fundo de Fomento Pesqueiro FRELIMO Partido da Frente de Libertac,o de MoNambique GDP Gross Domestic Product GOM Government of Mozambique IDA International Development Agency IMF International Monetary Fund ISP Instituto Superior Pedag6gico LAM Linhas Aereas de Mo,ambique M2 Money and Quasi-money MB-10 Common Account for counterpart funds deposits MINED Ministry of Educaion MOC Ministry of Comnmerce MOF Ministry of Finance MOH Ministry of Health MZMv Metical or Meticais NGO Non-Government Organization OGE Or,amento Geral do Estado or General State Budget OGL Open Generalized License PDP Priority District Program PER Public Expenditure Review PFP Policy Framework Paper PFT Trienal Financial Plan or Plano Financeiro Trienal PHC Public Health Care PTIP Trienal Public Investment Program or Plano Trienal de Investimento Publico RENAMO National Resistance of Mozambique or Resistancia Nacional de Mo,ambique SIDA Swedish International Development Authority SNAAD System for Non-Administrative Allocation of Foreign Exchange SNE National Education System SPA Special Program of Assistance SSA Sub-Saharan Africa TA Technical Assiatnce UEM University Eduardo Mondlane UNDP United Nations Development Program USD US Dollar USAID US Agency for International Development FISCAL YEAR Government = January 1 to December 31  TABLE OF CONTENTS Executive Summara pg. i. 1. The 2nd PER and the context of the transition from a war to a peace economy pg. i. 2. Backgound: the post-Independence crisis (1980-1984) and the adjustment process in Mozambique (1986-90) pg. iv. 3. Public Expenditures and the adjustment process pg. viii. 4. The improvements in sectoral policies pg. xvi. 5. Quantitative projections of public expenditures for the future pg. xxvi. 6. Summary of Conclusions and Recommendations pg. xxix. ChIR2ter I : THE ADJUSTMENT PROCESS AND PUBLIC EXPENDITURES IN MOZAMBIQUE pg. 1. Section L.L. Introduction: the specificity of a Public Expenditure Review (PER) in a war economy pg. 1. Section 1.2. An assessment of the adjustment process 1986-1990 pg. 2. Section 1.3. Pattems of Government's expenditures during the adjustment process pg. 11. Section 1.4. Summary and Conclusions: the role of Public Expenditures in Mozambique's "heterodox" adjustment process pg. 13. Section 1.5. : Structure of the Report pg. 14. This report is based on the findings of a core mission that visited Mozambique in October/November 1991. The main mission consisted of Luiz A. Pereira da Silva (AF6CO), Carla Grasso (consultant), Rocio Castro and Maria Teresa Benito (AF6CO). Sectoral contributions were received from Ricardo Silveira and Ruthanne Deutsch (for Education and Health), Roberto Echeverria and Arne Disch (for Agriculture and Fisheries), John Roome (for Infrastructure) and David Phillips (for Industry and Energy). This Document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Mozambique - 2nd PER - Table of Contents  Chapter 1 PUBLIC EXPENDITURES IN MOZAMBIQUE IN 1991 pg. 19. Section 11.1. : The importance of PER for macroeconomic regulation in Mozambique pg. 19. Section 11.2. Govemment Expenditures in 1991 first year of the 5th PFP pg. 19. Section 11.3. Summary, conclusions and recommendations: the new challenges for public expenditure programs in the transition to peace pg. 31. Annex 11.1. Mozambique - Conditions of accessibility in February 1990 pg. 40. Annex 11.2, : Mozambique - Demobilization of the military pg. 41. Annex 11.3. : Mozambique - Summary of Government Finance 1980-1991 pg. 46. Annex 11.4. : Mozambique - Govemment's recurrent and investment budgets for 1991 pg. 49. Chapter 1I : CROSS-SECTORAL AND INSTITUTIONAL ISSUES FOR PUBLIC EXPENDITURES IN MOZAMBIQUE pg. 51. Section 111.1. : Progress made since the first PER pg. 51. Section 111.2. : The collection of counterpart funds pg. 51. Section 111.3. : Institutional issues in public finance management pg. 65. Section 11.4. Summary, conclusions and recommendations: pg. 71. Annex 111.1. Accounting of Counterpart funds pg. 80. Annex 1112. : Monetary Accounts pg. 81. Mozambique - 2nd PER - Table of Contents  Chapter IV SOCIAL SECTOR'S (EDUCATION AND HEALTH) PUBLIC EXPENDITURE REVIEW pg. 83. INTRODUCTION pg. 83. THE EDUCATION SECTOR pg. 84. Section IV.]. : Overview of the Education sector pg. 84. Section IV.2. : The Education Sector Expenditures pg. 86. Section IV.3. : The Education Sector Public Investment Program pg. 89. Section IV.4. The Education Sector Financing pg. 92. Section IV.5. : Forecasting resource requirements for the Education Sector pg. 96. THE HEALTH SECTOR pg.l00. Section IV.6.: Health Sector status pg.l00. Section IV.7. : The Health Sector Expenditures pg. 103. Section IV.8. : The Health Sector Public Investment Program pg. 106. Section IV.9. Efficiency of resource allocation pg.109. Section IV.10. The Health Sector Financing pg.l 10. Section IV.11. Forecasting resource requirements for the Health Sector pg. 14. Chapter V AGRICULTURE & FISHERIES SECTOR PUBLIC EXPENDITURE REVIEW pg. 1 17. AGRICULTURE Section V.]. An Overview of the Agricultural sector pg. 1 17. Section V.2. The Institutional Organization, Strategy and Piiorities pg. 120. Section V.3. Total Sector's Expenditures pg. 126. Section V.4 Structure of the Agricultural sector overall financing pg.133. Mozambique - 2nd PER - Table of Contents  Section V.5 Public expenditure requirements for the transition in the Agricultural sector pg.136. Section V.6 Summary and recommendations of the 2nd PER for the Agricultural sector pg. 136. FISHERIES Section V.7 An Overview of the Fisheries sector pg. 139. Section V.8. Fisheries Sector's consolidated public expenditures pg.148. Section V.9 Fisheries sector issues pg.148. Section V.10 Summary and recommendations of the 2nd PER for the Fisheries sector pg. 158. Annex V.]. Organigram for the Fisheries Sector pg. 159. Annex V.2. Major Firms in the Fisheries Sector pg. 160. Annex V.3. Registered Catches pg. 162. Annex V.4. Sofala Bank Fisheries pg.163. Annex V5. Value of Exports of the Fisheries Sector pg.164. Annex V.6. Relative importance of Income and Expenditure in the Fisheries Sector pg. 165. Annex V.7. Investments in the Fisheries Sector pg. 166. Chapter VI INFRASTRUCTURE SECTOR'S PUBLIC EXPENDITURE REVIEW pg. 167. TRANSPORT SECTOR (RAILWAYS, ROADS, COASTAL SHIPPING AND CIVIL AVIATION) pg.167 Section VI.] Intrduction, summary of findings and recommendations pg. 167. Section V7.2. : Sectoral Institutional Organization and Strategy pg.168. Section V13. : Sectoral Public Expenditures pg. 181. Mozambique - 2nd PER - Table of Contents  THE WATER SECTOR Section VI.4 Overview of the Water sector in Mozambique pg. 1 87. Section V.S. :. Sectoral Public Expenditures pg.187. Section VI.6. Financing of Public Expenditures and potential for increased financial resources pg.188. Section Vl.7. Conclusions and recommendations: pg. 190. Chapter VII : INDUSTRY AND ENERGY SECTORS PUBLIC EXPENDITURE REVIEW pg.191. THE MINING AND INDUSTRIAL PROCESSING SECTOR Section VII.l. : Overview of the Minig and Industrial Processing sector pg.191. Section V11.2. : Insttutional structure, Organization and Strategy for the Industry sector pg.192. Section V11.3. : Total Public Expenditures in the Mining and Industry sub-sector pg.193. Section V11.4. : Financing Public Expenditures - Mining and Industry sub-sector pg.196. Section VII.5. : Public Expenditures and Industrial strategy during the transition to a peace economy pg. 196. THE ENERGY AND TELECOMMUNICATIONS SECTOR Section V11.6. : Overview of the Energy and Telecommunications sector pg.201. Section V11.7 : Institutional and Organization structure pg.202. Section V11.8 : Total Public Expenditures program pg.202. Section V11.9. : Strategy for the transition to peace and its implications for Public Expenditures pg.204. Section VII.1 0: Implications of Peace: medium-term investment scenario pg.206. Section VII.)): Summary and Recommendations: the implications of Peace for the sector pg.206. Mozambique - 2nd PER - Table of Contents  Chapter VIII SIMULATION OF ALTERNATIVE MACROECONOMIC SCENARIOS FOR PUBLIC EXPENDITURE POLICIES pg.209. Section VIII.) Introduction pg.209. Section V111.2 The essential features of the PER Model pg.210. Section VIII.3 Results of the simulations pg. 214. Section V111.4 Linkage between monetary and public expenditure policies pg. 223. Section Vll.S Sectoral enveloppes and macroeconomic scenarios pg. 232. Annex VIII.). The PER Model pg. 240. Annex V111.2. Graphs of major macro variables simulated by the PER Model pg. 263. Mozambique - 2nd PER - Table of Contents  EXECUTIVE SUMMARY 1. The 2nd PER and the context of the transition from a war to a peace economy, from emergency aid to reconstruction and economic and financial Independence 1. Improvements in public expenditure programs in countries that have on-going civil wars or a high degree of social strife and political instability might seem a thankless task. The civil war, acting as an unproductive tax and/or a fixed additional cost on all economic activities, was and still is at the center stage of all economic analysis in Mozambique. In spite of that, a Second Public Expenditure Review (2nd PER) for Mozambique started much before (March 1991) the present fundamental changes in the country's political scene could be foreseen (i.e., the recent peace agreementl between the Government and the main opposition movement, RENAMO). At that time, the building and/or the improvement of the methodological and analytical framework for Public Expenditures in Mozambique seemed necessary regardless of the political and economic scenarios that could be envisaged. Today, the signing of the Peace Agreement adds a new dimension to the 2nd PER. Peace could open the first period of time since the mid-1960s (beginning of the armed struggle for Independence) when the country could focus its attention entirely and exclusively on developmental issues. Peace will also require that, during a transition period, public expenditures will have to contribute substantially to the rehabilitation and reconstruction of the country2 since it is likely that private investment-led growth will only occur after a long period of time. That raises both short- (tactical) and long- (strategic) term issues for the use of public resources during the transition from war to peace. The longer term issue for Mozambique is to be able to generate a growth pattem that is sustainable without the present high levels of foreign assistance. Even when an optimistic scenario is contemplated for the regional economy of Southem Africa, the challenge, is immense. The shorter term issue for Mozambique --with its present institutional framework and administrative capabilities-- is to be able to move from what was --and still is to a great extent-- an emergency-aid economy toward an economy that will progressively formulate its own independent development goals and reconstruction objectives. 