Peru - Financial Sector Adjustment Loan Project

The World Bank FOR OFmCAL USE ONLY MICROFICHE COPY Reportb N.p-5791-PE Report No. P- 5791-PE Type: (PR) MITRA, S. / X30129 / I7 019/ LAlCO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US$400 MILLION TO THE REPUBLIC OF PERU MAY 18, 1992 This dome has a resticted dblibutc and may be usd by ripiets only In the perfonnrm of tber offca dutie Its contnts may not odewise be dbcosed withou World Bank authrization.  CURRENCY EQUIVALEBTS (As of May 7, 1992) Currency Unit - Nuevo Sol (SI.)1 US$1.00 S/1.125 S/.1.OO - US$0.889 FISCE YEAR January 1 - December 31 ABBREVIATIONS AFP Asociacion de Fondos de Pensiones (Private Pension Fund) ALADI Asociacin Latino-Americana de Integraciln (Latin American Integration Association) BN Banco de la Naci6n CNV Comisi6n Nacional de Valores (Securities Comission) COFIDE Corporaci6n Financiera de Desarrollo (Public Financial Corporation) FLAR Fondo Latinoamericano de Reservas (Latin American Reserve Fund) FONCODES Fondo Nacional de Compensaci6n y Desarrollo Social (National Fund for Social Compensation and Development) GTZ Deutsche Gesellechaft ffir Technische Zusamaanarbeit (German Technical Cooperation Agency) IDB Inter-American Development Bank IPSS Instituto Peruano de Seguridad Social (Peruvian Social Security Institute) tLT Medium- and long-term NIPS Non-Financial Public Sector PSBR Public Sector Borrowing Requirement SAL Structural Adjustment Loan SBS Superintendencia de Bancos y Seguros (Superintendency of Banks and Insurance) SUNAT Superintendencia Nacional de Administraci6n Tributaria (Tax Administration) YMB0OLS USED IN TEXT TABLES Data not available or applicable. -- Zero or less than half the final digit shown. 1/ On July 1, 1991, a new.monetary unit, the Nuevo Sol (Si.), was introduced at a conversion factor of S1.1.00 - I/m.1.0O. The so-called Inti Mill6n (I/m.) -- equivalent to one million Intis (I/.1,O00,000) -- was introduced on December 16, 1990 to simplify accounting and as a means of transition between the Inti and the Nuevo Sol.  FOR OMCLIL USE ONLY FINANCIAL SECTOR ADJUSTMENT LOAN TABLE OF CONTENTS Page No. Loan and Program Summary . . . . . iv I. THE LOAN IN THE CONTEXT OF ARREARS CLEARANCE AND COUNTRY ST1ATEGY .. o.a... . . . . . . . . . . . .* . .. 1 Sustaining Stabilization and Deepening Adjustment . . . 2 Fostering Private Sector Development and Public Sector Reform . ..................a..... 2 Alleviating Poverty and Promoting Human Resource Development .. .............. 5 Rehabilitating Key Infrastructure . . . . . . . . . . . 5 Technical Assistance, and Economic and Sector Work . . 5 II. ECONOMIC POLICIES AND DEVELOPMENTS . . . . . . . . . . ... 5 Background ........................... 5 1985-90 .............................9 The Stabilization Package of Mid-1990 to Early 1991 . 10 III. THE ECONOMIC PROGRAM . . . . . . . . . . . . . . . . . . 12 Program Objectives and Policies . . . . . . . . . . . . 12 Recent Economic Developments .....*. ...... 14 Poverty Alleviation ..... ........ ..... 17 Assessment and Risks . .. .. .. .. .. .. . . 18 IV. EXTERNAL FINANCING . . . . . . . . . . . . . . . . . . . . . 19 Introduction # . .* * * * * * 9 * * * *.. . . . . .. 19 The 1991-92 Financing Plan . ............ . 21 Financing Beyond 1992 . ......... . .. 24 . .. . . .. . . This document hs a restricted distrbution 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.  - ii - TABLi 0 CONTENTS (CONT'D.) Pate No. V. THE STRATEGY OP FINANCIAL SECTOR REFORM . . . . . . . . . . 25 The Reform Strategy and Implementation in 1990-91 . . . 25 The 1992-93 Reform Program . . .. 27 VI. THE REPOI OF PUBLIC BANKS 28 Development Banking ................. 28 Banco de la Na^i6n 31 Privatization of Comercial Banks . . . . . . . . . . . 33 VTI. THE REFORM OF REGULATORY ARRANGEMENTS ... . . . . . . . . 35 Introduction . . 4 * 9 . . . . . . . . . . . . 35 Banking Legislation, Regulation and Supervision . . . . 36 Capital Markets and Pension Funds . * * * * 40 VIII. APPRAISAL OF THE REFORM PROGRAM AND RISKS . . . . . . . . . 42 IX. THE PROPOSED LOAN . ............ .. . . * *.. . . .. 43 Description 9 * * vo * * * ................ 43 Technical Assistance .... * . . * ................ * 44 Cooperation vith the Fund and IDB . . . . . . . . . . . 44 Procurement, Disbursement, Audit and Administration u . 45 X. RECO1A4EVDATION .............. . 47 ASMM Annex 1: Letter of Financial Sector Development Policy . . . . . 48 Annex 2: Matrix of Financial Sector Reform Policies . . . . . . 62 Annex 3: Macroeconamic Prograsm and Projections . . . . . . . . . 