Honduras - Reforming public investment and the infrastructure sectors : a joint World Bank and Inter-American Development Bank study

Report No. 14084-HO Honduras Reforming Public Investment and the Infrastructure Sectors A Joint World Bank and Inter-American Development Bank Study September 12, 1995 Latin America and the Caribbean Region Document of the World Bank  GOVERNMENT FISCAL YEAR January I - December 31 CURRENCY EQUIVALENTS Currency Unit = Lempira US$1.00 = L8.4 (May 1994) ACRONYMS AND ABBREVIATIONS AGSAC Agricultural Adjustment Credit CABEI Central American Bank for Economic Integration CEM Country Economic Memorandum/Poverty Assesment. 1994. CNEE National Comission for Electric Energy CNSSP National Comission for the Supervision of Public Services DGAC Directorate General for Civil Aviation DGCCA Directorate General ot Roads and Airport Maintenance DGT Direcci6n General de Tributaci6n (General Directorate of Taxation) DGMCA Direcci6n General de Mantenimiento de Caminos y Aeropuertos ENP National Ports Enterprise (Empresa Nacional de Puertos) ESAC Energy Sector Adjustment Credit ENEE Empresa Nacional de Energia Electrica (National Electric Energy Enterprise) FHIS Fondo Hondurefho de Inversi6n Social (Honduran Social Investment Fund) FNH Ferrocarril Nacional de Honduras FOSOVI Fondo Social de Vivienda (Social Housing Fund) HDM Highways Design and Maintenance Model HONDUTEL Empresa Hondurenia de Telecomunicaciones (Honduran Telecommunications Enterprise) ICOR Incremental Capital Output Ratio IDA International Development Assiciation IDB InterAmerican Development Bank IMF International Monetary Fund ]MPREMA Pension Funds for Civil Servants and Teachers INFOP Instituto de Formaci6n Profesional (Institute for Professional Training) INJUPEMP Instituto Nacional de Jubilaciones y Pensiones de Empleados del Poder Ejecutivo (National Institute of Retirees of the Executive Power) MTEF Mediumn Term Expenditure Framework PE Public Enterprise PFP Policy Framework Paper Pi Public Investment PIP Public Ilvestmenit Program PIR Public Investment Review PRAF Programa de Asignaci6n Familiar (Family Income Support Program) SANAA Servicio Aut6nomo Nacional de Agua y' Alcantarillado (National Autonomous Water and Sewerage Service) SI)SP Ministry of Health Si'S San Pedro Sula SCHP Ministry of Finance SEC Ministry of Economy and Commerce SE.COPT Secretaria de Comunicaciones. Obras Publicas y Transporte (Ministry of Communications, Public Works, and Transport) SECPLAN Ministerio de Planificaci6n (Ministry of Planning) SlICP Secretaria de Hacienda y Credito Publico (Ministry of Finance and Public Credit) SISPU Sistemila de Inversiones del Sector Publico (Public Sector Investment System) UNAH Universidad Nacional Aut6noma de Honduras (National Autonomous University of Hlonduras) UNICEF United Nations Children's Fund IJNDP Programa para el Desarrollo de las Naciones Unidas (United Nations Development Program) UPNFM Universidad Pedag6gica Nacional Francisco Morazan WDR World Development Report  Reforming Public Investment TABLE OF CONTENTS PREFACE jj; EXECUTIVE SUMMARY iv RESUMEN EJECUTIVO xi 1. INTRODUCTION: THE ECONOMIC IMPACT OF PUBLIC INVESTMENT 1 Public Investment and Public Finances I Public Investment and Macroeconomic Instability 2 Macroeconomic and Microeconomic Inefficiencies of Public Investment 4 Who Invests in the Public Sector? 4 The Sources of the Problem 5 2. INVESTMENT PROGRAMMING AND IMPLEMENTATION 7 Lack ofStrategy and Lack of Project Evaluation Criteria 7 The PIP and Investment Budgeting as Tools of Fiscal Management 9 Recommendations 12 3. INFRASTRUCTURE PROVISION: COMPETITION, PRIVATIZATION AND REGULATORY REFORM 13 Structure of Infrastructure Service Provision and Competition 13 Regulation of Infrastructure Service Provision 19 Structures for Monitoring and Controlling Sector Policy 20 Tarif Setting Procedures and User Charges for Infrastructure Services 22 Maintenance of Infrastructure Stocks 25 Financing of Maintenance and Investment in Roads 27 Recommendations 29 4. PUBLIC INVESTMENT AND POVERTY ALLEVIATION 33 Lack of a Strategy for Poverty Reduction 33 Public Financing of Education and Health 34 Fixed Investment in the Social Sectors and the Poor 37 Recommendations 40 BIBLIOGRAPHIC REFERENCES 42 This report is based on the findings of a joint World Bank/Inter-American Development Bank team. The team was integrated by Daniel Cotlear (WB, team leader and main author of this report), Frannie Humplick (WB, co-author of Chapter 3), Luis Cosenza (IDB, electricity), Joaquin Carabayo (IDB, roads), George Guess (WB, investment planning and budgeting), Francisco Ochoa (IDB, water and sewerage), Zvi Raanan (IDB, ports and airports), Alfredo Sarmiento (Ruta Social, social sectors) and Danilo Alvarado (IDB, statistical appendix). Mike Stevens (World Bank) was peer reviewer for Chapter 2. Edilberto Segura, Donna Dowsett-Coirolo and Ian Bannon are Country Director, Division Chief and Lead Economist respectively for the World Bank. Miguel Martinez and Jorge Sapoznikow are Regional Manager and Division Chief, respectively for the Inter-American Development Bank.  ii A joint World BanklIDB Study TABLES Table 1-1: Public