2. The overall foreseeable cost of rehabilitating and reconstructing the physical infrastructure damaged by the war is likely to amount to several percentage points of Mozambique's GDP. Very rough and preliminary estimates for the transition period's annual gross "rehabilitation bill" amount to about 15 percentage points of the present GDP or about USD 200 million (broken down into about USD 60 million in infrastructure rehabilitation -4.5 percent of GDP; about USD 13 million for improving and rehabilitating rural and urban water supply -1 percent of GDP; about 2 or 3 percent of GDP for rehabilitation of schools and possibly another 2 or 3 percent for health centers; and last but not the least, about S to 6 percent of GDP for initiating the demobilization of military personnel in 1992). These numbers are estimates and should be taken only as indicators of orders of magnitude. It is also almost inevitable that a time lag will occur between the implementation of expansionary public expenditure policies (associated with the country's On August 7, 1992. a Solemn Declaration was signed by both the President of the Republic of Mozarnbique and the leader of the major opposition movement, Resistencia Nacional de Mocambique or Mozambique's National Resistance (RENAMO). The document reaffirmed their commitment to a peace agreement and set the stage for negotiations aiming at a cease fire by October 1 and general elections under the auspices of the United Nations. Sixteen years of war were finally ended on October 4 with the signing of the Peace Agreement between RENAMO and the Government of Mozambique's FRELIMO Party (Partido da Frente de Ubertag4o de Mocambique). 2 In that sense an increase in the ratio of Central Government Expenditures (CGE) over GDP is likely to happen because of the time lag between investing in rehabilitation and reconstruction and the expected corresponding supply response Mozambique - 2nd PER - Execunve Summary  ii rehabilitation and reconstruction priorities) and the collection of the "peace dividends" (e.g., new growth pattem, additional tax revenues, etc.) by the Govemment. Therefore, maintaining the present stabilization process is likely to require additional extemal assistance. It is also very likely that the effectiveness of this additional extemal assistance effort will depend on its degree of flexibility: untied aid will certainly be necessary to face the changing circumstances that Mozambique is going to have during this transition period. However, this additional extemal assistance requires a number of conditions to be met before new commitments are made. Inter alia, both the Government and the donors will have to ensure that the existing extemal financing is being disbursed on a timely basis and that resources are being allocated efficiently and according to the future development objectives of the country. That, in tum, requires progress in the areas of public finance and public sector management, monetary and financial policies and sectoral public expenditure policies. The 2nd PER is precisely covering these three broad topics. 3. Progress in the areas of public finance and public sector management is of the utmost importance given the role of the public sector in the coming phases of rehabilitation and reconstruction. The monitoring of public expenditures will be a critical task in order to maintain the stabilization objectives of the country's reform program during this phase of fiscal expansion. The strengthening of the phases of budget preparation and execution and the integration and/or merging of both the recurrent and the capital budgets are important tasks lying ahead. The coordination between the fiscal authorities and the donors (already a very important necessity in the past) will be essential to assess the degree of implementation of projects and to maintain donors' allocation in line with agreed development priorities. In addition to that, only a strengthened public administration would be able simultaneously to: (i) take into account the additional transitional costs of safety nets related to the drought, the demobilization of military personnel and their re-integration into a civilian life, and the reintegration of civilian refugees; (ii) prepare the Rehabilitation and National Reconstruction Plan; and (iii), maintain and improve the existing macro management instruments (the Budget, the Public Triennial Investment Program (PTIP) and the Triennial Financial Plan (PFrT)). 4. For all these reasons, the central task of public finance management will be to target a reasonable profile for the fiscal deficit after official grants over the coming years and monitor public expenditures accordingly (i.e., making the level of expenditures in line with the inflows of revenue both domestic and foreign or in other words, keeping the stabilization pattem of the reform program despite the uncertainties brought by the new political situation). The importance of macro-economic consistency during this transition explains why this 2nd PER uses extensively macroeconomic scenarios deriving from a macro-modeling exercise to discuss the consistency between public expenditure programs and the economic reform program (see Chapter VIII). Given Mozambique's heavy dependence on external sources of financing and its vulnerability to domestic political shocks, this approach ensures adequately what could be the upper limit of expansionary public expenditure policies given an explicit set of exogenous variables (e.g., available extemal financing for a Reconstruction Plan). 5. Simulating the macro-consistency of public expenditure policies is particularly important now that the Peace Agreement has been signed, thus altering radically both the perception of potential foreign investors regarding the country's prospects and domestic factor productivity. The transition to peace will be a difficult process where stabilization obiectives will have to be kept in the Government's agenda while, at the same time. sectoral expansionary policies (reconstruction and rehabilitation) will have to be implemented to attain hopefullv much higher levels of growth than in the nast. The only way to test the consistency of these two (only apparently) contradictory elements of the future political and economic agenda is to ensure through a macro-model the consistency between the overall stabilization targets with the desired (and badly needed) levels of sectoral expansionary spending. 6. Progress in financial management and appropriate monetary policy will be also a critical element during the transition to a peace economy. The general objective that Mozambique will have to achieve is to continue shifting from a system of administrative allocation of financial resources (with direct controls through either credit ceilings or administrative allocations of credit and foreign exchange) to a system relying much more on price mechanisms (indirect control through interest rate policy and no pre-determined administrative or sectoral allocations). Mozambique - 2nd PER - Executve Summary  7. Maintaining stabilization objectives will require a strong supervision of monetary and credit developments if the Government wants to avoid an inflationary outburst deriving from the rehabilitation / reconstruction effort and the associated inflow of extemal financing. In particular, the lack of a comprehensive and consistent picture of 'the consolidated public sector borrowing requirements needs to be corrected. Special financing through sector-specific development funds needs to be avoided and a better interaction with the emerging commercial banking system is recommended. Similarly, the resort to credit creation outside the banking system (e.g., through the issuance and acceptance of promissory notes) needs to be discontinued. 