70 Annex 4s A Summary Note on the Financial System . . . . . . . . 81 Annex 5: The Principal Features of the Banking Law . . . . . . . 89 Annex 6: Supplementary Loan Data Sheet . . . . . . . . . . . . . 97 Annex 7: The Status of Bank Group Operations in Perfi . . . . . . 99 Annex 8: Project Bibliography . . . . . ............ 101  - iii - UL9 0 CONTIENS (O IT'D.) Pase No. Table 1s Long Term Economic Trends 1965-90 . . . . . . . . . . . 6 Table 2: Selected Economic Indicators . . . . . . . . . . . . . 10 Table 3s Economic Program . .*............... 13 Table 4s External DeBt eb, * o *t*........ 20 Table 5: External Financing 1991-1992 . . . . . . . . . . . . . 22 CHARTS Chart l Real Gross Domestic Product . . . . . . .......0 3 Chart s Gross Fized Investment .............. 3 Chart 3s Exports . . . . . . . . . * * * * 3 Chart 4s Tax Revenues . .. * ......... ... . . ... . . . 4 Chart 5s Public Sector Borrowing Requirements . . . . . . . . . 4 Chart 6s Consumer Price Index . .. ... . . ..... . . . . . 7 Chart 7s Real Interest Rates . . . . . . . . . 7 Chart s Real Exchange Rate .................. 8 Chart 9s Consumer Price lndex . ........... ..... 15 Chart 10: Central Government's Operations . . . . . . . . . . . . 15 Chart 11: Central Bank: Net International Reserves . . . . . . . 15 Chart 12: Lending and Deposit Rates in Soles . . ........ 16 Chart 13: Central Bank: Monetary Base . ............ 16  - iv - PE_RU FIRANCIAL SECTOR ADJUSTMENT LOAN Loan and Pworram Sumnarv Borrower: Republic of Perfi Executing Aaencv: Ministry of Economy and Finance Amounts US$400 million equivalent Terms: Repayable in 20 years, including five years of grace, at the Bank's standard variable interest rate. Loan Objectives: The proposed loan would support Perd's medium-term program of macroeconomic stabilization and structural reforms, in particular reforms undertaken within the financial sector. Loan DescriDtion: The loan recognizes the far-reaching program of reform of the financial sector adopted by the goverrment and the policy steps taken since mid-1990. It supports reforms to be undertaken in 1992-93 in the areas of development banking5 reduction of the role of the large public banks, Banco de la Naci6n; privatization of commercial banks; banking legislation, supervision and regulation; and capital markets. Benefits: The reforms supported by the loan would lead to efficient financial intermediation, thereby improving the allocation of resources. Competition would be sharpened by the removal of restrictions on credit pricing and allocation, the withdrawal of the state as a provider of financial services, and by the development of a rational frameaork for prudential regulation. The development of capital markets would be promoted. The reform program is essential to the consolidation of the stabilization effort and to achieving sustained growth. Risks: The risks to the macroeconomic program stem from continuing fragility in public finances, especially in public revenues, complications in the execution of monetary policy presented by currency substitution, and, in the transitional adjustment phase, high real interest rates and an overvalued currency. Risks in policy implementation may arise if the Congress elected upon the adoption of a new constitution is fragmented or if the policy actions taken by the present emergency government  - v - are challenged on legal grounds. Risks specific to the financial sector are posed by weak balance sheet positions in banks, inadequate provisioning, and the weak (though improving) standards of supervision. To address these risks, the authorities are attampting to enhance credibility in the policy stance through strict maintenance of cash fiscal balance and stringent monetary policies. Institutional capacities have been strengthened to implement reforms. Legislation -- partly in the form of decrees -- has been prepared to implement the reform program. Banking supervision is being strengthened, vigorous inspections of banks conducted, and capital adequacy and credit concentration standards are being raised. Dilsbursement: The loan would be disbursed in two tranches. It is envisaged that the first tranche (US$300 million) would be released at end-December 1992 upon the clearance of arrears to the Bank and the fulfillment of other effectiveness conditions. The second tranche (US$100 million) is expected to be released at end-1993. ADDraisal Renor:s Not applicable.