Finances in Latin America (9 Countries), 1993 2 Table 1-2: Finances of Public Enterprises in 1994 3 Table 1-3: Growth and Investment 4 Table 1-4: Structure of Public Investment 4 Table 2-1: Investment Program for 1995 11 Table 3-1: Market and Regulatory Structure in Infrastructure Services 14 Table 3-2: Performance of the Telecommunications Sector 15 Table 3-3: Performance of the Ports Sector 15 Table 3-4: Comparative Ship Charges in Honduras and Guatemala, 1992 15 Table 3-5: Performance of the Water Sector 18 Table 3-6: Distribution of Costs and Tariffs for Telecommunications 24 Table 3-7: Costs of Electricity Supply by Private and Public Enterprises 27 Table 3-8: Summary of Sectoral Recommendations 32 Table 4-1: Public Investment in Social Sector Infrastructure 33 Table 4-2: Total Expenditures in Social Programs (% of GDP) 34 Table 4-3: Expenditures and Enrollment in Education (%) 36 Table 4-4: Social Sector Coverage 37 Table 4-5: Investment Targeting by FHIS 38 DIAGRAMS Diagram I - 1: Public and Private Investment as a Percent of GDP I Diagram 1-2: Overall Deficit and Public Investment 3 Diagram 1-3: Disbursement of Extemal Debt and Public Investment 3 Diagram 3-1: Access to Telephone Services in the 1990s 15 Diagram 3-2: Households with Access to Electricity in the 1990s (percent of total) 16 Diagram 3-3: Quality of Electrical Services in the 1990s (system losses as % of output) 16 Diagram 3-4: Population With Access to Water Supply Services in the 1990s (percent of total) 18 Diagram 3-5: Index of Tariffs for Selected Public Services (in real terms, 1993 = 100) 23 Diagram 3-6: Roads in Good Conditions (%) 26 TEXT BOXES Box 2- 1: Three Polemic Projects 8 Box 2-2: A Medium Term Expenditure Framework (MTEF) 10 Box 3-1: Recent Regulatory Reforms in Electricity 16 Box 3-2: The High Cost of Maintenance Neglect 26 Box 3-3: The Case for and against a Road Fund in Honduras 29  Reforming Public Investment iii PREFACE This report is prepared by the World Bank and the IDB as a contribution to their ongoing policy dialogue with the Government of Honduras. The policy dialogue of the World Bank with the Administration of President Reina began in January 1994 with a presentation to the members of the transition team of the World Bank's Country Economic Memorandum/Poverty Assessment (CEM). The main macroeconomic message of that report was the need to restore the fiscal equilibrium lost during the presidential elections of 1993. The CEM was published in English in November 1994 and later, at the request of the Government, it was translated into Spanish to encourage dissemination of its results in Honduras. During early 1994, the economic dialogue continued based on discussions of the Govemnment's Policy Framework Paper (PFP), of the results of supervision missions of the Agricultural Sector Adjustment Credit (AGSAC) and the Energy Sector Adjustment Credit (ESAC). and of documents produced in preparation for a forthcoming Public Sector Modernization Credit. The policy dialogue of the Inter-American Development Bank with the Reina Administration was initiated at the beginning of the Administration through the supervision of sectoral reform projects in energy, agriculture and finance. This dialogue was continued through several missions leading to the Programming Mission and the presentation of IDB's Country Paper to the authorities in mid-1995. IDB has also been involved in policy dialogue with the Government through the preparation of the programs for the Reform of the Public Sector, the Reform of the Water and Sanitation Sector, the Refonn of the Judiciary, the Reform of the Legislative and the Refonm of the Tax Administration. In early 1994, it became clear that one of the main challenges to be faced by the new administration was improving the management of public investment and the provision of infrastructure services. The Government and the IMF requested that the World Bank and IDB undertake a study to make recommendations in this area. Preparations for the study were supported by the Economic Cabinet and particularly by SECPLAN which prepared a Public Investment Program document especially for use of the mission. The IMF supported the effort by making available some of its data on the evolution of public investnient. Task managers of sector projects financed by the World Bank and the IDB also contributed to the preparation of the mission, and later provided comments on early drafts of this report. The report is based on the findings of a visit to Honduras in December 1994 and its results were updated during subsequent visits. An initial draft of this report was prepared in the field in December 1994 and discussed with the Authorities at that time. An advanced draft was presented to the authorities in June 1995. Discussions of the draft report were held individually with each of the sector agencies and a general presentation was given to the Economic Cabinet. The conclusions reached during those discussions are reflected in this report. In addition to this report, team members prepared sector reports discussing in greater detail the issues for the following sectors: Roads; Ports and Airports: Telecommunications; Electricity; Water and Sanitation; Investment Planning and Budgeting: and Social Sectors. After incorporating comments from the task managers responsible for the respective sectors in both banks, the reports were sent to the Government in January 1995. Additional copies of these reports can be obtained fromn the World Bank or IDB.   