8. By the same token that financial needs of the public sector need to be clearly defined and monitored, it is also clear that part of the financial requirements during the transition will not be eligible to strict commercial lending. When needed (e.g., for social and political reasons, or because the market prospects for a specific activity are uncertain / unclear/ not assessed, etc.) a policy of transparent subsidization of the budget is preferable to a policy of administrative allocation of financial resources (e.g., through ear-marked lines of credit or sector-specific or enterprise-specific interest rate policies). 9. Finally, progress in financial management will be crucial to improve the rate of collection of counterpart funds. Transparency of accounts and a clarification of cross-enterprise / Treasury debts will help in determining the best routes to facilitate the collection of these revenues. 10. Progress in sectoral policies will finally consolidate the above mentioned steps. It is an important element of the Government's development strategy. Specifically the enhancement of human resources and the rehabilitation of social and physical infrastructure, particularly in rural areas, will have to be maintained as valid development objectives. The rehabilitation and reconstruction of both physical and human infrastructure are the highest priorities in order to restore a high growth pattem for the economy and catch-up with the pre-Independence levels of output, which --in some cases-- can be considered as the development targets for a given sector. The sectoral strategies need to take into account both available domestic resources and the amount of external assistance to (i) optimize the use of their overall resource envelope; (ii) avoid the dependency syndrome where the planning, disbursement and implementation of projects rely exclusively or mainly on donor-driven procedures; and (iii), limit the recourse to special sectoral financing through development funds,"Fundos de Fomento," outside the renewed banking system and/or Government's budget support. 11. However and more specifically, progress in sectoral strategy will also imply revisiting some of the implicit sectoral strategies elaborated during the civil war and insecurity period. Peace indeed changes a number of assumptions that were used by both the donors and the Government to build the past public investment program. For example, restored accessibility in the rural areas gives more weight to an Education and Health strategy focusing on the pre-war network of primary schools and health centers rather than strengthening the university in the capital city; improved security conditions in the countryside could alter a cost-benefit analysis comparing inland road transportation with air or coastal maritime transportation; and, the need to succeed in the demobilization of the military and the reintegration of civilian refugees into productive economic and social activities could modify temporarily the balance between large-scale agricultural projects, public works programs and family-sector and small-scale projects in the forthcoming public investment programs of the transition. 12. For the moment, managing an economy that is still affected by the war has important implications for the allocation of public expenditures. Despite today's low level of domestic revenues and production, the Government has, to the extent possible, to meet existing social and economic obligations nation-wide. Furthermore, military expenditures inevitably crowd out development- oriented expenditures. Finally, the insecurity in the countryside makes an economic return to. investment low and uncertain. Therefore, these difficulties associated with the armed conflict bring a quasi-inherent inefriciency in public spending which will remain for a while. The altemative of reducing or cutting expenditures in insecure Provinces is neither politically feasible nor economically desirable in the longer term. Mozambique - 2nd PER - Execuave Summary  iv 13. In what follows, a brief picture of the post-Independence crisis (1980-84) and the adjustment process (1986-90) in Mozambique is given; then, the role and the characteristics of Public Expenditures during the adjustment process (1986-91) are analyzed; improvements in sectoral policies related to the reform process are reviewed; and, finally, quantitative projections of public expenditures for different scenarios for the future are examined. 2. Background: the post-Independence crisis (1980-84) and the adjustment process (1986-90) in Mozambique 14. The political and economic factors that have been constraining Mozambique's development process are weU known: during the five centuries of colonial rule little was done to develop social and physical infrastructure. Independence in 1975 came after a long armed-struggle against the former colonial power. The take over of the colonial administration by the liberation movement, the Frente para a Libertacao de Mocambique (FRELIMO), happened in a context where, on the one hand, little technical expertise on how to manage a colonial economy was in the hands of the liberation movement, and, on the other hand, fears of retaliation against whites had triggered a massive exodus of former Portuguese settlers to Portugal and South Africa. Given the occupational structure of the economy, where whites had preempted about 90% of skilled and semi-skilled jobs, this massive exodus of human capital tumed out to be, in fact, a time-bomb in the hands of the new authorities. The shortage of skiUed manpower was acute even by Sub-Saharan African standards. Partly by the lack of technical expertise and partly by ideological choice, the authorities relied on inappropriate economic policies to address the urgent development needs of the country. Thus, Mozambique's path to macroeconomic instability is not extremely different from what could be drawn from Latin American experiences with populist macroeconomics . It extends the framework to its most extreme consequences and is, of course, compounded by destruction caused by the civil war. a) In an initial stage, a new Government takes over the colonial administration with little administrative capabilities and the belief that income distribution should improve visibly and radically in the short term. This view is understandably supported by the majority of the population deeply dissatisfied with economic policies during the colonial era. The package implemented includes a wage hike benefiting mainly workers in the formal sector and the public administration and the extension of social welfare benefits to a much larger share of the population (Education and Public Health). The real wage is usually set at a higher level than that of the colonial era (and sometimes combined with an allowance of basic goods given in kind to public sector employees). Wage differentials are also usually substantially reduced in almost all categories irrespective of acute shortages of skilled workers at almost all levels of productive and administrative activities. Simultaneously, the new Government also freezes domestic prices and the exchange rate to guarantee its redistributive policy. In parallel or soon after these initial steps, the new Government is confronted with an armed opposition movement usually sponsored by political enemies. Military expenditures have to rise. Some of the cost of the emerging civil war is financed by external assistance but some need to be financed domestically. b) The consequences of both the measures implemented and the civil war are quite straightforward: there is a dramatic increase in the fiscal deficit, on the one hand, and a collapse of domestic output and of exports, on the other hand. The fiscal deficit increases as a result of both the wage hike and the provision of social welfare benefits to a much larger share of the population than before. Rising military expenditures also contribute to boost public spending. The collapse of domestic output and exports, in turn, is caused by both the growing insecurity in the countryside and the consequent inflow of refugees into the urban areas, and the adverse price incentives resulting from the freezing of producer prices and the exchange rate. In Mozambique for example, by 1986, real GDP had fallen to about two thirds of the 1980 level, exports were reduced to less than one third of their 1980 value and Mozambique - 2nd PER - Execuave Summary  v accounted for only about 15 percent of imports and the financing of the extemal imbalances led to the accumulation of extemal debt arrears. c) These first round consequences trigger; in tum, a second round of problems. First, in order to finance a growing fiscal deficit and in view of the lack of a modem financial sector, the new Govemment either monetizes the growing fiscal deficit through printing money or borrows abroad. The collapse of domestic production and the lack of price incentives to private producers cause both the emergence of parallel market activities and the need to increase the imports of previously domestically produced goods (a sort of inverted import- substitution strategy). Of course, the monetization of growing deficits also triggers an accelerated depreciation of the currency which given its fixed parity translates into a skyrocketing premium in black markets for foreign exchange. -The strengthening of parallel markets finally reduces even more the rate of tax collection and compounds even further the crisis of public finance. Once the country reaches a creditworthiness limit for commercial extemal borrowing the classic balance of payment crisis appears. The need for a reform program, possibly under the auspices of the IMF and/or the Bank becomes inevitable. 