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIORAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN TO THE REPUBLIC OF PERU 1. I submit the following report and recommendation concerning a proposed loan to the Republic of Perfi for the equivalent of US$400 million to support the program of reform of the financial sector. The loan would be for a period of 20 years, including five years of grace, at the Bank's standard variable interest rate. I. THE LOAN IN THE CONTEXT OF ARREARS CLEARANCE AND COUNTRY STRATEGY 2. In May 1991, the Board adopted a new policy for countries in protracted arrears demonstrating a record of cooperation with the Bank, which involved the approval by the Board of loans in a period leading up to the clearance of arrears but with disbursements taking place only upon the elimination of arrears (Additional Sungort for Workout Programs in Countries with Protracted Arrears, R91-70, April 11, 1991 and SecH91-509). Countries eliglble for assistance under this policy were required to: (i) adopt an economic stabilization and adjustment program supported by the Fund and the Bank; (ii) demonstrate a complete external financing package; and (iii) maintain current debt service payments to the Bank. 3. The Board approved the application of this policy to PerG in July 1991 (Per6s The Bank's Approach to a Country with Protracted Arrears, R91-171, July 12, 1991). With the adoption of this policy, the Bank intensified its country assistance to PerO in the form of macroeconomic and sector policy advice and technical support, which had earlier been initiated with the change of governa.Ant in mid-1990. In September 1991, the Bank participated actively in the formulation of an external financing plan for 1991-92 that required substantial contributions from bilateral donors. Consistent with this policy, the Bank has been preparing a program of four adjustment loans, of which two have already been presented to the Board. A trade reform loan was approved by the Board in February 1992 and a structural adjustment loan in March 1992, each of one tranche in the amount of US$300 million. As the third in the series of adjustment loans to PerGi, it is proposed that the Bank extend a loan in the amount of US$400 million in two tranches in support of a program of financial sector reform. It is expected that the loan will be signed, declared effective and the first tranche (US$300 million) released at end-1992 upon the clearance of arrears, with the second tranche (US$100 million) being released in the final quarter of 1993. The final adjustment loan -- in support of privatization and private sector development -- in the amount of US$260 million is under preparation, with Board presentation being envisaged in the final quarter of 1992. 4. The Bank has also been developing its country assistance strategy for the period through FY95. During this period, the Bank expects to deepen its support of the adjustment program through additional lending and economic  and sector work, and also expects to present investment loans now under ptaparation. These loans are proving to be time and staff inteasive in preparation, not least because of the hiatus in Bank lending to Per6 and the need to strengthen Per6's public institutions. 5. To strengthen public management, the Bank has launched a major program of technical assistance, crucial for the successful implementation of the medium-term economic program. It has mobilized resources for these activities through the Japanese Grant Facility and the Deutsche Gesellschaft fUr Technische Zusammanarbeit (GTZ), and is currently exploring other possible avenues of financing. The Bank has secured Japanese grants for approximately US$F million for seven technical assistance projects in the financial sector, debt statistics and management, the social sector, water and sanitation, energy, and privatization, and has secured GTZ grants for about US$1 million for agriculture, macroeconomic stabilization and structural reforms, energy, mining and industry, infrastructure, and human resource development. Thus, even before being able to disburse from its own resources, the Bank has mobilized substantial resources for project preparation and implementation. 6. The Bank's country assistance strategy is directed at four long- term objectives: (i) sustaining stabilization and deepening adjustment; (ii) fostering private sector development and public sector reform; (iii) alleviating poverty and promoting human resource development; and (iv) rehabilitating key infrastructure. 