Reforming Public Investment v EXECUTIVE SUMMARY 1. High levels of public investment (PI), low levels of savings and an inefficient system of regulation for the provision of infrastructure services constitute a key obstacle to macroeconomic stability and growth in Honduras. The main source of macroeconomic instability is a structurally high fiscal deficit, which reached over 10 percent of GDP in 1993 and was reduced to 7.5 percent of GDP in 1994 with the implementation of courageous measures by the Administration inaugurated in January 1994. Public investment and debt service for debt contracted to finance past investment constitute over half of public expenditures. The new Administration found its hands tied with rigid investment contracts signed by the previous Administration and was forced to cut recurrent expenditures, postpone desired investments in the social sectors and increase taxes to begin to bring the fiscal deficit under control. An inefficient system of regulation adds to the fiscal burden created by this investment by further draining the public finances to compensate for incomplete cost recovery by the public enterprises in charge of providing the main infrastructure services. Over two thirds of public investment is implemented by five agencies: The Ministry of Communications, Public Works and Transportation (SECOPT) and the main four public enterprises (PEs). Public finances will not be brought under control until the sectors where the four PEs provide services are reformed and until the reform process initiated in SECOPT in 1991 is completed. 2. In addition to its impact on macroeconomic instability, there are important macroeconomic and microeconomic inefficiencies associated with PI which constitute an obstacle to economic growth. The macroeconomic inefficiencies consist of a crowding out of private investment and a growing ineffectiveness of investment in generating growth. Public investment has grown every decade since 1950 as a proportion of GDP and as a share of total investment. Until the 1970s, the growth of public investment accompanied growth in private investment. From 1980 on, the growth of public investment has occurred at the expense of private investment levels. The growing ineffectiveness of investment is reflected in the more than doubling of the ICOR from 1950-79 to 1980-94. 3. The provision of infrastructure services is characterized by lack of competition and inefficient regulations which have led to important microeconomic inefficiencies: (i) low coverage -- usually excluding the poor; (ii) poor quality of service and lack of enforcement of safety and environmental regulations; (iii) distortionary tariffs; (iv) lack of maintenance; and (v) the unsustainable use of foreign credits to finance the maintenance of the road network. 4. Public investment is high because the state has replaced private investment by monopolizing key economic areas and by regulating these areas in ways that restrict or prevent private participation and competition. The poor performance of the PEs in infrastructure provision can be attributed mainly to the overextended role of the state and the lack of competition in the provision of infrastructure services. The public sector is in control, to varying degrees, of all four of the major functions in infrastructure provision: ownership, operation, regulation, and sectoral policy setting, monitoring and control. There is little competition in the provision of infrastructure. Telecommunications are served by public monopolies. Electricity and railways are sectors where private providers have some participation, however the public enterprises dominate the supply with the private operators operating only at the fringe of the market. About half of the services in ports are provided directly by the traders, however important inefficiencies remain for other users of the port, partly related to an inefficient system of regulation. While some horizontal unbundling has taken place in the case of water and sanitation services by the decentralization of some of the services to some municipalities and the development of private and community providers, the sector has not developed a competitive structure. Transport services is a sector where divisibility could allow the development of a textbook case of competition. However, licensing of urban and intercity transport services has created an oligopolistic structure behind protected markets. 