15. In effect, in early 1987, the Government initiated an Economic Rehabilitation Program (ERP) to tackle the economy's structural problems and distortions and was supported by both the IMF and the Bank. The stated intention was to shift toward a more market-based economy with less administrative controls and with more reliance on intemational and domestic market mechanisms to provide signals to economic agents. The ERP correctly revolved around the idea that stabilization had to be addressed up front in the reform process. The program has involved, inter alia, reforms in the following areas: price liberalization (including the unification of the exchange rate markets); fiscal adjustment; tight monetary policy; and improving the efficiency of public administration. 16. The major characteristics of the reform program are as follows: a) Stabilization of the economy through restrictive fiscal and monetary policies came up front in the reform program to ensure the deactivation of the money machine (the monetization of fiscal deficits and/or the granting of "bad" credit to an inefficient public sector). After reaching more than 18 percent of GDP in 1984, the Government's fiscal deficit (after official grants) was reduced to about 1 percent in 1991 while money/quasi-money (M2) was set to grow at less than the inflation rate and credit ceilings were established. However, progress in reducing the public sector consolidated fiscal deficit is difficult to assess because of the lack of consolidated public sector fiscal accounts inclading the quasi-fiscal deficit of the Central Bank, "Banco de Mocambique" (BDM). The establishment of such accounts is taking quite some time because of the existence of informal ad hoc agreements between the Treasury, some parastatals and both the banking system and the Central Bank. In addition, a workable strategy to separate the central and commercial banks within the present Central Bank has not been achieved yet. As a result, there are still high amounts of unclassified or off-balance sheet assets (representing more than twice the current GDP) that may be disguising significant losses (present or past) of the public sector. b) A gradual liberalization of prices succeeded in eliminating most of the money overhang in the economy. (After addressing the flow problem of the fiscal deficit, the reduction of the money stock became a matter of ascertaining the trade-offs between a potential supply response and the adverse social consequences of changing the level of domestic prices.) In line with a massive devaluation of more than 600 percent at the start of the reform program in 1987, domestic administered prices were realigned by about 160 percent and only then progressively liberalized. Real money balances have been consistently declining (a decrease of 43 percent in 1987 and an average decrease of 5 percent from there on): the ratio of M2 to GDP fell from about 80 percent in 1983 to about 35 percent in 1991. c) Changes in the incentive structure (the exchange rate regime, private ownership, etc.) proved critical for obtaining a supply response from both exporters and producers for the domestic market. However, the civil strife situation does continue to be the major impediment to the resumption of economic activities in the countryside. Besides a move of Mozambique - 2nd PER - Executve Summary  vi the real exchange rate from about 100 in 1985 to about 850 in 1991, private sector activities have been encouraged but concentrated essentially in the tertiary sector in urban areas. Export growth, in real terms, has accelerated from about 4 percent per annum in 1988 to about 11 percent per annum in 1990, and 28 percent per annum in 1991. d) Inflows of foreign savings (through aid or direct private investment) played an essential role in increasing competition, creating positive extemalities, setting new standards for both labor and capital and supporting balance of payments (BOP) stability. In that respect the Mozambican case is exceptional: total official grants rose from about 3 percent of GDP in 1986 to more than 21 percent of GDP in 1991. That allowed the Govemment to start repaying the banking system while stopping its non-concessional extemal borrowing. e) The establishment of a minimum social safety net was an important mechanism to preserve a much needed political consensus in a transition to a market economy. Food and income subsidies represented an important component of the fiscal packages (about 3.5 percent of GDP in the initial year of the program) agreed on by both the Fund and the Bank. That, in tum, reinforced the political stability of the FRELIMO Govemment allowing the commitments for the proper set of reforms. Despite the civil strife situation, or maybe because of that, the FRELIMO leadership was able to debate the pace of reform path intemally while showing extemal commitment to the program's objectives. 17. To summarize, donor financing has been playing an essential role in supporting the process of reforming the Mozambican economy. Government spending (particularly donor driven public investment) played and still plays a major role today in Mozambique's growth process. The adjustment process followed by Mozambique is heterodox: all actors participating in the process acknowledged that it was unrealistic and counterproductive in Mozambique to reduce the external imbalance through an up front reduction in public expenditures (e.g., to "adjust" expenditures -- public and private-- to the level of available domestic resources given the dramatic collapse of domestic output). In fact, an expansion of extemally financed public expenditures was the basis upon which to build, rehabilitate and maintain the country's social and physical infrastructure which, in tum, would eventually become an incentive for private sector investment. There was up front an implicit assumption that while it was important to develop a market-oriented institutional framework and a corresponding system of incentives, private sector confidence would only emerge after the end of the civil war and with strong evidence that political stability in the country would last. In the meanwhile, it was important to mobilize and to use external financing in the reform process. 18. In that context, the major achievement of the ERP is to have reversed the economic decline of the early 1980s and to have put in place the necessary incentive mechanisms consistent with a marked-based economy. Despite the civil war, there were a number of areas of success including the resumption of strong growth in the export sector and the attainment of more realistic levels for the fiscal deficit, together with its financing by non-inflationary external sources. Given these characteristics, the success achieved in stabilizing the economy remains somewhat fragile and dependent on the continuing inflows of high levels of foreign savings. Mozambique - 2nd PER - Executve Summary  ..... .....................*...... ...... Ins pereent changep. Ap ag i 0~~~~~~~0 GDP real growth - - 0.5 -3.4 -12.9 0.9 -8.8 0.9 4.4 5.4 5.4 1.3 0.3 ' ' ,4 Import real growth -- i.e 11.5 -20.3 -13.4 -13.1 28.0 7.6 -2.0 28 0.0 1.9' 4.. 2._ Export real growth -- -10.9 7.8 -37.1 -37.2 -2.0 -8.3 8.3 4.4 8.4 10.6 27.5 .14.6 11.8 Inflation (CPI) - - 18.6 12.0 14.8 46.1 8.2 163.5 69.2 44.2 32.0 34 5 20.0 68.7 N Nomindal Exchange Rate -- 9.1 6.8 6.4 5.6 1.7 46.4 609.3 84.5 40.8 24.8 54 3 3.9 162.8 O Increase In Read Money Supply (M2) -- 26.1 9.5 7.0 -0.8 -22.7 2.3 -39.3 5.5 7.1 0.2 -29.0 3.6 *11.1 In percentage of GDP TotalConsumptlon 99.5 97.4 101.0 108.3 104.5 101.4 99.9 106.2 117.3 119.1 111.8 1102 101.7 112.9 O Private 81A 76.8 77.4 79.9 78.5 78.9 74.5 85.1 94.7 93.6 86.2 86 2 782 89.1 0 Government 18.1 20.7 23.6 28.4 26.0 22.4 25.4 21.2 22.6 25.5 25.6 24.0 23.5. 23.8 la 0* Government Revenues 22.3 25.7 26.0 26.7 26.1 25.5 25.8 32.7 37.4 40.0 40.3 44.2"" s ' -* or which OMdal Grants 2.7 2.3 2.5 3.2 2.7 2.0 2.3 9.2 14.0 16.5 16.9 20.8 2.5 .155 .. Government Current Expenditures 18.1 20.7 23.6 28.4 26.0 22.4 25.4 21.2 22.6 25.5 25.6 24.0 23.5 23.8 -. Government Overall Fiscal Defidtc Before Omdal Grants -9.6 -12.0 -16.9 -21.4 -18.1 -3.6 -7.5 -13.6 -20.5 -24.2 -26.3 -25.1 .t2. 1.90 After OMdal Grants -7.0 -9.7 -14.4 -18.2 -15.4 -1.5 -5.2 -4.4 -6.5 -7.7 -9.4 -4.3 - -6.5 , o Gross Investment (Indud.VarStocks) 18.9 20.3 19.3 9.9 10.6 6.9 9.7 23.8 32.6 33.0 38.1 41.8 13.7 33.j9 Private 7.8 5.6 2.5 -6.5 -4.9 2.3 4.2 7.9 11.3 10.8 13.9 17.3 1.6 12.3 Government 11.2 14.7 16.8 16.4 15.5 4.5 5.6 15.9 21.3 22.2 24.2 24 5 12.1 21.6 Gross Nat. Savings Ind. Off. Transf. 3.2 4.8 1.5 -5.0 -1.8 0.7 2.5 3.0 -3.3 -2.5 5.1 106 0.8 2.6 Private -1.0 -0.2 -0.8 -3.3 -1.9 -2.4 2.1 -8.5 -18.1 -17.0 -9.6 -9 6 .1.1 .12.6 Pub0c 4.2 5.0 2.4 -1.7 0.1 3.0 0.4 11.5 14.8 14.5 14.8 20.2 1.9 15.2 IQ Current Account Delidt exduding oMdal transfers -18.4 -17.8 -20.3 -18.2 -15.1 -8.3 -9.6 -30.0 -49.9 -52.1 -49.9 -52.0, ..> 4i .4'.8 Induding oMdal transfers -15.7 -15.5 -17.8 -14.9 -12.4 -6.2 -.7.2 -20.8 -35.9 -35.5 -33.0 -31.2'12.8. 41.3 lxi ~ ~ ~Ttl oerm'00 Total Government Expenditures 29.3 35.4 40.3 44.8 41.6 27.0 30.9 37.1 45.7 48.9 51.5 50.4:::. ::35,6. 46.7 (including interest and enterprise debt ass.) p.m Gross Domestic Product inacurot MZMBillion 78 81 93 92 108 147 167 428 657 966 1,340 1,909 in curent USD Billion 2.41 2.28 2.45 2.29 2.54 3.40 . 