7. Sustaininz Stabilization and Deenenina Ad1ustaent. Since mid- 1990, the authorities have pursued structural reforms to set the stage for sustained economic recovery. Market-oriented reforms (including deregulation) have beeu implemented in trade, monopoly rights, privatization, port services, foreign investment, land tenure, labor markets, social security, tax policy and administration, and the financial sector. Bank lending operations in Peroi have initially focussed on a program of adjustment loans. The trade reform loan recognized measures taken to reduce tariffs, eliminate non-tariff barriers and export subsidies, and reform customs. The SAL aimed at consolidating stabilization by supporting the continuation of non-inflationary budget financing, improving tax collection and implementing tax reform. It also redefines government functions and reduces public employment, lays out strategies for privatization, increases labor mobility, and reduces state intervention in agriculture. 8. Fosterint Private Sector Develoument gad Public Sector Reform. Bank support in this area will focus on reforms to encourage competition, private sector investment, and privatisation. Bank support is being provided through: (a) the reforms in the SAL and Trade Reform Loan; (b) the privatisation component of the AL; (c) the banking privatization component in this proposed loan; (d) the proposed privatization adjustment loan; (e) the technical assistance program for privatisation funded by a Japanese Grant; and (f) privatization components in the proposed power, transport, and water sector loans.  - 3-. Peru: Real Gross Domestic Product 110~ ~~1J910 10 0 < Chart 1 TI, 1 i twt siwt us 1u us1et onJ us*o Peru: Gross FMxod Inwstment (As percent o1 GDP) 27 22 Chart 2 in tut we t wi s wn s waws u 0ua Peru : Exports (As percent of GDP) 21 Chart 3 Ptcaeattean Source: National Statistical Institute and Central Bank.  - 4 - Tax Revenues (As percent of GDP) 18 - 14 12 Chart 4 6 I_ I L I I I i I It L .s " | fi * f 10y1 1973 1976 197" 1979 1981 1988 1986 1987 198 1991 199g 1998 Projeotions Public Sector Borrowing Requirements (As percent of GDP) 16 14 12 10 62 < < \ g ~~~~~~~~~~~Chart 5 17 102 1974 1070 1978 1980 12 1984 1086 1088 1990 1002 Projections Source: National Statistical Institute and Central Bank.  -5- 9. Alleviating Poverty and Promotint Human Resource DeveloDment. The Bank is assisting the government in formulating and implementing a poverty alleviation strategy, and in promoting human resource development. The Health and Nutrition Project would support basic health services and nutrition to the poor in selected regions. It would help in formulating a poverty alleviation strategy and identifying reforms in food assistance programs. A subsequent operation in primary education would address rehabilitation needs, with special attention to the poor. 10. Rehabllitating Kel Infrastruc'.ure. The Bank's strategy includes rehabilitation loans for the power, transport and water sectors, which have suffered from lack of maintenance. These loans will also support policy and regulatory changes to promote private sector participation and investment (e.g. through concession arrangements). Over the medium term, these loans will be supplemented with loans to support further rehabilitation and sectoral reforms, a- well as selected new investments. Projects for rural financing, irrigation infrastructurt and municipal development are also in the lending pipeline. 11. Techaical Assistance. and Economic and Sector Work. The Bank is playing a prominent part in supporting technical assistance and is developing an intensive program of economic and sector work. As noted, to counter weaknesses in public management, the Bank has mobilized external funds amounting to a'mut US$9 million (principally from Japanese and German sources) to finance wide-ranging technical assistance within the government. A technical assistance loan to support privatization is being developed in parallel with the privatization adjustment loan. Economic and sector work has ranged from macroeconomic, structural reform, trade reform and financial sector reform studies to work on labor markets, privatization and deregulation strategies, and an environmental sector study. Further studies on health, nutrition and education, poverty assessment, energy, mining, irrigation, water supply, telecommunicatlons, transport, and policy reform in infrastructure are envisaged. II. ECONOMIC POLICIES AND DSJVQMf S Background 12. Over the past decade, Pert has suffered from falling rates of economic growth that have in recent years led to economic stagnation (Table 1 and Charts 1 to 3) and accelerating inflation stemming from loose fiscal and monetary policies (Charts 4 to 7). These were exacerbated by a flight from local currency holdings, and persisting difficulties in servicing external debt that have resulted in the accumulation of massivo arrears to all creditors. This pitiful development experience was associated with a large expansion in the role of the state in the economy initiated in the late 1960s, which created a policy environment and a legal structure inimical to sustained, efficient growth.  - 6 - Table 1: Per6 - Long Term Economic Trends 1965-90 1965-75 1976-80 1981-85 1986-90 (annual chanae in percent) Real GDP 4.7 2.6 -0.2 -1.8 Gross fixed investment 7.9 2.3 -8.4 3.0 Export volume a/ 1.8 7.7 1.5 -3.4 Impc t volume a/ 6.7 0.6 -7.8 3.0 Consumer prices 11.8 54.9 105.6 972.5 (average. as percent of GDP) Gross fixed investment 18.0 16.8 15.4 16.2 Exports 15.4 20.8 21.2 20.8 Non-financial public sector balance ... -5.5 -6.7 -7.3 External current account balance -2.5 -1.8 -3.6 -5.5 External debt ... 59.5 60.8 70.8 i/ Goods and non-factor services. Sources Central Bank of Per6 and IFS. 13. Relative Prices were severely distorted by government controls over exchange rates, allocation of credit and wages as well as over final output prices. External trade vas distorted through an overvaluation of the local currency, multiple exchange rates, high tariffs and quantitative restrictions. The pattern of domestic production departed increasingly from efficiency. In factor markets, ill advised employment protection laws coupled with high tax rates on labor led to misallocation ard stivulated the growth of an informal sector. The marketability and the use of lan,' as collateral was greatly restricted, and capital flows were distorted by heavy regulation and growing state participation in the financial sector. The policy environment squeezed returns to investment in reflection of growing inefficiency, dampened export growth and led to unsustainable current account deficits and the build up of external debt (Table 1). By 1985, real per caput GDP was 13 per cent lower than a decade earlier.  - 7 - Peru - Consumer Price Index t7c (Prcentage chae ed @1 pof t) 160 150 140- 130 120- tio - ~ ~ ~ ~ ~ ~ Poecin 100 go Chart 6 80 70 60 40- 30- 20- 10 0 191117 1979 1983 1 1987 1 1991 I 1995 1973 1977 19SS 1908 1989 1993 Projections Real Interest Rates Source: Nati(Percent. annt al IvwuC t) 70- so so 40 30 20 10 0 Chart 7 -10 -20- -30- -40- -50 -60 -70 -80 1984 1985 1986 1987 1988 1989 1990 199 01-92 0 LendIng Rate + Depoalt Reat Source: National Statistical institute and Central Bank.  Chart 8 Peru: Real Exchange Rate (July 1985 = 100) 120 100 / 80- 60 ; 0 0 40 40 1971 1973 1976 1977 1979 1981 1983 1986 1987 1989 1991 1/ Rise in the index indicates depreciation. Source: Central Bank.  -9- 1985-1990 14. The government in power between 1985 and 1990 adopted a strategy of stimulating domestic demand and limiting external debt servicing as the means of re-initiating growth. The public sector borrowing requirement (PSBR) soared from 5.8 per cent of GDn in 1985 to 15.3 per cent of GDP in 1988 as wide scale tax reductions were enacted, public employment and wages boosted, and the public enterprise sector generated increasing losses. The PSBR was financed largely by recourse to the Central Bank. The authorities decided to limit public sector external debt payments to a maximum of 10 per cent of exports of goods and non-factor services, and to service only those creditors that had undertaken to provide a net inflow of foreign resources. 15. The inflationary effect of this policy stance was initially dampened through price and interest rate controls, expanding subsidies, a pronounced fall in real terms in public sector tariffs and by a multiple exchange rate system that yielded highly overvalued rates. (The sharp appreciation in real terms of the sol between 1985 and 1990 is illustrated in Chart 8.) In addition, domestic money demand expanded as the economy experienced a sharp but highly temporary boom -- output grew by 17 per cent in 1986-87. As the unsustainability of policies became evident in the course of 1987, confidence evaporated and a flight from local currency precipitated a hyperinflation from the final quarter of the year. Output fell markedly in 198$ and lack of credibility in exchange rate policies became increasingly felt with the depletion of international reserves. 