5. The role of the state is yet to be redefined in a way that allows the economy to rely more on the market for efficiency and on the private sector for financing. Numerous initiatives for privatization or other forms  vi A joint World Bank/lIDB Study of participation in the provision of infrastructure services are being considered by the authorities and interest in these initiatives is developing in the private sector. There is a Presidential decision to privatize telecommunications, the new electricity law (despite some important flaws discussed in the main report) opens the way for the private sector in new generation and distribution, there is talk of concessioning/privatizing several services in ports, airports, roads, railways and water and sanitation. The private sector has also shown interest in some of these possibilities, although the terms in which this interest would materialize remain unknown. Two joint World Bank/IDB adjustment operations are under preparation, to support these initiatives. A Public Sector Modernization Credit will support the privatization of HONDUTEL and the corporatization and concessioning of airports. A Water and Sanitation Adjustment Credit will support the decentralization and reform of this service. A Transport Sector Rehabilitation Credit is providing technical assistance for the reform of ports and airports. 6. For 1995, the Government aimed at raising the share of the social sectors in the budget to 35 percent of public investment. This target was surpassed in the 1995 budget where the share of the social sectors in public fixed investment is 38 percent. Furthermore, for 1995 Congress has approved a budget that allocates 56 percent of total primary (i.e. non-interest) expenditures to the social sectors. Despite the large fiscal allocation to the social sectors, there remains a widespread perception, that includes Government officials, public opinion and donor agencies, that not enough is being done for the poor through the PIP and the economic policy framework. Two reasons explain this perception. First, the Government needs to develop a strategy explaining how poverty reduction is to be achieved. There is no statement that explains the Government's strategy for growth and poverty reduction, identifying the links between the two. Lacking such a strategy, Government officials place excessive emphasis on direct interventions, subsidized credit, price controls and control of the tariffs of public enterprises. The lack of an explicit strategy for poverty reduction is partly due to lack of information and analysis about who the poor are and how they can be reached through public policy and investment. Second, most of the investment in the social sectors is not reaching the poor because of its bias in favor of the middle classes and because of inefficiencies in the way public services are provided. In 1994, 73 percent of the investment in the social sectors was assigned to areas that have a very limited impact on the welfare of the poor: housing financed by the pension funds, water and sanitation investments by SANAA and higher education. Changing this bias will require drastic changes in the composition of new investment and in the operation of the social sectors. 7. Public expenditures in the social sectors, at almost 9 percent of GDP, are high relative to incorne by international standards. The main challenge at present is in the education sector, where despite a notable expansion of coverage at the primary level to its current level of 86 percent, Honduras continues to lag behind comparable countries in terms of educational achievement, even among the young who benefited from the recent expansion of coverage. Given the Government's fiscal constraints, improving the quality of social services will depend on achieving greater efficiency rather than on increasing expenditures. 8. A change of paradigm is needed in primary education, moving away from an emphasis on expansion to one of increased quality. The Ministry of Education, with support from an IDA credit is beginning implementation of the new paradigm of improving quality. Quality of education is strongly correlated with non-salary recurrent expenditures (e.g. textbooks and training). Although the budgetary allocation to education, at over 4 percent of GDP, is high by international standards, non-salary current expenditures are under 4 percent of the sector budget and have fallen by 20 percent since 1980. This decrease was due to the need to expand coverage, which required a larger allocation to the construction of new infrastructure and the hiring of additional teachers. It was also due to the rapid increase in the weight of transfers to higher education in the sector budget. Also, administrative costs per student have more than doubled since 1980. As the budgetary allocation to the sector is already high, increased quality requires savings and a reallocation of sector resources. Savings could be obtained by reducing administrative costs and by reducing the high rate of student repetition. The Government should also explore the (admittedly politically difficult) possibility of reallocating resources from higher education to primary education.  