4.13 1.49 1.24 1.30 1.44 1.33 OMdal Transfers to Gov. Budget in cuffent MZM Billion 2.1 1.8 2.3 3.0 2.9 3.0 3.9 39.6 91.8 159.8 226.3 397.0 in current USD Billion 0.06 0.05 0.06 0.07 0.07 0.07 0.10 0.14 0.17 0.21 0.24 0.28  viii 3. Public Expenditures and the adjustment process (1986-91) 19. In 1991, Central Government Expenditures (CGE), by far the largest component of Public Expenditures in Mozambique, accounted for more than 50 percent of GDP. In 1991, they represented about MZM 959 billion (about USD 668 million) out of a GDP of about MZM 1,871 billion (about USD 1,304 million). The CGE/GDP ratio is much higher than the average for Sub- Saharan African (SSA) countries of the sum of overall Government consumption (about 33 percent of GDP) added to an average public investment ratio over GDP for SSA countries of about 10-13 percent3. The macroeconomic importance of Govemment spending in Mozambique increased substantially from the mid-1980s until now. That corresponded to the dramatic increase of extemal assistance given to Mozambique after 1986 in support of its economic reform program. 20. This very high Government's expenditure figure by any standard is explained by the need to keep providing public goods and services to the population while the country's GDP was experiencing a dramatic fall due to the civil war. It is also clear that due to the civil strife situation which has severely affected all private sector activities in the past and even now remains the major obstacle to private-sector led economic recovery; the role of the public sector is and will remain essential during the rehabilitation and reconstruction period. This characteristic of the country was acknowledged and integrated into its stabilization program. Because of the armed conflict, military expenditures have been naturally crowding out development-oriented expenditures and represented about 27 percent of overall Government spending in 1991. However, despite the war, the Government has maintained a strong commitment toward protecting social sector expenditures which received about 34 percent of total Government expenditures in 1991 (of which about two thirds or 20 percent went to Education and Health). Nevertheless, the absolute level of social sector expenditures remains insufficient to cope with the needs of the population. Moreover, because macroeconomic imbalances have been financed essentially by external support, and because extemal support comes usually through tied project-aid, there is an imbalance between recurrent and capital expenditures (e.g., sometimes insufficient levels of resources available for maintenance and other recurrent spending). However, this imbalance is sometimes merely a statistical bias (e.g., a misclassification of the true nature of the extemal assistance). 21. Mozambique is now facing a new phase in its economic development: the foreseeable transition to a "peace" economy. This is an important juncture in its process of economic reform under the Economic. and Social Rehabilitation Program (ESRP) which stresses economic recovery and expansion of GDP as the key objectives of the adjustment process. On the one hand the impact of the civil war is still adversely affecting the rehabilitation and recovery of the country's economy and hence, keeping it stabilized at a low-level equilibrium. On the other hand, there is already a need to prepare the economy for a post-war situation with concomitant additional -but foreseeable- burdens on public finance. Most of these are linked to the on-going process of military demobilization and the return of civilian refugees. 22. Mozambique is facing this transition in a new intemational context4. The level of extemal financing which traditionally supported the country's development needs will not only have to be maintained but will likely have to be increased in order to cope with the additional needs arising from both the rehabilitation and reconstruction process (and also the demobilization and the return of refugees). However, it is as yet undetermined whether the required amounts of additional extemal 3 Source: African Development Indicators, 1992, The United Nations Development Program and the World Bank, May 1992. 4 Mozambique is also facing this transition in a new domestic context. As a result of both its adjustment process and extemal shocks (e.g. the substantial decrease in foreign assistance from the former centrally planned econonies (CPEs) of Eastern Europe and the USSR and the repatriation of about 18,000 Mozambican workers from the former East-Germany) the various segments of the formal economy (the Government, the parastatals, the centraVcommercial bank, the emergency-aid economy and the defense-related economy) which enjoyed previously a certain degree of autonomy, are progressively being forced to merge within a single consolidated economy covering the whole public sector. Mozambique - 2nd PER - Executive Summary  ix financing could be mobilized for Mozambique5. 23. Therefore, the transition to peace has to be carried out in a difficult context of uncertainty regarding the overall resource envelope. Both its available domestic resources (output and domestic revenues) and the amount of additional external financing are, so far, difficult to determine accurately. However, one assumption that one has to make is that it is likely that the global level of external assistance that the country has been receiving for the last couple of years will at best be maintained for a couple of more years before starting to decline progressively. The four challenges that Mozambique faces in this transition to a "peace" economy are: (a) the immediate pressure for incremental public expenditures; (b) the need to improve the efficiency of public expenditures; (c) the need to continue improving public sector management; and (d), the need to continue obtaining additional untied assistance. 3.1. The immediate -ressure for incremental nublic expenditures 24. The first challenge for Mozambique is to address the immediate pressures for incremental public expenditures that are coming from two major areas: the unforeseen cost of demobilizing and reintegrating military personnel and refugees into a productive economic and social activity; the additional costs caused by the drought which is affecting all Southem Africa; and, the rising demands for additional recurrent expenditures at a sectoral level. Therefore, Mozambique could be facing an additional expenditure burden of about 8-10 percent of GDP in the short term before the beneficial impact of peace could bring additional revenues. Therefore, one of the biggest challenges for the Government during the transition to peace is the need to raise additional revenues. Raising additional revenues is an essential factor to make the expenditures program more flexible. Those additional revenues would have to come from both an increase in extemal assistance and an improvement in the efficiency of the present system. In what regards the variables that are under the direct control of the Mozambican Govemment, any increase in revenue collection will have to come from the present tax system and the improvement in counterpart funds collection. Under the present circumstances the latter is the major determinant, but not the only one, of any significant growth in sectoral expenditure programs. However, improvement in the efficiency of the present system can also bring substantial benefits. a) The additional burden 25. The cost of demobilization and reintegration of military personnel. The Govenmment initiated in 1990 the demobilization of its armed forces6. Peace will require immediate additional expenditures resulting from the demobilization of part of the military and the reintegration of civilian refugees into an economic activity. These costs will be substantial but they will also trigger the recovery of economic activity in the Provinces. In that sense, they are likely to be one of the most profitable investments for longer-term development. The Government has issued a study on the cost of a first phase of demobilizing the military which estimates the cost of this first phase to be about MZM 114 billion between November 1991 and December 1992 (6 percent of the 1991 GDP, of 5 The donors pledges for 1992 in the December 1991 Consultative Group Meeting showed an increase from a total (including food-aid, debt cancellation and debt rescheduling) of USD 1,071 million in 1991 up to a total of USD 1,151 million for 1992. That represented an increase of 75 percent in USD terms. At that time, without a cease- fire, it seemed likely that the total extemal assistance to Mozambique was about to reach or was very close to an "implicit" ceiling or an upper limitL Peace adds a new dimension to this process where donors' pledges could increase given the needs during the reconstruction period. A lot will depend on the outcome of the present political negotiations emerging after the Peace Agreement signed between the President of the Republic and the leader of RENAMO. 6 Starting in 1987, the withdrawal of Eastern European and Soviet military assistance --only partly recorded in the OGE-- forced the Government to use domestic resources to fund a substantial amount of previously externally- funded military expenditures. In that respect, the Government is working with the donors on a temporary external support for the demobilization of the military. Mozambique - 2nd PER - Execunve Summary  x which about 1 percent is domestic and about 5 percent requires external financing)7. The study should be the basis to further work on quantifying all costs and benefits of the process beyond the first phase: the additional charges of the demobilization; its potential savings; its longer-term impact on the economy; etc. 26. The cost of reintegrating the civilian refugees is likely the most difficult item to assess. Its impact on public finance, however, is certainly very important. The Government is planning to address the issue in its National Reconstruction Plan. About 4 to 5 million Mozambicans can be considered either refugees or displaced persons. 