16. The rapid rise in inflation exacerbated the fiscal deficit with central government revenues falling by one-half (in relation to GDP) between 1985 and 1989 in reflection of the erosion in real tax revenues from collection lags, rising evasion as well as the effects of tax reductions and unadjusted public tariffs. The subsidies associated with the multiple exchange rate system and expanding lending by development banks at low interest rates led to the emergence of a large quasi-fiscal deficit. Monetary financing of the PSBR rocketed at a time when domestic money demand was falling rapidly in conditions of disintermediation. The authorities responded to the deteriorating fiscal accounts by cutting public investment outlays to historically low levels, with the greatest reduction taking place in health and education. Yet, without an attempt to address the fundamental imbalances within the economy, inflation continued to soar and real activity plummeted. 17. Economic mismanagement reached a climax in 1989 and 1990. Real GDP contracted by nearly 16 per cent in 1989.90, with fixed investment falling by over 10 per cent (Table 2). About 75 per cent of the labor force was unemployed or partly employed. In 1990, per caput incomes were 23 per cent lower than in 1985 and amounted to no more than the levels prevailing in the late 1950s. Consumer prices rose by over 2700 per cent in 1989 and 7600 per cent in 1990; the fiscal base had shrunk greatly and with it tax revenues and public tariffs were approaching zero in real terms. The financial sector was severely battered by the inflation and depression in activity with its associated disintermediation and currency substitution; real domestic liquidity in 1990 was about one-sixth of its value five years earlier. At  - 10 - mid-year, when the administration left office, international reserves were virtually exhausted and over two-thirds of Perfi's external debt of US$22 billion was in arrears, with arrears to the Bank, the Fund and the IDB totalling US$2.2 billion. Table 2s Per6 - Selected Economic Indicators 1980-88 1989 1990 1991 Annual average (chanses. in Percent) GDP (real) 1.1 -11.9 -4.6 2.9 Gross fixed investment 0.8 -16.9 8.0 2.8 Exports a/ -3.3 23.8 -7.9 3.3 Consumer prices (end of period) 149.6 2775.3 7649.6 139.2 (in Percent of GDP) Gross fixed investment 23.2 16.2 14.2 14.0 Exports A1 17.2 12.5 11.2 ... Non financial public sector balance -6.7 -7.9 -5.4 -2.7 Quasi fiscal balance -1.9 -2.8 -1.1 -0.5 Public sector borrowing requirement 8.6 10.7 6.5 3.2 External current account balance -4.5 -1.1 -3.9 -4.9 External debt bI 64.4 92.0 111.4 127.3 (in billions of US dollars) (13.3) (19.9) (22.1) (23.2) g/ Goods and non-factor services. k/ GDP calculated at 1979-87 average real exchange rates. Source: Central Bank of Pert. The Stabilization Package of Mid-1990 to Eayly 1991 18. The authorities that assumed office at end-July 1990 adopted a firm program of macroeconomic stabilization and structural adjustment with the objective of arresting inflation and creating the conditions for a recovery of activity in the private sector. The measures involved a correction of the large fiscal deficit, the pursuit of tight monetary policies and the provision of incentives to the private sector to expand output in an efficient manner. To this end, distortions in relative prices were ironed out, a sharp reduction in the PSBR was effected and the economy was exposed to foreign competition.  - 11 - Specifically, the measures includedt (i) 8 rise in the uricea of publlc sector goods and services ranging between 1000 per cent and 3000 per cent to restore balance in public enterprise accounts; (ii) the elimination of numerous exemptions on indirect taxes accompanied by a reduction in VAT from 18 per cent to 14 per cent as well as the imposition of temporary taxes of 10 per cent on exports and 1 per cent on net wealth; (iii) a reduction in marginal reserve reauirem_nts on bank's domestic cui:ency liabilities from 80 per cent to 40 per cent and, effectively, the free determination of interest rates on loans and deposits; (iv) a substantial relaxation of price controls; (v) the unification of the exchanae rates and a free float; (vi) abolition of nearly all quantitative import restrictions and of some import tariff exonerations, the consolidation of a complex tariff system into one with three rates of 15 per cent, 25 per cent and 50 per cent, and (vii) liberalization of restrictions on current 2ayments for external transactions. 19. Fiscal discipline was exerted by the institution of a cash management committee at the Ministry of Finance that limited expenditures to available cash revenues. Public sector wages were held down, while wages (and prices) in the private sector were allowed to be market determined. In the months following the initial package, public sector prices continued to be adjusted periodically in line with costs. 