Reforming Public Investment vii 9. Most of the investment in small scale infrastructure for water and sanitation (i.e. excluding SANAA and the municipality of San Pedro Sula), education and health is built by the social investment fund (FHIS). FHIS was created in 1990 to contract small-scale construction with private builders. Its agility and relatively low administrative costs has allowed the Government to increase substantially the construction of small-scale social infrastructure. The precision of the targeting of the investments by FHIS has been the subject of considerable debate. In favor of FHIS, it must be noted that in comparison with most other public agencies which usually exclude the poor, FHIS does reach the rural localities and shantytowns inhabited by the poor. However, official data show that there has not been efficient targeting in the sense that, in per capita terms, the poor benefit from FHIS investments only to the same extent as the rest of the population. 10. While the Government is planning to strengthen FHIS in preparation for an expansion of its activities in the near future, more than what is currently planned will be needed to overcome four weaknesses in its institutional setup. First, the line ministries for education and health and the water authorities do not participate effectively in the setting of priorities. In the social sectors, the real limitation to the expansion of services is not financing for bricks and mortar, it is rather the capacity of the line ministries to finance, train and equip more teachers and health workers and to develop effective maintenance procedures for the water systems. The expansion in infrastructure should be limited by the possibilities of financing its recurrent costs, and should be guided by clear priorities. Second, by procuring its projects through direct contracting procedures, FHIS has provided contractors an incentive to become promoters for new investments -- a contractor designs and lobbies for the approval of projects in the knowledge that he will receive the contract to execute it. While this has been advantageous in terms of agility, it has not helped in the development of priorities based in the needs of the beneficiaries. Third, FHIS has been increasingly open to political pressure: 46 percent of disbursements took place during the presidential campaign of 1993. Fourth, one of the objectives of FHIS has been the creation of employment. Occasionally, this has taken precedence over the need to ensure the quality of the investments. In mid-1995, the IDB and the World Bank approved credits for FHIS which introduce measures to address these issues. 11. A successful reform of PI and the provision of infrastructure needs to confront three key issues: * Public investment programming lacks a strategy and its implementation suffers from procedural weaknesses. The lack of a strategy makes it easier for interest groups to succesfully lobby for socially inefficient investments. The procedural weaknesses have opened the way to mistakes in the choice and preparation of investment projects, to costly implementation of these investments and to the development of underfinanced recurrent obligations. Large unplanned expenditures are added to the budget every year during implementation. * The regulatory framework for the provision of infrastructure services is inefficient, obsolete and combines excessive control over areas which require autonomy, with lack of regulation over areas of public interest that require oversight. This is reflected in: * Lack of competition and displacement of the private sector from the provision of infrastructure; * Lack of quality control; * Politicized tariff setting procedures that contribute to the financial deficits of PEs, limit the available financing for the expansion of services and generate distortions in resource allocation; * Absence of a maintenance policy (except for the road subsector); and + Absence of a fiscal framework to finance the maintenance of a road network; * An explicit strategy for poverty reduction needs to be developed to guide investment in infrastructure for the social sectors.  viii A joint World Bank/lIDB Study Public Investment Programming and Budgeting 12. There are no sectoral strategies to guide public investment. In each sector it is necessary to ask fundamental questions about the role of the govemment -- the responsibilities of the state and how they should be discharged. In some cases what previously was deemed to be a function of government should now be devolved to the private sector. In other cases, the govemment may continue to budget for an activity, but sub-contract its delivery to the private sector. Overall, the government needs to develop a strategic vision of its role in each sector against which public investment proposals can be evaluated. For each sector, strategies should be developed and should include a discussion of the needs and problems and the objectives for the sector laying out program targets for the next few years. The role of the public and private sector in reaching those objectives should be clearly specified. 13. The investment approval process is highly bureaucratic and lacks analytical content. Inject analysis into the investment approval process by: * linking approval of proposed investments to sectoral strategies; * appraising sectoral investment in the form of an investment program rather than individual projects. The Govemment should develop sectoral envelopes to force the examination of trade-offs by sector agencies;