27. Estimating the additional requirements due to the drought. The emergency alert issued on March 12, 1992, includes preliminary estimates of food aid requirements for the 1992/93 year (May 1992-April 1993) taking into account the impact of the drought. It is estimated that 1.2 million tons of food aid (358,000 tons for relief distribution) were appealed for, compared to the 976,800 tons that were requested at the 1991 consultative group meeting (CG) (234,000 tons for relief). This implies an additional amount of about 250,000 tons over the 1991 appeal. This assumes a 50% reduction in domestic output and the same level of commercial food imports as in the previous year (both of which account for a small proportion of total requirements). The number of beneficiaries eligible for food relief is estimated to increase by I million to 2.8 million compared to the 1991 appeal. 28. The rising demands for more recurrent expenditures at a sectoral level. In many sectors (Water Supply, Roads, Health, Education) the levels of recurrent expenditures available through the General State Budget, "Orgamento Geral do Estado," (OGE) and/or the PTIP are insufficient to maintain the existing stock of capital and/or to achieve reasonable objectives of each sector's strategy. Demands coming from the sectors are clearly incompatible with the overall envelope. However, in the transitional period where priority will be given to the reintegration of refugees and military personnel, the availability of recurrent expenditures will be a critical variable for the success of the demobilization/reintegration program. 29. Therefore, it will be necessary to start shifting and/or redeploying public expenditures to finance additional recurrent expenditures at a sectoral level. It could be assumed that the reclassification exercise provides an estimate of the "real" level of recurrent spending at present: about MZM 61 billion of the Capital budget (3 percent of GDP in 1991) are in fact recurrent expenditures classified in the investment budget bringing total recurrent spending to about 28.5 percent of GDP. Now, it could be assumed that most of the refugees population is not benefiting from any assistance coming out of the Government's budget. If, in addition, one assumes that the reintegration of civilian refugees and military (about one to two tenths of the total population) means that public expenditures will have also to cover this new segment of the population (even at its present low level of service), that would obviously mean an increase in expenditures of about the same ratio (10 percent or about 3 percent of GDP). Of course, redeployment and/or efficiency gains may occur. However, a conservative estimate is that the pressure for additional recurrent spending in the social sectors could represent for the transitional period about 2-3 percent of GDP (about 10 percent of total recurrent expenditures in 1991). b) The potential for additional revenues 30. The impact of the above mentioned expenditure items is expected to be reflected in 1992 and beyond. The Govemment will need to assess how much could be mobilized from extemal sources (e.g., inter alia, in the collection of counterpart funds where further steps need to be taken both by Government and donors to ensure sustainability of the progress made) and how much could be mobilized from improvements in the collection of domestic revenues (tax and non-tax). 31. Additional revenues from improvements in the collection of counterpart funds. Counterpart funds are defined as the local currency value foreign assistance, excluding Government project 7 See Republic of Mozambigue. A Demobilization and Reintegration Program for Mozambican miliuuy personnel (First Phase, 1991-1992), Maputo October 1991. Mozambique - 2nd PER - Executive Summary  xl financing and emergency aid. They are, on the Government revenue side, essentially a mirror reflection of the external assistance received by Mozambique. These funds are a major source of revenue to the Treasury, and have a direct impact on the level of public expenditures, and on Government repayment to the banking system. The generation of counterpart funds depends on the non-government sector's capacity to absorb foreign assistance and the efficiency of domestic credit markets. Given the substantial amount of extemal aid received by Mozambique, not only in absolute terms (USD 650 million in 1991) but also relative to the size of the economy (50 percent of GDP), the management of counterpart funds has significant implications for macroeconomic policy. Problems in collecting and recording counterpart funds are the result of inefficient practices involving both the Govemment and the donors. Remedies to that situation will constitute a challenge for both the donors and the Govemment. 32. In terms of the accounting of counterpart funds, the following results were obtained: the local currency value of the counterpart funds that could have been generated in 1991 was MZM 445 billion. Of this total, MZM 335 billion were recorded (75 percent). One interpretation is that part of the unpaid counterpart funds were transferred to the non-Government sector in a variety of ways, such as, through the issuing of promissory notes (PNs) by some of the recipient companies or simply as implicit subsidies provided primarily in the form of unrecorded counterpart funds. In order to meet the ambitious targets in counterpart fund collection, it is important that the recording system of counterpart funds be improved. Table 2 MOZAMBIOUE - Summary table on counterpart funds (1990-91) In MZM Billion and Percentages (Source: Chapter Ell) 1990 1991 1990 1991 Tot. Official Grants (A) 226.3 397.0 Tot. Disbursements (B) 191.8 176.4 Tot (A)+(B) 418.1 573.4 Potential CPF 350.0 445.0 100.0 % 100.0 % Unrecorded 78.8 110.0 22.5 % 24.7 % Recorded 271.3 335.0 77.5 % 75.3 % Awaiting Collection 90.0 94.0 25.7 % 21.1 % Prom. Notes 83.0 94.0 23.7 % 21.1 % Collected 181.2 241.0 51.8 % 54.2 % 33. Since 1990, the Government has taken a number of positive steps aimed at improving transparency, accountability and efficiency in the management of counterpart funds (e.g., discontinuing the acceptance of promissory notes as a means of payment). With the improvement in the recording system, a reasonable assumption would be that a proportion of counterpart funds subject to delayed payment agreements could be available to increase public expenditures. This proportion would consist of promissory notes maturing in 1991 (the promissory notes issued in 1990 and maturing in 1991 represent about MZM 35 billion or about 2 percent of GDP in 1991). However, this could have other implications: first, on the credit ceilings established under the present reform program (if the banking sector has to refinance the promissory notes issued by the importers); and/or second, on the financial viability of importers (if repayments can not be done through the banking system). 34. Additional revenues from improving tax collection. Improvements in the present tax system could also bring additional revenue. It is necessary to strengthen inspection and collection of taxes Mozambique - 2nd PER - Executive Summary  xii both in terms of personnel and procedures. Data from the Ministry of Finance8 indicate for 1990 that the collection of income tax amounted to about MZM 9 billion (about 10 percent of the taxable income and 0.5 percent of the 1991 GDP). Studies should be conducted, aimed at identifying measures that can be adopted to reduce the erosion of tax revenue by inflation. It is possible that improvements in the income tax system could increase the coverage of tax collection and extend it to Mozambicans working for specific intemational organizations and to some of foreigners who are permanent residents9. Based on an estimate of the size of wage payments related to externally- provided technical assistance (about MZM 90 to 100 billion in 1991), a progressive schedule applying to the relevant taxable individuals (depending on specific conditions applied by donors) could possibly bring another MZM 9-10 billion on top of the present income tax revenues (0.5 percent of GDP in 1991). As explained in the Public Sector Pay and Employment Review, this will need to be discussed between the Government and the donor community. 3.2 The need to iMnrove the efficienCv of Public ependitures 35. The second challenge that Mozambique is facing in its transition to peace concems the continuing improvement in the efficiency of public expenditures (i.e., identifying sound public expenditure programs producing the highest sustainable growth pattem at the lowest cost for public finance). The efficiency of public expenditures in Mozambique depends on three factors, one endogenous and two exogenous: (i) continued improvement in public sector management tools (see below); (ii) better donor coordination (including the untying of external assistance as explained below); and (iii) the end of the civil war and the consequent "peace dividends". 