20. In early 1991, the adjustment measures were strengthened by a further simplification of the tax system, with the current system relying principally on five taxess on incomes of individuals and corporations, on wealth of individuals and corporations, value added tax, on selective consumption and tariffs on imports. In general, the tax base was expanded (with elimination of exemptions) and tax rates were reduced. The temporary taxes on exports and net wealth were removed. The tax administration system was overhauled and its enforcement mechanisms strengthened. The authorities published a list of 23 public enterprises eligible for urivatization and removed public sector monopolies in various activities. Public eumlo'ment was reduced with the institution of voluntary retirement schemes. 21. The execution of monetary golicv was sharpened by measures taken to reduce the quasi-fiscal deficit: subsidized lending by Banco Agrario was eliminated and the overall activities of this bank limited to small farms in socially deprived areas. A new banking law was adopted to strengthen prudential requirements, capital adequacy and concentration ratios, promote universal type banking and open the sector to foreign investment. 22. The external pasments and trade gystem was further liberalized progressively in the course of 1990. All restrictions on private current and capital transactions have been eliminated (except for those on amortization of certain classes of external debt). With the abolition of export surrender requirements (on foreign exchange), removal of limitations on investment income and capital transfers and the permitting of foreign exchange deposits at home and overseas, the payments regime has been greatly liberalized. Subsidized export credits and other export subsidies were eliminated. The tariff regime was simplified to a maximum rate of 25 per cent, with most items being subject to a tariff of 15 per cent.  - 12 - 23. The rigid labor lrotection laws were amended to broaden provisions for redundancies and to establish a better regime to capitalize the contributions towards compensation at the time of redundancy or retirement. Land urouertv rithts have been broadened and strengthened. Corporations (including agrarian cooperatives) can now legally become private estates. Moreover, land is now freely transferable and can be used as collateral. III. THE ECONOHIC PROGRAM ProLras Obiectives and Policies 24. The economic program for 1991-92 was intended to consolidate the macroeconomic stabilization measures taken in mid-1990 and early 1991 and to deepen the process of structural reforms then initiated. The program is being supported by an arrangement with the Fund (the rights accumulation program) that spans the period to end-1992 as well as by the Bank's program of adjustment lending. The principal targets of the program (Table 3) are a reduction in the rate of inflation to low single digit monthly rates by the turn of the year 1991/92 and to less than 2 per cent per month by end-1992, a return to growth averaging 3 per cent for years 1991/92 based on a recovery of investment, and the attainment of a viable external financing position. The objectives would be achieved by continued prudent fiscal and monetary policies, market determined interest rates and exchange rates, supported by fundamontal structural adjustments within the economy. 25. The burden of the adjustment effort is placed on fiscal and monetary policies. The program envisages an elimination of domestic financi n of the PSBR in 1992, from 3.3 per cent of GDP in 1990 to 0.1 per cent of GDP in 1991. The PSBR itself fell markedly in relation to GDP from 6.5 per cent in 1990 to 3.2 per cent in 1991, as a result of severe restraints on expenditures. In 1992, the PSBR will be allowed to rise to the equivalent of 4.4 per cent of GDP because additional external aid flows are expected to allow higher investment spending than originally projected. Thus, net public capital expenditures will rise from 1.9 per cent of GDP in 1991 to 3.7 per cent of GDP in 1992. A recovery in central government revenues is projected to stem from reforms in the tax system and in tax administration. Revenues are being strengthened by a simplification of the tax system, reductions in exonerations, a rise in VAT to 18 per cent, an increase in selective consumption taxes, an extraordinary payroll tax of 3 per cent in effect during 1992, a gross assets tax of 2 per cent on companies, some receipts from privatization and, importantly, strengthening of tax administration. 26. The program will be supported by a continuation of tight monetarX policies and a market determined excbanm rate; under the Fund program, limits  - 13 - Table 3: Pert - Economic Program 1989 1990 1991 1991 1992 Program Out-turn Program A. Rev Taraets (change Ln 2rcent) GDP -11.9 -4.6 2.8 2.9 3.5 Consumer prices (end of period) 2775 7650 132.0 139.2 37.0 (as Dereent of GDP) Investment 17.2 14.6 14.5 16.0 16.3 External current account balance -1.1 -3.5 -4.4 -4.9 -5.4 (in millions of US dollars) (-395) (-1300) (-2100) (-2420) (-2549) (flows, in millions of US dollars) Net international reserves 687 163 400 953 344 (increase) B. Rev Instruments (as vercent of GDP) Central government revenues 6a 7.8 7.6 7.9 9.0 Total expenditures 14.0 13.2 10.7 10.6 13.1 Non-financial public sector balance -7.9 -5.4 -3.1 -2.7 -4.1 Quasi-fiscal balance -2.8 -1.1 -0.5 -0.5 -0.3 Public sector borrowing requirement 10.7 6.5 3.6 3.2 4.4 External financing (ncl. arrears) 2.9 3.2 3.1 3.1 4.4 Domestic financing 7.8 3.3 0.5 0.1 _ Source: Central Bank of Perfi and Pund staff.  - 14 - have been agreed on expansion of net domestic assets of the Central Bank, on total net domestic borrowing of the public sector as well as on changos in net external short-term debt. Interest rates are determined by market forces. The authorities are making greater use of open market operations in the conduct of monetary policy with the eventual aim of reducing reliance on still-high reserve requirements. The sol will float freely in the foreign exchange markets with limited intervention. 27. In monitorint PerG's Performance under its macroeconomic program, the Bank will pay particular attention to four variables in 1992: (i) that central government revenues do not fall short of 9 per cent of GDP; (ii) primary deficit of the non-financial public sector is no larger than 0.6 per cent of GDP; (iii) money base expansion in the twelve months to end- D:ember should not exceed 40 per cent; and (iv) stock of other Central Bank monetary liabilities in soles should not exceed 10 per cent of the monetary base. The Bank will pay particular attention to measures of fiscal revenue enhancement and expenditure control which will contribute to efficiency, equity and the sustainability of adjustment in the medium term. It will consult closely with the Fund. 28. The economic nroaram for 1993 and supporting policies will be agreed with the Bank in late 1992, and will provide the basis for Bank adjustment lending (including lending under the proposed loan) in 1993 as well as for an arrangement with the Fund -- the successor arrangement to the rights accumulation program. 29. Structural reforms that the government has programmed for 1992 have been detailed in the SAL document (P-5714-PE, March 2, 1992). In summary, public sector roforms center on a reduction in the size of the government and in public employment. The tax administration system will be further strengthened. Privatixation will be undertaken in a wide range of sectors (including financial). The authorities will develop a povertv alleviatiou strategy and a program for priority investment in social sectors. Agricultural reforms have involved improvements in land tenure, agricultural marketing and credit, water usage and will be advanced further. The authorities will deepen labor market reforms to increase flexibility in employment and pay. The social security system (pensions and health) will be partially privatized and regulations for private participation drawn up. Recent Economic Develouments 30. The initial stabilization package generated a burst of "corrective" (one-time) inflation and a sharp fall in economic activity, accompanied by the emergence of high real interest rates (Charts 9 to 13). With the maintenance of a balanced budget on a cash basis (Chart 10) sad firm monetary policies, inflation fell rapidly thereafter (except for a spike in early 1991 when public sector prices were again adjusted). Inflation ranged at monthly rates of 7-9 per cent for the first eight months of the year, but between October 1991 and January 1992 ranged at 3.5 to 4 per cent. Inflation accelerated to an average monthly rate of 6 per cent in February and  - 15 - Peam - Consumer Prbe ndex (POentug ne end of month) Chart 9 o~~~~ . . . . . . ' A J A 8 O N O J P M A M J J A @ O N D J P H A A* -o - ApU1W80 Cal Im mentls Operation (MinM US$) '44 000 Chart 10 -J A 00 0O J P 8A" J J A 00 ND J a 19w - Jwuuy 1n02 == @rt RW Central Bnk : Nt Int. eserve (buns of Us$) IA is. 0* /Chart 11 *A I