36. One, if not the major, problem in public resource allocation in Mozambique is the limited amount of recurrent expenditures vis-a-vis the existing stock of capital that has to be maintained or rehabilitated. The segmented nature of the economy, donors' independence vis-a-vis central investment guidelines and the lack of reliable communications between the Provinces and the central Government had compounded the problem: scarce resources for recurrent expenditures have been spread across sectors. Though keeping a relatively adequate cross-sectoral structure (in percentual terms), the result is that the levels of actual recurrent expenditures are grossly inadequate to maintain the existing facilities or fulfill the requirements of the sectors' development strategies. 37. Mozambique needs to deepen the PTIP exercise in order to prepare public expenditure scenarios with areas of emphasis where efficiency gains can be achieved. In particular, that would require: a) Selecting more focused public expenditure policies in sectors where scattered allocation does not allow the implementation of a sustainable and coherent sectoral policy (for example; in Agriculture, continuing the policy of reducing expenditures for large-scale irrigation schemes; in Education, focusing public expenditures on the priority sub-sectors such as Primary Education; in Transportation, modifying the intra-sectoral profile of public expenditures by reducing the portion of public investment on rail-port corridors). b) Programming operating/maintenance expenditures more realistically and integrating them into the budget (OGE). The planning and programming phases of both the PTIP and the OGE could start with the assessment of the sectoral recurrent needs before identifying the sectoral investment ceilings and new projects (for example, in the water and roads sectors, resources for maintenance were considered extremely low as compared to the investment portfolio). This would require strengthening the dialogue between the Ministry of Finance, the National Planning Commission (CNP) and the sectoral ministries. In particular,, continuing the work in progress to identify the share of recurrent expenditures financed 8 Source: Direcao Nacional de *Ipostos e Auditoria Ministry of Finance, August 1990. 9 As explained in Public Sector Pay and Emplovment Review, The World Bank, Report No. 9815-MOZ, December 1991, p. 50. Mozambique - 2nd PER - Executve Summary  xiii through the investment budget is essential. c) Reducing expenditures in non-development sectors (like defense-related activities) to the extent possible. The demobilization process (which will require in the short term additional resources) is a good example of expenditure cuts that will increase available resources for development-oriented activities in the medium-long term. d) Reducing inefficient public sector commercial operations, either through restructuring, privatization or associations and joint-ventures with private entrepreneurs (for example, the leasing-arrangements that can be put in place for both the maintenance of the road network and the Maputo rail-port corridor). 3.3 The need to continue imDroving Public Sector Management 38. Despite substantial progress in the area of public sector financial management, the most important tool to implement and monitor stabilization policies and/or to undertake expansionary reconstruction policies, the Government's budget - OGE, still suffers from weaknesses. The major problem arises from the still weak integration between the OGE and the donor-driven investment budget. The PTlP, in particular, lacks information on implementation rates of donors investment projects, thus posing serious problems. As a result, it is difficult to confirm early if a budgetary exercise has been restrictive or expansionary (the poor quality of monetary statistics also compound the problem). Therefore, the third challenge for the transition is to continue improving the performance of public sector management. This will have to address the following areas: improving the quality of data and National Accounts; improving the presentation of consolidated public sector accounts; linking financial sector reform with the public expenditure financial problems; and, continuing the improvement of both the planning / programming and monitoring / execution phases of the Government's budget . 39. Monitoring the economy through improving the quality of data and National Accounts. It is important that Mozambique enters peacetime with the statistical instruments it needs to make better assessments of the effects of economic reforms program on the real economy. Consequently, the quality of basic statistical data such as the National Accounts should be improved. Since there is a great deal of uncertainty, it is very difficult to assess the margins of errors in the estimates of some key aggregates that are crucial for the monitoring of the program (for example, GDP)10. 40. Improving the presentation of the consolidated public sector accounts. Improving the consolidated public sector accounts, means, inter alia. the inclusion of public non-Government credits and debits into a comprehensive financial picture of the whole public sector. The normalization and/or liquidation of financial debits between the Treasury, the rest of the public sector (essentially the parastatals) and the Central Bank ought to be encouraged as an essential part of the reform process. Also, the success of the privatization program depends on restoring the financial viability of the banking system; the clearing of non-perforning debt of the parastatals depends on an accurate programming of the needed financial cash flows; and the overall budgetary programming relies on an assessment of the stock of domestic public debt. 41. The central feature of this clearing and cleaning process revolves around determining the net creditor/debtor position of the public sector for each individual actor and as a whole (the Treasury, the Central Bank and the parastatals). To make matters more complicated, the crucial issue is to assess the amount of credit/subsidies that have been generated by the release of extemal financial 10 The basic data used to calculate output are sectoral production data. However, there is no information on important technical coefficients (for example, the relationship between value added and value of output) and only limited information on the services sector. Therefore the estimate of GDP is constructed from the aggregation of expenditures but the assumptions on the size of informal agricultural private consumption, private investment, etc., play a decisive role without any possibility of cross-checking their accuracy. Given the importance of GDP as the denominator of most of the indicators for the present reform program, it is critical to improve its statistical accuracy. Ifozambique - 2nd PER - Execunve Summary  xiv assistance to Mozambique (the counterpart funds, see Chapter III). Indeed, a balanced extemal account can correspond to a variety of intemal situations in terms of the stocks and flows of counterpart fundsll. There are important sequencing issues (like the relation between reforming the financial sector, separating the two wings of the Banco de Mocarnbique, preparing the privatization of parastatals, writing off past debts, etc..) that will have to be related to the targets set by a monetary policy for the transition period. 42. Financial reform and public expenditures. The cleaning of accounts may not be enough to build the required instruments for sound macroeconomic policy in Mozambique. Although it is important to acknowledge that the reform program has succeeded in reducing direct Central Bank funding to finance the Government's deficit, it could be argued that the present strategy may not be strong enough to avoid future losses in the banking system. A sanitized central bank balance sheet will certainly help to better monitor the reform process, as well as strengthen the country's financial infrastructure (banking legislation, supervision, training capabilities, etc.). The question is whether that infrastructure is enough to control the leakages from the banking system, especially those that are likely to appear during the transition period to peacei2. 43. During the transition period, it is very likely that whatever progress is made in separating the commercial and central bank wings of the Banco de Mogambique (BDM), and despite improvements in credit allocation, the banking sector will be facing high risk lending demands and potential mounting losses. Almost none of the enterprises have sufficient equity or stable business profits to be creditworthy by commercial standards. There is probably no altemative to high risk lending from the banks for the transition because the prospects for a recovery of the economy in the medium term can be judged acceptable. However, this should be acknowledged and dealt with openly, because the future responsibility of high risk lending in the banking system will eventually fall on the Government and will have an impact on fiscal policies. A number of possible solutions exist ranging from open subsidies to privatization of enterprises and new entries of banks into the new banking system that go beyond the scope of this exercise. However, irrespective of the mix of solutions, banks will have to move toward greater transparency, accountability and when needed, a transparent involvement of the Treasury during the transition period. 44. Improvements in the efficiency of public expenditure programs needs to be accompanied by making the monitoring, planning and budgeting procedures more comprehensive and expeditious. Donors perceived improvements in public sector financial management as a critical condition in order to increase the amount of untied external assistance to Mozambique. The donor community would not be prepared to accept major shifts in the structure of aid unless it can be assured that the inflows of external financing be spent on properly defined development objectives and in a transparent manner. This will require, inter alia: a) Monitoring and controlling the execution of the budget with a more detailed breakdown of budget items. As it was mentioned, presently only global items like "Salaries" or "Material and Supplies" can be controlled. A more detailed breakdown would allow the 11 Besides the accounting problems related to the counterpart funds, the assumption that the non-Government sector can absorb external concessional aid on a sound commercial basis may need to be revisited. The existence of a quasi net lending by the Treasury (through the promissory notes and/or through the Special Funds, "Fundos de Fomento") to non-Government sectors (e.g., the parastatals) can be considered net credit creation outside of the banking system (there is apparently no record of such transactions in the consolidated balance sheet of the fmnancial sector). This illustrates that most of the potential recipients of external concessional aid are unable to borrow on commercial terms. More worrisome, the capacity of these borrowers to repay the Treasury is in some cases doubtful. This obviously affects the fiscal accounts (revenues) although, overall, the external account is balanced. 12 Following the recent experiences in reforming centrally planned economies, there is growing skepticism that the standard strategy of passing a new banking law, training Central Bank staff to perform bank supervision, and instruct commercial banks to stop losing money can contain losses in highly distorted economies. There are two reasons why bank supervision is not robust enough: (i) the lag between granting a loan and when the loan falls into arrears; and (ii) bank supervision is a highly politicized process: bank supervisors usually do not close banks. Evidence from developed countries are plentiful. Mozambique - 2nd PER - Execuuve Summary  xv Budget Directorate to analyze actual resource allocation linking sectoral development objectives with expenditure programs. b) Improving the disbursement and controlling procedures at the Central Bank given the complexity and the number of different procedures required by donors. c) Integrating into the area of budget execution the information on execution of investment financed by extemal sources (that information is now only partly available and is under the responsibility of the donor community). This task was partially started in October 1991 and efforts should be made to continue the work and make the appropriate results available to both the CNP and the Ministry of Finance (MOF). It is of the utmost importance that the donor community shares with the Mozambicans its information on the execution of its projects so that the Government can have a clear and complete picture of budget execution as a whole 13. d) Improving the management of the public debt which could be put under a single agency outside the BDM. In addition, computerizing procedures and strengthening of the staff are important since public debt management needs a dynamic "on-line" process for examining and controlling the cash position, the volume and the timetable of public debt service flows at any moment. d) Programming the financial execution of the Budget. Together with a further disaggregation of Government's expenditures, it is recommended that each budgetary unit present to the MOF proposals for timetable / schedule of payments of endowments. The MOF should hence be able to control the programming of the financial execution of the OGE and thus formulate the guidelines and directives for sectoral schedules of payments, limits for periodical withdrawals from the Treasury's accounts and the required level of general cash flow. 3.4 The need to continue obtaining untied external assistance. 45. The fourth and last challenge for Mozambique relates to the continuation of donors' efforts to increase the proportion of untied external financial assistancel4. This will accompany the improvements in public sector management and would represent an important incentive aiming at enhancing the efficiency of expenditures. In practice, this would mean a gradual shift, that would be linked to progress made on the public sector's management capabilities, from a relatively tied project- aid assistance to a more untied program-aid assistance or, in other words, from an assistance directed primarily to the investment budget to one directed to both the recurrent ad the investment budgets. For example, the analytical work that estimated the size of recurrent expenditures included in the investment budget is a first step for identifying the areas where the donor community has been actually financial recurrent expenditures. This analytical exercise should now evolve toward practical 13 The CNP will be working in this direction with the UNDP and the donor coordination groups to prepare a common data sheet on financial and physical implementation of the projects; this is a fundamental piece of information for evaluating the progress made and the level of real investment in social and productive sectors. The World Bank will continue urging the information exchange process to become a priority for the donor community. 14 In tha respect, the Tokyo Special Program Services (SPA) initiative on Public Expenditure Reviews also supports and addresses this issue. It could be assumed that efficiency gains in public expenditures in Mozambique is related with the relation between tied to untied external financing. The argument revolves mainly around the fact that a fixed or tied allocation of external assistance may adversely affect development-oriented policies because of the rapidly changing circumstances driving the demand for foreign exchange and imported goods in a still war- devastated economy. When demand shifts considerably because of exogenous factors, it could be counterproductive to maintain a too tied supply of foreign assistance. Obviously, some degree of tied assistance can help the Government in better controlling the mobilization and utilization of external financing. However, there could be a trade-off between the growth performance of the economy and the characteristics of external financing. Mozambique - 2nd PER - Executive Summary  xvi solutions allowing a reclassification of expenditures and an untying of a share of extemal assistance. Another example is the possible untying of a share of foreign technical assistance (linked to projects) and its shift to support the needed pay raises of higher level, skilled, public sector technicians (through a special salary fund instead of topping up salaries on a non-transparent manner). 4. The improvements in sectoralpolicies 46. By strengthening macroeconomic management tools Mozambique can aim at facilitating the improvements of sectoral policies. Sectoral policies will aim essentially at the rehabilitation and reconstruction of the human and physical infrastructure of Mozambique. However, peace also means that progress in sectoral strategy will also imply revisiting some of the implicit sectoral strategies elaborated during the civil war and insecurity period. Peace indeed changes a number of assumptions that were used by both the donors and the Government to build the past public investment program. 47. Sectors could be divided into two broad categories: first, sectors which are providers of services and inputs; and second, productive sectors. The ideal situation (see Figure 1 below) is one where the productive sectors are restored into a high growth pattern as quickly as possible with the help of external assistance and domestic budgetary resources. High growth, in turn, increases domestically produced resources and impacts favorably the Government's budget. That, finally, allows a progressive reduction of the levels of extemal assistance. The critical issues here are, therefore, (i) to find the proper mix of external assistance/domestic resources and (ii) to find the proper sequencing between jump-starting the reconstruction process with heavy investments on the service sectors and the accompanying public expenditures in the productive sectors. Furthermore, realistically, there will be a time lag between the supply response of the productive sectors and the injection of resources into the economy either in the service or the productive sectors. Those resources will have to be injected into botih the productive d the service-provider sectors because of technical linkages (e.g., between increasing agricultural output and the availability of transportation and infrastructure). FIGURE 1: SERVICE PRODUCTPSE SECTORS SECT'ORS SOCIL4, SECTORS AGRICULT.i ENERGY *FSHERIE TELECOM. EXTERNAL .GVRNMENT ASSISTANCE BUDGET Mozambique - 2nd PER - Execudve Summuary  In 1991 SOCIAL SECTORS AGRICULTURE TRANSPORT & IND. & ENERGY TOTL Non-Reclassified Expenditures INFRASTRUCT. EDUCAT. HEALTI TOTAL AGRIC FISHER. TOTAL TRANSP. WATER TOTAL INDUST. ENERGY TOTAL .: