Peru - Policy Notes

Document of The World Bank FOR OFFICIAL USE ONLY CONFIDENTIAL Report No. 14824 PE PERU POLICY NOTES July 21, 1995 Country Operations Division Country Department III Latin America and the Caribbean Region i This document has a restricted distribution and may be used by recipients only in the performance of I their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Glossary of Abbreviations and Acronyms AFP Administraci6n de Fondos de Pensiones Retirement Fund Administration BCRP Banco Central de Reserva de Perii Central Reserve Bank CBO Community Based Organization CEM Country Economic Memorandum COPRI Comisi6n de Privatizaci6n Privatization Commission EFF Extended Financing Facility ESW Economic and Sector Work FONAVI Fondo Nacional de Vivienda National Housing Fund FONCODES Fondo Nacional de Compensaci6n y Desarrollo National Compensation and Development Fund GDP Gross Domestic Product IDB Inter-American Development Bank LD Instituto Libertad y Democracia IMF International Monetary Fund INEI Instituto Nacional de Estadistica e Informacion National Statistics and Information Institute INFES Instituto de de Infrasctrutura de Educacion y SaludHealth and Education Infrastructure Council INADE National Development Institute IPSS Peruvian Institute for Social Security Instituto Peruano de la Seguridad Social MCF Municipal Compensation Fund MEF Ministerio de Economia y Finanzas Ministry of Economy and Finance NGO Non-Government Organization ONP Oficina de Normalizaci6n Provisional PLSS Peruvian Living Standards Survey RER Real Exchange Rate RP Registro Predial RPI Registro Piblico de la Propiedad Inmueble SUNAT Superintendencia Nacional de Tributaria USAID United States Agency for International Development VAT Value Added Tax PREFACE This report was written subsequent to the success of the deep reforms undertaken by the Fujimori Government of 1990. Growth has been swift, poverty reduction has been pronounced, and markets have been re-established not only domestically but globally. Yet issues remain to be addressed. The government must maintain its focus, and remain firm in its objective to create a more efficient market-oriented economy which extends the proceeds of growth to all Peruvians. At the same time the stage must be set for further efficiencies and the incorporation of the more marginal populations of Peru. These two goals are not disparate but may be addressed through the same instruments, which include decentralization, pension reform, and the establishment of property rights. These notes present issues in keeping with government objectives to further the progress achieved and extend development to all regions and peoples of Peru. Edgardo Favaro was the overall task manager of the Policy Notes and is the principal author of the note on capital flows. A background paper for this note was prepared by Michael Michaely. Edgardo Favaro and Donna MacIsaac prepared the second note on poverty. A background paper was produced by Gustavo Yamada (financed with GTZ). Cheikh Kane is the principal author of the third note on reforming the pension system. Eleoterio Codato is the principal author of the fourth note on decentralization. The note was based on a paper prepared by Tarcicio Castaneda and Luisa Fernandez (Consultants financed with a GTZ grant). Geoffrey Shepherd and Elena Panaritis prepared the fifth note on property rights. Musa Asad and Alberto Valdes prepared the sixth note on agricultural price, trade and marketing. Fred Levy and Donna MacIsaac contributed with extensive comments and support in editing the final manuscript. This study also benefited from the helpful comments of Suman Bery, Alejandra Cox-Edwards, Norman Hicks, Dan Morrow and Mateen Thobani. The Department Director, Division Chief and Lead Economist are, respectively, Yoshiaki Abe, Dan Morrow and Norman Hicks. Excellent secretarial assistance was given by Melisa Geronimo-de Lara. EXECUTIVE SUMMARY Background 1. The policies adopted since 1990 effectively strengthened government production of key public goods (security, a stable economic environment) while, at the same time, reduced the scope of government intervention in the economy. As a result they defined an implicit subsidiary role for the Peruvian state in the economy and strengthened the role of market mechanisms in the allocation of resources. 2. The fundamental redefinition in the role of the state brought about a significant recovery in Peru since 1990: terrorism was subdued and the economy improved. The eradication of terrorism in most of the country allowed for a radical increase in economic activity and huge increases in consumption spending, particularly in the Urban and Rural Sierra. Since 1991, the economy has grown by 16.5 percent, annual inflation has dropped from 410 percent to 18 percent and the percentage of families below the poverty line has dropped from 55 percent to 49 percent. 3. These remarkable improvements delineate a turning point from an economy in tatters to one able to provide new and more productive jobs thus setting the stage for sustained poverty reduction and growth. Advancing this transition from economic stagnation, increased inequality, and anarchy to sustained economic growth, poverty relief and order, will require the government to stay the course, to increase the quality of public services, and to strengthen property rights -- all policies which should attract new investment. 4. By providing a brief introduction to some key policy issues these Policy Notes are intended to contribute to the policy debate in Peru: they discuss the implications the external financing program over the short-term and medium-term, the effects of the reforms on poverty levels since 1991, pricing and marketing issues in agriculture, property rights, decentralization and pending issues in social security reform. 5. While these Policy Notes in no way exhaust the list of important issues and challenges facing the new administration, the selection of these topics is the outcome of discussions held with the Government, with members of the academic community and public policy groups and with representatives from the private sector. It is also the outcome of previous ESW (the CEM "Peru at the Crossroads: Building a Modern State", the Private Sector Assessment and the Public Expenditure Review). These Policy Notes study areas identified as important within the Country Assistance Strategy to Peru as well as areas in which the Bank can contribute significantly to clarify issues and identify the costs and benefits of different policy options. 11 The Policy Notes 6. The first note discusses the short-term and medium-term sustainability of Peru's external financing program. It highlights the role of capital inflows to Peru in facilitating the recent economic recovery and the links among capital inflows, sound domestic policies and international financier's confidence in the region and Peru. 7. Reductions in the confidence of international investors will inevitably result in reductions in short-term capital inflows to not only the region but also Peru. This calls for cutbacks in the rate of growth (and maybe the levels) of public and private sector spending - namely, stiff fiscal policy and tight management of the expansion of credit to the private sector. While the size of the current account deficit should be followed closely, the main source of concern stems from financing the deficit with short-term capital inflows. 8. The second note discusses changes in consumption spending and poverty between 1991 and 1994. Not surprisingly the recovery of the economy resulted in huge welfare increases for the vast majority of Peruvians. With the elimination of serious economic distortions and the re-establishment of public order there have been increases in labor force participation and/or personal incomes which both fostered the increase in per-capita consumption spending. This economic recovery, although experienced across all regions and activities, has especially benefited those areas and peoples devastated by a decade of terrorism and isolation. The bulk of these welfare improvements are likely to be a one time gain linked to the re-establishment of normal conditions necessary for the development of economic activity. Thus sustained poverty reduction will depend on sustained increases in investments in human capital and targeted programs will remain important for the protection of vulnerable groups. 9. The third note discusses the role of decentralization in improving the quality of some public services. Some public services, such as national defense, may be efficiently provided in a centralized manner; others, such as good quality of education cannot. The note identifies institutional issues, such as the lack of clarity in functional assignment among different jurisdictional levels, and financial issues, such as the current high level of expenditure and fiscal centralization, which interfere with the improvement of quality provision of some public services. It also suggests directions for reform through the establishment of an intergovernmental transfer system, a clear definition of the roles of different government levels, and greater financial management autonomy at the municipal level. 111 10. The fourth note discusses issues in the completion of the social security reform. It summarizes the main problems associated with the current combination of regimes, discusses three options for a unified pension system, gives an assessment of the new draft law for private pensions, estimates the unfunded liabilities associated with existing pension schemes, and provides recommendations. The completion of social security reform is a crucial pillar to increase domestic savings and thus to finance investment in human and physical capital. 11. The fifth note discusses the development of property rights in Peru. For over a century Peru has had a system to provide legal recognition to real property rights--a system which has favored a privileged minority, mostly in urban areas, and done nothing for the poor majority. The system's complex and demanding procedures effectively block ownership establishment among poor and informal owners who are unable either to afford or comply with the procedures. In 1988, Peru initiated a new system of property rights which, unlike the old, is able to reach poorer informal owners. Although the new system has operated on a limited scale, so far, the effective provision of registration has already resulted in economic benefits. In greater detail, this note analyzes why the traditional system does not work and why the new one does. It also examines the remaining issues and challenges to formalization of real property rights in Peru and proposes the establishment of a National Program for Property Formalization based on the new system. 12. The sixth note discusses issues in pricing and marketing in the agriculture sector. Agriculture remains as one of the key sectors in Peru's economy. This note identifies the huge improvement in institutional and market mechanisms since 1990 which result from trade and price liberalization policies and improved security of property rights on land. The development of an efficient and competitive agricultural sector requires further improvements in the institutional setting. This includes a timely approval of land and water rights legislation and continued trade and price liberalization. In particular, this note highlights the importance of continued reductions in protectionist measures, including restrictions in the coverage and discretionary power of agriculture price surcharges, and recommends the redesign of public expenditures in agriculture towards activities that will have a significant impact on poverty reduction. Table of Contents 1. AFTER THE TEQUILA EFFECT: ADJUSTING SPENDING ........................................................1 A. CAPITAL INFLOWS AND AGGREGATE SPENDING ......................................................................................1 B. CAPITAL INFLOWS WILL DROP FROM THE LEVEL OF THE LAST FOUR YEARS.............................................2 C. POLICY IMPLICATIONS ........................................................................................................................... 3 D. ADJUSTING SPENDING DOWNWARDS ......................................................................................................4 E. THE PUB C SECTOR ..............................................................................................................................4 F. THE PRIVATE SECTOR ............................................................................................................................ 7 G. THE EXCHANGE RATE REGIME...............................................................................................................7 2. DID THE POOR BENEFIT FROM PERU'S RECOVERY?............................................................9 A. W HO BENEFITED FROM THE RECOVERY?..............................................................................................10 B. W HY HAVE THE POOR BENEFITED? .......................................................................................................14 C. POLICY LESSONS ................................................................................................................................. 17 3. DECENTRAIZATION ................................................................................................................... 25 A. THE STRUCTURE FOR PUBLIC SERVICES PROVISION...............................................................................25 B. INSTITUTIONAL AND FINANCIAL ISSUES AFFECTING PUBLIC SERVICE PROVISION ....................................28 4. REFORMING THE PERUVIAN PENSION SYSTEM...................................................................38 A. W EAKNESSES OF THE CURRENT SYSTEM...............................................................................................38 B. THREE OPTIONS FOR A UNIFIED PENSION SYSTEM .................................................................................39 C. A CRITICAL ASSESSMENT OF THE DRAFT PENSION LAW FOR PRIVATE PENSION FUNDS ...........................42 D. OVERALL UNFUNDED PENSION LIABILITIES AND CASH FLOW ISSUES......................................................46 E. SUMMARY OF RECOMMENDATIONS AND TRANSITION ISSUES..................................................................49 5. THE DEVELOPMENT OF REAL PROPERTY RIGHTS IN PERU............................................56 A. OWNERSHIP, SECURITY, AND FAIRNESS ................................................................................................57 B. RURAL AND URBAN PROPERTY OWNERSHIP IN PERU..............................................................................58 C. THE TRADm ONAL SYSTEM OF PROPERTY ADMINISTRATION .................................................................60 D. THE NEW SYSTEM OF PROPERTY ADMINISTRATION...............................................................................62 6. PRICING, TRADE, AND MARKETING IN THE AGRICULTURE SECTOR............................71 A. IM PROVING PRICES AND TRADE..............................................................................................73 B. REDEFINING THE STATE'S ROLE IN MARKETING AND INPUTS.............................................78 C. CONCLUSION .................................................................................................................................. 80 Tables 1. The Import Surplus and Capital FLows, 1991-1994............................................................................. 2. Savings and Investments..................................................................................................................... 4 3. Public Sector Operations..................................................................................................................... 5 4. The Real Exchange Rate (Tradable/Non-Tradable Price), 1990-1994 ..................................................8 5. Poverty M easurements by Region......................................................................................................13 6. Education and Experience by Region.................................................................................................15 7. W ork Force Participation .................................................................................................................. 20 8. Characteristics of the W ork Force......................................................................................................21 9. Regressions of W orker Earnings (log)...............................................................................................22 10. Peru's M ain Pension Regimes ........................................................................................................... 52 11.1 The Cost of a Minimum Pension Gurantee with an Average Return of 5% ......................................53 11.2 The Cost of a Minimum Pension Gurantee with an Average Return of 3% .....................................53 Tables: (Continued) 2. Implicit Pension Debt......................................................................................................................... 54 13. M aturity Structure of the Implicit Debt.............................................................................................54 14. Consolidated Accounts of the Three M ain Pension Systems..............................................................55 15. Growth of Production in Agriculture .....76 16. Real Agriculture Prices in Peru ........................................................................................................82 17. Surcharges for Agricultural Importables in Peru ...............................................................................82 18. Public Funds Allocated for Agriculture Campaigns (1992-93 and 1993-94)......................................83 19. M AC Tractors Program .................................................................................................................... 84 R efe ren ces .............................................................................................................................................8 5 1 1. AFTER THE TEQUILA EFFECT: ADJUSTING SPENDING 1.1 Capital inflows have played a major role in Peru's recent economic recovery. They have been the consequence of sound domestic economic policies and of greater international financier's confidence in the region and in Peru. 1.2 Despite the government's continued commitment to tight fiscal and monetary policy, the external environment has changed and Peru must now deal with the consequences of greater uncertainty in the region. Because of reduced international financier's confidence in the region and other factors, Peru must expect a reduction in short-term capital inflows. This poses two challenges: first, the economy must reduce its rate of spending. More specifically, the new external conditions call for reductions in the rate of growth (and maybe the levels) of public and private sector spending -namely, stiff fiscal policy and tight management of the expansion of credit to the private sector. These are the topics addressed in this note. Second, the financial system will very likely need to adjust to portfolio shifts and withdrawal of deposits. These challenges call for establishing a lender of last resort and enhancing supervision of the financial system. A. CAPITAL INFLOws AND AGGREGATE SPENDING 1.3 A remarkable feature of Peru's external payments in recent years is the large size of capital inflows, of both a long and short-term nature. This is shown in Table 1. Table 1: The Import Surplus and Capital Flows, 1991 - 1994 (in $ millions) 1991 1992 1993 1994 Import surplus of goods and services 1283 1696 1774 2161 Capital inflows Long-term Privatization 0 6 160 2054 Other private sector -119 131 430 939 Public sector 845 475 647 659 Total 726 612 1237 3652 Short-term* 1808 1576 1037 1727 Total capital inflows 2534 2188 2274 5379 Increase of (net) international reserves 1251 492 500 3118 * Includes errors and omissions Source: Nota Semanal Banco Central de Reserva del Peru, various issues (primarily the issue of March 9, 1995) 1.4 Short-term capital inflows amounted, during 1991-1994, to over US$6 billion, or about US$1.5 billion per year. The (net) long-term capital inflows have been as 2 substantial amounting again during the four-year period to over US$6 billion dollars. In this case, a remarkable increase took place in 1994--mainly due to exceptional proceeds from privatization. Taken together, the long and short term (net) capital inflow has been, for the respective years from 1990 to 1994, US$12.4 billion, or an average of US$3.1 billion per year-- i.e., about 6 percent of the country's annual GDP. The remarkable economic growth of Peru in recent years (1993 and 1994) has thus depended to a significant extent on the availability of foreign finance to provide for investment and for imports and the size of the import-surplus of good and services, i.e., the deficit or current account has thus amounted to some 5 percent of GDP, approaching 6 percent in 1994. B. CAPITAL INFLOWS WILL DROP FROM THE LEVEL OF THE LAST FOUR YEARS 1.5 For several reasons short-term capital inflows should be expected to fall from their level in recent years. First, an important part of the past inflow has been the consequence of Peruvian's shifting from deposits held abroad (the "Miami deposits") to the holding of foreign currency deposits in Peru. This has not reflected an increase in the demand for money, but rather a change in location. Such re-adjustment of stocks is, of course, a limited process, which cannot proceed on a similar scale for many years, and has probably come close to its end. Second, with the domestic reduction of inflation, and the increase in real activity, the demand for money (whether sol or dollar denominated) has increased. The monetization of the economy will continue to increase but at a slower pace than in the last two years. Third, the very high interest rate in Peru, which was both justified and reflected a universal experience during successful stabilization episodes (partly mirroring the afore-mentioned increased demand for money) should not, nor should it be expected to, last for years in the future. Fourth, even assuming that the Mexico crisis will not have any further ramifications (such as a crisis in Argentina and Brazil), and will not touch Peru directly at all, it will have a residual effect of reducing confidence in the stability of financial systems in major Latin American countries such as Peru, and may encourage expectations for longer-term trends of exchange rate devaluations. For all these reasons, a substantial reduction of short-term capital inflows to Peru should be expected. The size of such fall must be a guess. But, reflecting recent experience, it may be reasonable to assume that in net terms, short-term inflows will be in 1995-1996 $600 million lower than in 1994. 1.6 So far as long-term capital movements are concerned, while proceeds from privatization will certainly drop from current levels private investment will remain strong. Long-term capital inflows into Peru consist of three main components. First, there is the purchase by foreign agents of (part or a whole of) privatized Peruvian companies, with the proceeds going to the government. Second, there are direct foreign investments in the Peruvian private sector (financial long-term investments, through the stock market or otherwise, are of minor significance). Third, there is the unilateral rescheduling of debts pending an agreement with creditors. The first component--proceeds of privatization-- may decline if the Government delays privatization of oil and electric companies. If that were the case these proceeds (which amounted to as much as US$2 billion in 1994) would be about US$1.1 billion in 1995, about US$340 million in 1996 and insignificant in the 3 following years. The second component --direct investment in the private sector-- does not face the same constraints, of a given inventory of enterprises for sale and is bound to increase in the coming years reflecting stepped up investment in the newly privatized companies and in the mineral s6ctor. The future of the third component depends on the type of agreement Peru reaches with the international commercial banks. An agreement will imply resuming flow interest and principal payment and, in that respect, put Peru in a tighter budget constraint. But, an agreement may also result in a positive net resource transfer from creditors to Peru. Overall long-term capital inflows, while below the level of 1994, will remain strong in the next few years. 1.7 Formulating a more concrete expectation, with precise numbers, would be futile. But a guess may be ventured that aggregate capital inflows will be about US$4.3 billion during 1995 (down from US$5.3 billion in 1994). While this drop in capital inflows will create pressures to reduce the rate of spending most of its impact will be on lower accumulation of international reserves (BCRP's international reserves increased by US$3 billion in 1994). C. POLICY IMPLICATIONS 1.8 The main source of Peru's external financing problems stems from financing the current account deficit with short-term capital inflows. But why should a current account deficit, caused mainly by an excess of spending over savings in the private sector, be a concern in a country where prices indicate true international scarcities? It is of concern because at the margin new private spending is being financed by 30 day deposits-- which may fly away at the first sign of uncertainty. 1.9 Maintaining current trends in aggregate spending in a scenario where capital inflows to Peru drop significantly would imply losses in international net reserves and pressures to devalue the exchange rate. Two strategies could be adopted. Firstly, the Government may delay adjustment by running down international reserves. This would postpone transitorily adjustment but would not avoid it. Moreover, adopting this strategy in a country with a very weakly developed capital market and in the current regional scenario could be catastrophic. It could erode confidence in the capacity of the Government to maintain price stability, encourage further dollarization of the economy and capital outflows, and eventually result in a large devaluation--exactly what Peru should avoid ("the Mexican scenario"). 1.10 A second strategy is to maintain a credible external financing program by cutting spending and letting the real exchange rate depreciate if necessary. This strategy is supported by the program designed by the Government and currently in discussion with the IMF. The managed adjustment supported by this program is preferable to one that occurs through a balance of payment crisis and a significant nominal devaluation. Its success will depend, to a large extent, on the speed with which the public and private sector adapt to the new financial environment. It poses formidable challenges because public spending is on the rise (this introduces inertia), expectations about further increases 4 in public sector wages and investment are high (this is encouraged by the fact that the government is cash-liquid), and the share of wages and pensions in public expenditures has risen (this introduces rigidity). It also poses a challenge because the private sector's expectations about the future of the economy are very optimistic. D. ADJUSTING SPENDING DOWNWARDS 1.11 At 5.5 percent of the GDP the 1994 current account deficit calls for reductions in the public and private deficits. Both are hard tasks. Table 2 portrays the composition of the public and private deficits in 1993 and 1994 and projects those for 1995. Table 2: Savings and Investments (As a percentage of GDP) 1993 1994 1995 Private Sector Gag -287 -36 -3.10 Private Savings 11,32 13,18 13,78 Private Investment 14,19 16,34 16,88 Public Sector Gap -2,64 -23 -2,18 Public Savings 1,65 2,59 2,28 Public Investment 4,28 4,98 4,46 Current Account 5,51 554528 Domestic Savings /1 12,97 15,78 16,06 /1 Measured domestic savings (at about 13 percent of GDP in 1993 and 16 in 1994) are underestimated and the current account deficit (at about 5.5 percent of GDP in 1993-1994) is overestimated in Peru. Domestic savings are equal to income minus consumption spending. But reported income is underestimated because it does not include the informal sector; it does not account for value added in coca production (which Bank and AID sources appraise at one percent of GDP); and it does not include income resulting from revaluation of assets. However, since expenditure financed from these sources is recorded in the national accounts, measured savings are underestimated and consequently the current account deficit is overestimated. E. THE PUBLIC SECTOR 1.12 Concerns regarding the public sector are presented in Table 3. At a rate of 41 percent, central government investment spending at constant prices has grown way too fast since 1993--the Fonavi financed component has grown by 98.7 percent at constant prices in the same period. Similarly, at a rate of 18.1 percent the growth in spending in wages and pensions at constant prices is not sustainable. Reversing these trends is a major 5 challenge. It will require defeating inertia and surmounting fiscal rigidities --at a time when the Government is perceived as cash-liquid as a result of the privatizations. Table 3: Public Sector Operations (In millions of new soles) 1993 1994 1995 I. Nonfinancial Public Sector Current Account (1+2) 4 113 6 262 7418 1. Current Account of the Central Government (excluding interest) (A-B) 3 085 4 792 6 464 A. Current Revenue 9204 14222 17610 B. Current Expenditure (excluding interest) 6119 9430 2. Current Account of the Rest of the Nonfinancial Public Sector 1 028 1 470 953 II. Capital Expenditure 3615 5611 6 153 M. Quasi-Fiscal Deficit 127 42 0 IV. Primary Balance Before Privatization (J-Hl-II) 371 609 1 264 V. Other Income 303 4 982 345 - Privatization 303 4 982 345 In Million US$ $169 $2267 $150 VI. Primary Surplus (IV+V) 674 5 591 1 609 VII. Interest Payments (1+2) 2717 3408 4180 1. Domestic 58 107 205 2. External 2659 3301 3976 In Million US$ $1 317 $1 503 $1725 VIII. Combined Public Sector Balance (VI-VII) -2043 2184 -2571 1. External Financing 2164 2384 3034 In Million US$ $1 085 $1 085 $1 316 2. Domestic Financing -121 -4567 -463 1.13 Reaching the target deficit will require cuts in public investment (from the level of 1994) and increases in public sector savings. As the share of wages and pensions in public sector spending has grown to about 60 percent of public sector income (which is a highly rigid item in a low inflation economy), the Government's possibilities to maneuver have become much more narrow than in previous years. Thus the bulk of public sector 6 downward spending adjustment will depend on drastic cuts in investment, a conservative public sector wage policy and, to a lesser extent, in possible increases in tax collection. 1.14 More precisely the public sector downward spending strategy will require: (a) Establishing selective investment cuts. The goal should be to stop (or at least delay) projects with low rates of return rather than cut investment across the board. For instance, the Public Expenditure Review (Report No. 13190-PE) established that 75 percent of roads included in the 1993- 1997 investment program had rates of return above 12 percent. Thus most of these road rehabilitation projects should be continued, while most irrigation investment should be drastically cut. Current budgetary procedures make it extremely difficult to control the quantity and quality of investment; the Treasury can only affect actual spending cuts through the Cash Management Committee. This should be reviewed. An emergency committee including the ministries of Economy, Presidency and Transport (with the advice of the technical secretary at MEF) should propose to the President an emergency plan with budget cuts consistent with a projected financial constraint agreed in advance. (b) Maintaining a conservative public sector wage policy. Pressures to increase public sector wages during 1995 will be high but should be resisted. It would be worthwhile to explore a treatment of future public sector wage increases as transitory (bonuses) rather than as permanent increases in the wage bill. This would make it possible to reduce the rigidity of the public sector budget, while maintaining a credible external financing program. This would be strengthened by: (i) rapidly reaching an agreement with the IMF on the targets of the 1995 EFF program. (ii) implementing a second wave of structural reforms with the support of the Bank and the IDB. (iii) reaching an agreement with the international commercial banks. This public sector wage strategy may have political costs, but the alternative (that is, using across the board wage cuts) would be not only more costly but also more difficult to enforce in a stable economy. (c) Linking the use of proceeds from privatization to the financing of public-- domestic and external--sector debt. As allocating the funds to this end (rather than using them to finance further consumption or investment spending) is equivalent to announcing to the private sector that taxes will not be increased in the future (to service an otherwise larger public debt), this would have a major impact in reducing uncertainty and in stimulating investment. High liquidity provides a cushion against uncertainty but also makes the Government vulnerable to spending demands. Thus by limiting discretion this proposal would also take pressure off the Treasury's shoulders. 7 (d) Maintaining a credible external financing program. This would be strengthened by: (i) rapidly reaching an agreement with the IMF on the targets of the 1995 EFF program. (ii) Implementing a second wave of structural reforms with the support of the Bank and the IDB. (iii) Reaching an agreement with the international commercial banks. F. THE PRIVATE SECTOR 1.15 With regards to the private sector, adjusting absorption also requires a drop in the rate of growth (and probably the level) of private sector spending. The private sector's aggregate demand growth was financed in large part by a 31.9 percent rise in real credit in 1994--well above the 24.6 percent rise in real liquidity of the financial system. This rapid growth of private sector credit is worrisome even for a credit starved economy like Peru. It comes at the expense of lower than average quality loans, is financed increasingly through the use of short-term international lines of credit, and may conceal credit rollover. The trend is alarming. For instance, the share of deposit increase as a source of credit expansion dropped from 75 percent in December 1993-September 1994 to 34 percent in December 1994-February 1995 while the share of short-term international lines of credit increased from 12 percent to 37 percent. 1.16 The following policies may be timely to slowdown the rate of growth of private sector credit: (a) Establishing a more strict supervision of bank's portfolios. In particular attention should be focused in identifying and penalizing credit rollover. (b) Equalizing marginal reserve requirement on the use of external credit lines to those on domestic dollar deposits. Currently, the marginal reserve requirements on the use of credit lines is zero. G. THE EXCHANGE RATE REGIME 1.17 The mechanism leading to the transformation of capital inflows into an import surplus (rather than the mere accumulation of foreign exchange reserves), beyond the impact on and through domestic expansion, must have been the change in the economy's real exchange rate. Table 4 shows the level of this rate during the period 1990-1994. The real exchange rate is arrived at by estimating the relative price of tradables versus non- tradables; that is, it is the price of the former in terms of the latter. A decline of the level of the rat4 is a real appreciation, and it should lead to an allocation of resources away from tradable to non-tradable activities, thus increasing imports (because the local production of importables falls), lowering exports, and creating (increasing) an imports surplus. An increase of the level, to the contrary--a depreciation--would encourage the tradables sector and lower the imports surplus. 8 1.18 It may be seen that the drop of the RER following the onset of the stabilization program was followed by a real depreciation during 1992-1994. The estimates presented in Table 4 (based on the revised national accounts) are very rough and should be perceived as only providing an order of magnitude; but the size of change is small enough to suggest that the rate of appreciation has not been very substantial. Since the dollar itself has depreciated, over this period, in relation to other major currencies, the appreciation of the sol in relation to a basket of currencies would be smaller than versus the dollar. 1.19 Adjustment to a new equilibrium with lower capital inflows may or may not result in a real depreciation of the exchange rate. Demand forces will push for a real depreciation so as to allow the expenditure switching necessary for reducing the import surplus. But supply forces have been also at work shifting the production possibilities of the economy and increasing Peru's capacity to produce a higher proportion of tradable to nontradable goods for a given real exchange rate. Whether supply forces will prevail over demand forces or not is an empirical issue. Even so, it is unquestionable that Peru is better endowed to exploit its natural resource industries (minerals, fisheries, tourism, agriculture) today than it ever was in the last two decades and if that trend continues we should expect that sustained growth will be followed by a real appreciation of the exchange rate rather than the opposite. Maintaining a floating exchange supported by tight fiscal and monetary policy remains as the best strategy to reduce inflation and minimize the costs of adjusting relative prices in Peru. Table 4: The Real Exchange Rate (Tradable/Non-tradable Price), 1990-1994 (1990 = 100) GDP Exchange Foreign Local Price Implied Price of Real Exchange Deflator Rate Prices of Tradables Non-tradables2/ Rate (=[41/[51 (Soles/$) (=[21*[31 Ti=.4 T2=.5 T3=.6 T, T2 T3 Year ) (2) (4) () ) (average) 1990 100 100 100 100 100 100 100 100 100 100 1991 463.5 380.4 104.2 396.4 508.2 530.6 564.2 78.0 74.7 70.3 1992 738.7 612.6 107.4 657.9 792.6 819.5 859.9 83.0 80.3 76.5 1993 1056.8 983.2 110.6 1087.4 1036.4 1026.2 1010.9 95.3 94.4 93.0 1994 1185.9 1086.9 113.4 1154.8 1139.3 1116.0 849 97.4 96.1 94.1 Source: Nota Semanal. Banco Central de Reserva del Peru, various issues (primarily the issue of March 9, 1995) / Assumed 2/ T = Share of tradable in the economy 9 2. DID THE POOR BENEFIT FROM PERU'S REFORM RECOVERY? 2.1 Peru has undergone a remarkable recovery since 1990: the economy has improved and terrorism has been subdued. There has been a steady drop in the rate of inflation (from 7600 percent in 1990 to 15 percent in 1994), vigorous economic growth (the GDP increased by 19 percent between 1990 and 1994) and enormous progress in reestablishing public order. Not surprisingly, but less well known, this recovery resulted in huge welfare increases for the vast majority of Peruvians. Remarkable improvements are registered in all areas of the country, rich and poor, surveyed in both 1991 and 1994: on average Peru's expenditure per-capita increased by 29 percent. At 34 percent, the welfare increases in the poorer regions, such as the Rural Sierra, are even more pronounced. 2.2 These results challenge a widespread notion that stabilization and structural reform adversely affect the poor in the short-run. Economic recovery and poverty reduction have followed a radical redefinition of the role of the Peruvian state in the economy. This redefinition meant strengthening government effectiveness to increase the provision of key public goods (most notably security and economic stability) while, at the same time, reducing the scope of government intervention in the economy to promote efficiency in the allocation of resources (for instance, through liberalization of prices, deregulation and privatization). 2.3 With the elimination of serious economic distortions and the re-establishment of public order there has been a huge increase in productivity and personal incomes both of which fostered the increase in per-capita consumption spending. This economic recovery, although scattered across all regions and activities, has especially benefited those areas devastated by a decade of terrorism and isolation and their people (endowed with lower human capital and facing fewer opportunities). In short, vigorous economic growth has not benefited only the small elite but rather has been shared by most Peruvians. 2.4 In view of the subjective and all encompassing nature of poverty discussions it is important to state the objective of this policy note: to determine the state of poverty in Peru and how this has changed from the commencement of the reform to present day. In this task we employ Peru's most recent Living Standards Measurement Survey (PLSS) of June 1994 and that of October 1991 which presents a period of time (slight less than two years) directly following the commencement of stabilization.' 2.5 This paper is organized in three sections. The first section portrays who benefited from the reforms in Peru. Using household survey data for 1991 and 1994, it illustrates the evolution of poverty: its extent, its severity and regional distribution. Results from the application of various poverty measurements (see Glossary) and analysis tests are Although a Living Standards Measurement Survey was undertaken in June and July 1990, a period directly preceding the initiation of the reform program, its coverage was limited to Lima. 10 presented and substantiated by stochastic dominance tests. The analysis of changes in poverty, expressed by expenditure per-capita, begs a study of the how such changes were financed. In this light we turn to an analysis of labor force changes. The second section examines why economic benefits have been so widespread and why the poor have benefited more than the average. Since the main asset of the vast majority of Peruvians is their human capital the analysis focuses on the labor market and in the explanation of changes in worker earnings between 1991 and 1994. It begins with a brief description of labor force participation and the labor market and proceeds with more in-depth analysis of worker earnings. Analysis of these monthly returns, being dependent on not only worker but labor market characteristics, are undertaken at both a national and regional level. The third section briefly discusses policy implications. A. WHO BENEFITED FROM THE RECOVERY? 2.6 Comparisons of incomes and expenditures between 1991 and 1994 provide something as close as possible to a controlled experiment of the effects of the reform program. Although the 1994 survey was more comprehensive than the 1991 survey, the comparative nature of the following analysis restricts the 1994 nation to the regions surveyed in 1991: Lima, Urban Coast, Rural and Urban Sierra. All monetary amounts reported in this note as well as changes in monetary amounts are regionally adjusted to Lima prices and refer to June 1994 New Soles.2 2.7 Although widespread, the benefits of economic reform have been higher in less developed areas than in Lima. Just as increases in GDP per-capita have been extraordinary in Peru, so too have been the changes in expenditure per-capita. On average the national increase in expenditure per-capita is 28.9 percent.4 As a point of comparison GDP per-capita increased by 19.8 percent over the same period. Not only nationally but in all regions expenditure per-capita increased from 1991 to 1994. The biggest increases occurred in the urban areas of the Coast and the Sierra where increases were 42 and 47 percent respectively. At 34 percent, improvements in the Rural Sierra have also been significant. Expenditure increases have been the smallest in Lima. 2.8 Such average improvements in households expenditure have extended to the lowest income ranges; in fact, at a national level the 32 percent welfare improvements of 2 First, using INEI's (Instituto Nacional de Estadistica e Informacion) price indices for 16 major cities in Peru, the monetary amounts within each survey were translated to reflect one month during which the survey took place: for 1991 this was the beginning of October and for 1994 this was mid June. Second, after pricing the regional food plus non-food baskets (poverty line) at Lima prices, the regional prices of each survey year are deflated by the relative price of this basket and expressed in terms of Lima prices. Finally, choosing INEI's price indices versus a price index of changes in the food basket only or the poverty line, current 1991 prices are brought to June 1994 new Soles. 3 Expenditure per-capita, herein, refers to household expenditure per-capita and is created by dividing the aggregate of all household expenditures equally among all household members. 4 Using a measurement of expenditure per-capita which excludes imputed rents there has been a more moderate increase of 18.6 percent. 11 the lowest quintile surpassed the average (29 percent). Nonetheless, we complement these more broadbased measures with measures of poverty ( see Table 5) and express the proportion of the population below that line. The poverty measurements (see Glossary) are derived through the applicatioi of regional poverty lines to regional per-capita expenditures. The poverty lines were developed for each survey year, by the Instituto Cuanto', as opposed to applying 1994 poverty lines to 1991 data expressed in 1994 new soles. As a point of reference the poverty lines for 1994 are follows: Lima (1741 New Soles), Urban Coast (1493 New Soles), Urban Sierra (1260 New Soles) and Rural Sierra (823 New Soles). 2.9 ,The poverty situation in Peru has greatly improved and the poor do not experience such extreme poverty as in the past. In 1991, the proportion of the population who fell below the poverty line, the proportion of income required to boost that population to the poverty line and the degree of poverty experienced among them, was alarming. Fifty-five percent of the population was poor; 24 percent of the population did not have enough money to buy basic food requirements. The income required to boost the poor to the poverty line (poverty gap) reached 21 percent of the poverty line and the importance of larger income transfers among the poor group was severe. But by 1994, each of these measures had fallen: the head-count index was 50 percent and the 17.5 percent poverty gap index suggests that budget requirements to reduce both absolute and relative poverty also decreased (see Glossary for more detailed description of these poverty measures). 2.10 Using comparable real household expenditures per-capita for each of the survey years we plot cumulative income (expenditure per-capita) distribution functions for 1991 and 1994. The horizontal axis measures income and the vertical axis measures percentage of individuals. The graph portrays the proportion of the population below a certain income level (at each income level). Thus, if within a range of income levels the distribution for one year is consistently above/below another it can be concluded that the proportion of the population which is poor, the head-count index, within that year is consistently greater/less than the other year. Thus, conclusions regarding the evolution of poverty would be robust to the poverty line chosen. As is easily seen in Figure 1 the conclusions drawn for various poverty lines/income levels are not dependent on the poverty line chosen and we can say that poverty, as measured by the head-count index, decreased. 2.11 In addition, as the cumulative distribution functions do not cross, it is possible to state not only that the proportion of the population in poverty (head-count index) decreased from 1991 to 1994, regardless of the poverty line chosen, but also that the depth (poverty gap) and severity of poverty (FGT of degree 2) decreased. This is clearly depicted in Figure 2: the deficit curve for 1991 lies above that of 1994. Therefore we can unequivocally state that the depth and severity of poverty in Peru decreased from 1991 to 1994. Moreover, these findings are statistically significant at a 5 percent level. 5 Instituto Cuanto is the private company which both executed and analyzed the 1991 and 1994 LSMS surveys. 12 Figure 1: First Order Sample Dominance - year91 year94 1.0- o 0.9- ,. 0.8- O8 0 nO.7 0.6- S0.5- o0.Z- 20.3- E0.2- :0.1 0.0 0 1000 2000 3000 Income Figure 2: Second Order Sample Dominance - year9l ---------- year94 0.40- 0.35- a 0.30- c- 0.25- 0.20- > 0.15- 0.10- 0.05- 0.00 0 1000 2000 3000 Income 13 2.12 High degrees of poverty are highly correlated with low endowments of physical and human capital.6 The Rural Sierra remains the region with highest proportion being poor (68 percent), with greatest income requirements (27 percent of the poverty line) to boost the poor to the poverty line, with lowest personal earnings (individual income per month is 178.5 soles of June 1994) and least educational workforce (average of 6.8 years of schooling). The Urban Coast and the Urban Sierra follow with poverty incidences of 49 percent and 42 percent, individual incomes of 372 and 318 soles per month and educational achievements of 9.9 and 10.8 years of schooling. At the other extreme, Lima has the lowest poverty incidence (37 percent), highest individual incomes (517 new soles of June 1994 per month) and also the highest educational level (average of 10.8 years). 2.13 High poverty incidence and low incomes are also positively associated with indigenous origin and lower mobility. In the poorer Rural Sierra, 53 percent of the working population7 are indigenous8' 89 percent of workers live in the same home in which they were born and the average individual has 15.5 years of experience in their current occupation (see Table 8 in Appendix). By contrast, in Lima 10 percent of the workforce is indigenous, 56 percent have a non-migrant origin and the average individual has 6.7 years of experience in their current occupation. Table 5: Poverty Measurements by Region Lima Urban Coast Urban Sierra Rural Sierra National 1991 1994 1991 1994 1991 1994 1991 1994 1991 1994 Expenditure per-capita (Annual) 2197 2739 1621 2301 1563 2297 900.2 1207 1699 2190 Gini Coefficient 0.373 0.374 0.353 0.379 0.358 0.357 0.371 0.367 0.398 0.399 Head Count 47.6 37.6 54.9 48.9 53.2 41.6 72.7 68.3 55.3 49.6 Poverty Gap 14.6 .10.6 20 17.1 20.8 14.9 34 27.2 20.9 17.5 Household Size 5.0 4.9 5.3 5.2 5.0 5.2 4.7 5.2 5.0 5.1 Sample Size (households) 848 873 363 519 502 507 594 720 2307 2619 Source: PLSS 1991 and 1994. 6 Income and capital per individual are positively correlated. Thus individual income data can be used to approximate unavailable capital data. 7 The workforce described herein refers to all individuals who report receiving employment income, i.e. those upon which our regressions are based. 8 Indigenous origin is determined by those whose maternal language is quechua, aymara, campa, shipibo or other native ( 1994 ) or by those whose maternal language is quechua, aymara or other native (1991). 14 B. WHY HAVE THE POOR BENEFITED FROM ECONOMIC REFORM? 2.14 The elimination of serious distortions and re-establishment of public order boosted productivity and resulted in creation of more jobs and higher earnings. First, we look at what happened with labor force participation and the supply of labor. Second, we study the determinants of worker earnings in 1991 and 1994. 2.15 Total employment in Peru increased by about 857 thousand individuals between 1991 and 1994. This was the result of an increase in labor force participation and a reduction in unemployment.9 At a national level, labor force participation increased from 46 percent to 48 percent of the population. Unemployment, expressed as a proportion of the working aged population, decreased among both working aged women and men. 2.16 In the poorer areas of the country outside of Lima, welfare improvements were accompanied by increased labor force participation (see Table 7 in Appendix). This increase was facilitated by a greater inflows of women to the labor market. In Lima, a decline in both women's and men's labor force participation was offset by increases in monthly employment earnings--due partly to increases in labor supply (number of hours worked per month) and partly to real wages increases. 2.17 The total number of hours worked was raised by 9.3 percent between 1991 and 1994. This resulted from the combined effects of an increase in jobs of 10.7 percent and a drop in hours of work per individual of 1.3 percent. With the exception of Lima, hours of work per individual fell in all areas of the country indicating that many of the newly created jobs have been part-time (a fact consistent with the higher participation of females in the labor market). 2.18 Table 6 summarizes the determinants of individual earnings at a national level and per region and year for all workers who reported income. Personal earnings depend on education, experience and hours worked and also vary by gender, race, occupation and location. We identify the contribution of each of these attributes to individual earnings for each year as well as for each region and interpret comparisons of these coefficients and changes in the coefficients as products of the reform process and correlates of poverty. The following results lead directly to conclusions of degrees and changes in labor market orientation and, in doing so, present the first real evidence of the effects of the reforms and, specifically, improvements in public order. 2.19 Returns to Education across Regions in 1994. Higher education and experience result in higher earnings because workers become more productive; but the value of these skills is also a function of the economic and social environment. Thus, not only do more years of education make a worker more productive, but also the rate of return on 9 Unemployment is defined as the all individuals who report having looked for a job in the last seven days who also were not employed. 15 education is higher in a well developed market like Lima than in a backward environment like the Rural Sierra. Table 6: Education and Experience by Region Lima Urban Coast Urban Sierra Rural Sierra National 1991 1994 1991 1994 1991 1994 1991 1994 1991 1994 Years of Education 10.4 10.8 9.7 9.9 11 10.8 7.2 6.8 9.9 9.8 Rate of Return on Education (%) 8.3 10.1 6.1 8.1 6.7 7.3 5.4 4.5 7.2 9.7 Experience in Current Occupation 6.8 6.7 9.1 7.6 8.9 7.8 16.9 15.5 9.3 9.3 Non-Migrant (%) 52 56 56 59 60 66 86 89 60 66 Primary Education or Less (%) 19 18 32 30 19 23 59 62 28 31 Earning Differential by Indigenous Origin -3.3 -7.6 -6.9 6.0 -23.9 -18.7 -31.3 -47.2 -28.7 -14.9 Sgrce: PLSS 1991 and 1994 and Appendix. Note: The coefficient c of a dummy variable in semi-logarithmic equations can be interpreted as a percent change in the endogenous variable only as long as c is close to zero. For larger values, in absolute terms, the percent change in the endogenous variable is given by 100 [exp(c) -1]. 2.20 While the average level of education in the Rural Sierra was 6.8 years in 1994, in Lima it was 10.8 years. Not surprisingly while the average rate of return on education for those staying in the Rural Sierra was 4.5 percent, in Lima it was 10.1 percent. This does not mean that getting more education is a bad economic decision for those born in the Rural Sierra; but rather that getting more education and staying in the Rural Sierra is a bad decision. This explains why those born in the Sierra who acquire more educational skills migrate to the rest of the country. 2.21 Changes in Returns to Key Attributes. Less economic distortions and more public order have resulted in a huge increase in labor productivity. This shows in higher earnings per hour worked, in a higher rate of return to education, and in higher return to experience from 1991 to 1994 (for details see Table 9 in the Appendix). For instance, at a national level the elasticity of earnings to hours of work increased from 0.74 to 0.78, the rate of return to education increased from 7.2 percent to 9.7 percent (more than 33 percent) and the return to experience from 2 percent to 3 percent. The direction of the results on elasticity of earnings to hours and experience is the same across all regions of the country. Also, with the exception of the Rural Sierra the increase in rate of return to education holds everywhere. 2.22 Market Improvements. The explanatory power of the earnings equations indicate that the functioning of markets was far more distorted by extraneous forces in 1991 than in 1994 and far less developed in rural than in urban areas. The percentage of 16 the variance of earnings explained by education, experience, and hours of work has risen between 1991 and 1994. It is also higher in Lima than in the Rural Sierra. To illustrate, while the national earning equations for 1991 (presented in Table 9 of the Appendix) explain only 48 percent of the variance of earnings, those of 1994 account for 58 percent. Also, at the regional level, the 30 percent of the variance of earnings explained by the earnings equation of the Rural Sierra compares poorly with the 59 percent explained in Lima. 2.23 As the level of distortions waned and market forces operate more freely the explanatory power of earning equations greatly increases. As an example consider the impact of public order on the relationship between education and earnings. Public turmoil adversely affects income. Ignoring this effect would result in an unstable relationship between education and earnings and a low explanatory power for the model. Likewise with a weakly developed rural market. The more fragmented a market is, the more likely it is that local, highly specific, factors affect earnings and the lower will be the explanatory power of an earnings equation. 2.24 Discrimination. The more developed the labor market the lower the effect of discrimination on earnings. This conclusion is evident if we evaluate more and less developed markets across regions or look at the national situation from 1991 to 1994. In 1991 the earnings of indigenous people were 3.3 percent lower than non-indigenous people in Lima and 6.9 percent lower in the Urban Coast; but they were 23.9 percent lower in the Urban Sierra and 31.3 percent lower in the Rural Sierra. The same relationship holds for 1994 (see Table 6). At a national level, the 14.9 percent earnings deficit of indigenous people in 1994 compares favorably to the 28.7 percent lower earnings observed in 1991. On a national basis, the difference between earnings of males and females of similar education and experience decreased marginally from 30 percent in 1991 to 29 percent in 1994. Thus, the effect of economic growth on male-female earning differentials has been far less important than the effect on indigenous/non-indigenous earning differentials. 2.25 Stability and Labor Market Legislation. Longer tenure in an occupation in Peru is more the result of lack of opportunities than of compliance with labor stability regulations. While workers in the Sierra are much more stable, the majority of these workers are involved in the informal sector and concentrated in agricultural work. We expect the impact of labor regulation to be more prevalent in the more formal labor markets of Lima, yet, in fact, the average tenure of occupation is less than half that of the Rural Sierra. As labor force regulation seeks to promote stability, these perverse results lead to the conclusion that tenure has little to do with the written law. 17 C. POLICY LESSONS 2.26 The program of reforms has reached the poor. Thus any future poverty reduction effort should build on the main lessons, namely, establishing an environment conducive to increases in productivity. However it must be kept in mind that much of these past improvements are catch-up effects as the economy is reoriented to the market and such dramatic welfare increases will not be easily reproduced. Future increases in personal income will also depend on an increase in the endowment of resources, especially human capital. Vhile targeted programs may provide important transitory relief there is no substitute for new jobs and more productive jobs. 2.27 The experience of Peru is important because again it includes some unsuspected postulates. Institutional factors such as law and order, stability, are usually considered as important for economic growth. However, little is known about the magnitude of their impact and their effect on individuals coming from different income deciles. The last fifteen years confirm that role for the state in providing these basic public goods is essential. 2.28 In the Urban and Rural Sierra, a low presence of the state fostered the expansion of terrorism, which discouraged new economic activities, increased production costs across every activity and increased poverty. They who had little or no education were the most affected by the spread of violence in the 1980s and also among those who benefited the most from the re-establishment of public order since 1992. This is why reestablishing public order in Peru remains a project with high rate of return. 2.29 Economic development based on market forces has been key in reducing income differentials based on discrimination. By increasing the cost of maintaining earning differentials based on race or gender more developed markets have effectively contributed to a reduction in discrimination in the labor market. 2.30 Labor legislation has little effect on supporting the causes it advocates: it applies to one half of the labor force, as half of the labor force are self employed, and compliance with it does not result in more labor stability for the average worker. However, this does not imply that labor legislation is benign. It may be the case that labor regulations undermine the efficient use of labor, the poor's most abundant resource, by increasing the costs of creating formal jobs. 2.31 Improving human capital is key for sustained economic growth and poverty reduction. Higher rates of return to education foreshadow increasing demand for education and that differences in education will have a big impact on income distribution in the future. Thus, in order to improve equity and allow the poor to take part of the profits of growth, it is necessary that education be accessible and impartial to region and income class. 18 2.32 Yet, targeted programs have a role to play. In the Rural Sierra workers with no education and fifteen years in the same occupation are condemned to poverty and as are their children. Even comparatively small measures can have a large effect on their welfare. First, it is critical to establish effective policies to provide education to the young thus enlarging the scope of their opportunities. Second, there will always be vulnerable groups such as children and the elderly who, without other family means, depend on social programs. In these cases, the provision of temporary relief through nutrition programs and basic health will remain essential. 19 GLOSSARY Poverty Measures Poverty measurement generally assumes that there exist predetermined and well-defined standards of consumption - called poverty lines - which must be reached if a person is not deemed "poor". Using a given poverty line it is possible to quantify the following measurements of poverty: The Headcount Index measures the prevalence of poverty. It is the proportion of the population whose income is below the poverty reference. The Poverty Gap Index (FGT of degree 1) measures the depth of poverty. It is the amount of income required to bring all impoverished individuals to the poverty line expressed as a proportion of the poverty line. As this measure depends on the distances of the poor below the poverty line it is seen as the aggregate poverty deficit of the poor or denoting the minimum cost of eliminating poverty. FGT Index (FGT of degree 2) measures the severity of poverty. It is a numeric expression of the aversion to poverty. Individuals closer to the bottom of the income distribution of the poor population are weighted more heavily in this poverty measure such that larger income transfers from a richer person to a poorer person within the poor population have a greater impact on poverty reduction. While the head count index is the most easily understood and commonly used measure of poverty it cannot be used to describe the impact of policies on the poor which result in poor people becoming more or less poor but not passing the poverty line. To analyze these effects we turn to the measures developed by Foster-Greer-Thorbeck which include the poverty gap (FGT of degree 1) and FGT of degree 2. A combination of these three measures can provide a multidimensional understanding of the magnitude and structure of the poor. 20 APPENDIX Table 7: Work Force Participation Urban Coast Women Men 1991 1994 1991 1994 Labor Force Participation 39.8 49.7 73.6 83.3 Proportion Paid 32.7% 40.7% 67.4% 78.4% Pay per Month 242.2 259.8 524.2 460.1 Hours Worked per Month 143.2 131.2 204.2 195.7 Lima Women Men 1991 1994 1991 1994 Labor Force Participation 55.7 47.4 80.9 77.7 Proportion Paid 54.3% 42.5% 79.0% 73.8% Pay per Month 265.5 348.8 609.2 624.4 138.4 159.7 199.5 208.9 Urban Sierra Women Men 1991 1994 1991 1994 Labor Force Participation 53.9 56.4 78.3 78.6 Proportion Paid 52.5% 43.4% 69.7% 68.6% Pay per Month 239.3 248.2 400.1 379.4 Hours Worked per Month 139.1 147.0 193.3 169.6 Rural Sierra Women Men 1991 1994 1991 1994 Labor Force Participation 75.9 77.8 93.3 95 Proportion Paid 30.3% 36.1% 69.5% 74.7% Pay per Month 129.6 115.1 180.9 214.1 Hours Worked per Month 138 135.1 209.7 199.1 Source: PLSS 1991 and 1994 21 Table 8: Characteristics of the Work Force Lima Urban Coast Urban Sierra Rural Sierra National 1991 1994 % chng 1991 1994 % chng 1991 1994 % chng 1991 1994 % chng 1991 1994 % chng Income per month* 466.8 517.2 10.8% 419 372.3 -11.1% 334.5 317.5 -5.1% 172.3 178.5 3.6% 384.1 372.5 -3.0% Hours per month 177.0 189.2 6.9% 184.1 168.3 -8.6% 180.8 166.8 -7.8% 212.0 191.7 -9.6% 184.8 182.5 -1.3% Public Sector 16% 11% -31.3% 16% 12% -25.0% 26% 20% -23.1% 11% 7% -36.4% 17% 12% -27.3% Laborers 2% 1% -50.0% 4% 3% -25.0% 4% 3% -25.0% 3% 3% 0.0% 3% 2% -27.0% Professionals 14% 10% -28.6% 12% 10% -16.7% 22% 17% -22.7% 7% 4% -42.9% 14% 10% -27.4% Private Sector 48% 50% 4.2% 35% 42% 20.0% 25% 27% 8.0% 17% 20% 17.6% 36% 37% 1.6% Laborers 26% 22% -15.4% 22% 30% 36.4% 12% 16% 33.3% 16% 18% 12.5% 21% 21% -0.5% Professionals 22% 28% 27.3% 13% 13% 0.0% 14% 11% -21.4% 1% 2% 100.0% 15% 16% 4.5% Self Employed 34% 37% 8.8% 49% 42% -14.3% 49% 51% 4.1% 71% 71% 0.0% 46% 49% 6.1% Home Workers 3% 2% -33.3% 1% 2% 100.0% 1% 1% 0.0% 1% 2% 100.0% 2% 1% -26.0% Unionized 29.9% 13.0% -56.5% 38.5% 23.0% -40.3% 49.9% 28.0% -43.9% 26.0% 12.0% -53.8% 34.5% 17.5% -49.3% Professionals and Technicians 15% 18% 20.0% 14% 15% 7.1% 21% 22% 4.8% 5% 4% -20.0% 14% 15% 10.0% Executives, Managers and 1% 1% 0.0% 2% 0% -100.0% 1% 0% -100.0% 0% 0% .. 1% 1% -50.0% Administrators Administrative Employees 14% 13% -7.1% 8% 6% -25.0% 9% 6% -33.3% 2% 1% -50.0% 10% 8% -23.0% Merchants, Salespeople 25% 26% 4.0% 29% 26% -10.3% 27% 31% 14.8% 10% 10% 0.0% 24% 23% -2.9% Service Workers 14% 12% -14.3% 9% 11% 22.2% 10% 8% -20.0% 3% 3% 0.0% 10% 9% -11.0% Agriculture, Forestry and Fishing 1% 1% 0.0% 8% 10% 25.0% 4% 9% 125.0% 64% 67% 4.7% 13% 20% 50.8% Non-Agricultural Workers- 30% 29% -3.3% 30% 31% 3.3% 28% 25% -12.3% 15% 14% -6.7% 27% 25% -8.9% Age 36.1 36.3 0.6% 37.8 37.3 -1.3% 37.3 37 -0.8% 39.9 38.6 -3.3% 37.3 37.1 -0.5% Schooling (years) 10.4 10.8 3.8% 9.7 9.9 2.1% 11 10.8 -1.8% 7.2 6.8 -5.6% 9.9 9.8 -1.0% Less than Primary 7% 6% -14.3% 12% 11% -8.3% 8% 9% 12.5% 29% 33% 13.8% 12% 14% 12.5% Primary Completed 12% 12% 0.0% 20% 19% -5.0% 11% 14% 27.3% 30% 29% -3.3% 16% 17% 6.9% Some Secondary Basic 16% 13% -18.8% 14% 15% 7.1% 13% 12% -7.7% 17% 18% 5.9% 16% 14% -13.8% Some Secondary Technical 1% 0% -100.0% 1% 0% -100.0% 1% 1% 0.0% 0% 0% .. 1% 0% -60.0% Completed Secondary 39% 37% -5.1% 30% 27% -10.0% 29% 28% -3.4% 16% 14% -12.5% 32% 29% -10.9% Some College 8% 11% 37.5% 9% 11% 22.2% 14% 12% -14.3% 4% 3% -25.0% 9% 10% 5.6% Some University 17% 21% 23.5% 15% 17% 13.3% 24% 25% 4.2% 3% 3% 0.0% 16% 17% 6.9% Experience (years)"* 6.8 6.7 -1.5% 9.1 7.6 -16.5% 8.9 7.8 -12.4% 16.9 15.5 -8.3% 9.3 9.2 -1.1% Married 44% 42% -4.8% 49% 45% -8.8% 56% 48% -13.8% 52% 49% -5.6% 48% 45% -5.3% Maternal Language: Spanish 97% 89% -8.2% 97% 96% -1.0% 87% 74% -14.9% 58% 47% -19.0% 89% 76% -14.1% Maternal Language: Indigenous 3% 10% 233.3% 3% 3% 0.0% 13% 26% 100.0% 42% 53% 26.2% 11% 23% 112.8% Non-Migrant 52% 56% 7.7% 56% 59% 5.4% 60% 66% 10.0% 86% 89% 3.5% 60% 66% 10.3% Male 59% 62% 5.1% 66% 62% -6.1% 61% 59% -3.3% 71% 68% -4.2% 63% 63% -0.2% Sample Size 1774 1634 -7.9% 608 1007 65.6% 866 940 8.5% 839 1211 44.3% 4087 4792 17.2% *Expressed in June 1994 New Soles ** Real experience in current occupation. Note: 1994 National total includes above regions only. -22- Table 9: Regressions of Worker Earnings (log) Labor Regressions: Peru 1991 T-Stat Coefficient T-Stat Coefficient T-Stat Coefficient T-Stat Coefficient Intercept -0.24 -2.1 -0.01 -0.1 0.03 0.3 0.34 3.1 Hours per Month ( log) 0.75 37.4 0.73 36.1 0.72 35.8 0.74 38.0 Years of Schooling 0.11 25.0 0.09 20.3 0.09 16.7 0.07 14.3 Years of Experience (Minc) 0.05 13.5 0.04 12.0 0.05 12.3 0.04 11.3 Experience Squared -0.0005 -9.0 -0.0005 -8.9 -0.0006 -9.3 -0.0005 -8.5 Male 0.20 6.1 0.21 6.3 0.26 8.1 Indigenous -0.75 -14.6 -0.73 -14.2 -0.34 -6.3 Married 0.15 4.4 0.15 4.4 0.16 4.9 Public Sector Laborer 0.08 0.9 0.06 0.7 Private Sector Laborer -0.02 -0.4 -0.14 -3.5 Public Sector Professional 0.06 1.1 0.04 0.9 Private Sector Professional 0.26 5.5 0.14 3.0 Urban Coast -0.04 -1.0 Urban Sierra -0.28 -7.1 Rural Sierra -0.86 -18.0 Adj R-sq 0.395 0.432 0.436 0.481 Source: PLSS 1991 and 1994 Labor Regressions: Peru 1994 Coefficient T-Stat Coefficient T-Stat Coefficient T-Stat Coefficient T-Stat Intercept -0.53 -6.1 -0.35 -4.1 -0.27 -3.1 -0.06 -0.7 Hours per Month (log) 0.82 53.7 0.79 50.6 0.79 50.7 0.78 51.9 Years of Schooling 0.13 34.6 0.12 30.1 0.11 25.7 0.10 23.9 Years of Experience (Minc) 0.05 17.9 0.05 16.4 0.05 16.7 0.05 15.8 Experience Squared -0.0005 -10.6 -0.0005 -10.4 -0.0006 -11.1 -0.0005 -10.5 Male 0.21 8.1 0.24 9.2 0.25 10.1 Indigenous -0.29 -7.7 -0.29 -7.6 -0.16 -4.3 Married 0.09 3.1 0.08 3.0 0.10 3.9 Public Sector Laborer -0.16 -1.6 -0.14 -1.4 Private Sector Laborer -0.13 -4.0 -0.18 -5.6 Public Sector Professional -0.05 -1.2 -0.05 -1.3 Private Sector Professional 0.17 5.2 0.12 3.7 Urban Coast -0.18 -2.4 Urban Sierra -0.31 -5.6 Rural Sierra -0.91 -15.8 Adj R-sq 0.539 0.552 0.559 0.584 Source: PLSS 1991 and 1994 -23- Labor Regressions: Peru 1991 Urban Coast Lima Urban Sierra Rural Sierra Coefficient T-Stat Coefficient T-Stat Coefficient T-Stat Coefficient T-Stat Intercept -0.01 0.0 -0.24 -1.7 -0.42 -1.9 0.70 2.1 Hours per Month (log) 0.82 16.2 0.81 33.2 0.81 21.0 0.53 8.6 Years of Schooling 0.07 6.6 0.10 15.8 0.09 9.8 0.09 6.4 Years of Experience (Minc) 0.06 6.5 0.05 10.7 0.05 7.0 0.02 1.9 Experience Squared -0.0008 -5.0 -0.0006 -6.7 -0.0005 -4.5 -0.0001 -0.9 Adj R-sq 0.419 0.513 0.449 0.152 Intercept 0.29 1.0 0.09 0.6 -0.11 -0.5 0.81 2.4 Hours per Month ( log) 0.75 14.2 0.77 30.6 0.78 19.7 0.55 8.7 Years of Schooling 0.06 5.2 0.08 11.8 0.07 6.6 0.05 3.3 Years of Experience (Minc) 0.05 5.6 0.04 8.4 0.04 5.8 0.02 1.6 Experience Squared -0.0008 -4.9 -0.0005 -6.1 -0.0005 -4.2. -0.0001 -0.8 Male 0.39 4.8 0.27 6.4 0.23 3.4 0.11 1.0 Indigenous -0.07 -0.3 -0.03 -0.3 -0.27 -2.9 -0.38 -4.2 Married 0.14 1.7 0.19 4.1 0.15 2.2 0.15 1.6 Public Sector Laborer 0.07 0.4 -0.27 -1.9 0.19 1.2 0.36 1.7 Private Sector Laborer -0.24 -2.6 -0.24 -4.6 -0.17 -1.6 0.26 2.2 Public Sector Professional -0.11 -0.9 -0.15 -2.4 0.12 1.4 0.78 4.5 Private Sector Professional -0.04 -0.4 0.10 1.9 0.09 1.0 0.86 2.0 0.447 0.537 0.467 0.196 Source: PLSS 1991 and 1994 -24- Labor Regressions: Peru 1994 Urban Coast Lima Urban Sierra Rural Sierra Coefficient T-Stat Coefficient T-Stat Coefficient T-Stat Coefficient Intercept -0.48 -3.1 -0.35 -2.6 -0.40 -2.1 -0.77 Hours per Month ( log) 0.85 31.3 0.82 34.7 0.82 23.5 0.76 Years of Schooling 0.10 13.4 0.12 20.3 0.10 11.4 0.10 Years of Experience (Minc) 0.05 9.0 0.05 11.5 0.04 6.3 0.04 Experience Squared -0.0005 -5.9 -0.0005 -6.8 -0.0005 -4.1 -0.0003 Adj R-sq 0.612 0.570 0.499 0.223 Intercept -0.24 -1.5 -0.09 -0.7 -0.20 -1.0 -0.07 Hours per Month ( log) 0.81 28.7 0.79 32.7 0.80 23.1 0.69 Years of Schooling 0.08 9.6 0.10 15.7 0.07 7.4 0.05 Years of Experience (Minc) 0.04 7.3 0.05 9.9 0.04 5.9 0.04 Experience Squared -0.0005 -5.3 -0.0005 -6.6 -0.0006 -4.3 -0.0004 Male 0.32 5.4 0.24 6.2 0.30 4.7 0.47 Indigenous 0.06 0.4 -0.08 -1.2 -0.21 -2.8 -0.64 Married 0.13 2.3 0.12 2.8 0.07 1.1 -0.06 Public Sector Laborer 0.04 0.2 -0.17 -1.0 -0.20 -1.1 0.17 Private Sector Laborer -0.16 -2.4 -0.20 -4.1 -0.14 -1.6 0.18 Public Sector Professional 0.20 2.0 -0.11 -1.7 0.25 2.8 1.06 Private Sector Professional 0.13 1.5 0.10 2.1 0.07 0.7 0.92 Adj R-sq 0.627 0.589 0.518 0.297 Source: PLSS 1991 and 1994 -25- 3. DECENTRALMZATION 3.1 Effective and efficient delivery of public services is crucial to facilitating productivity increases in the economy that are necessary to sustain growth; to improve welfare for the majority of the population, especially the poor; and to restore government credibility and legitimacy. Decentralized systems of government are more likely to provide some public services more efficiently and responsively. With their geographical frame of reference closer to their citizens, local governments are well positioned to prioritize and coordinate investments across sectors. Provided that the national tax laws permit them an adequate resource base, local governments are in a position to finance maintenance costs and to recover capital costs, thereby reducing the need for capital subsidies from the central government. 3.2 Improving the quality of public services through decentralization requires deep reforms at both the central government and local government levels. The following steps need to take place: (a) Strong reform efforts in central government ministries prior to defining decentralization functions for the different government levels. (b) Converting central government investment funds into matching grant funds for municipalities. (c) Reforming the intergovernmental fiscal transfer system to promote fiscal effort and administrative efficiency. (d) Endowing municipalities with enough flexibility for determining local tax rates according to their income generation capacity and targets of local development plans. 3.3 The rest of this note is organized as follows: the second section portrays the current structure of public service provision. The third section discusses institutional and financial issues which affect the quality of public services provision. The fourth section advances recommendations that could lead to improved decisions for the provision of public services. A. THE STRUCTURE FOR PUBLIC SERVICES PROVISION 3.4 In Peru, there are, in practice, two government levels--the central government and municipalities (provincial and district)--that have executive and legislative branches. Central government authorities (the President and Congress), and local authorities (Mayors and Councils) are elected by popular vote for five- year terms. The 1993 Constitution recognizes a third jurisdictional level (the -26- regions) which was originally established in 1988 and suspended in 1991. Although the Constitution calls for the regional executive--termed president--to be elected after the enactment of the regional organic law, these positions are now appointive. All regional expenditures are financed from central government appropriations. As a result, regions are, in effect, administrative branches of the central government. 3.5 Peru is one of the most centralized countries in the world. While local governments exist as legal entities, their share of total public expenditure is small. Data for 1993 puts the local share of public expenditure at about six percent. This is not only far below the levels of industrial countries, but also substantially below the level of other countries in Latin America. 3.6 Public expenditure is also highly concentrated within the central government's Ministry of the Presidency. This Ministry controls fifteen public enterprises, programs, and decentralized public institutions and has a virtual monopoly over investments in basic infrastructure and social programs. Among the most important of its agencies are INFES (Infrastructure for Education and Health), INADE (National Development Institute), and FONAVI (National Housing Fund)10 With the concentration of these activities outside the traditional line ministries, there is a dissociation between the policy and regulatory functions of the latter and the control over sector expenditures. Most of these entities bypass local governments to work directly with community and non-governmental organizations. As a result, coordination is very limited and funds are allocated in a fragmented fashion. 3.7 While some responsibility for social sector expenditure has recently been transferred to the regions, most notably in education and health, the regions still have little autonomous control over expenditure allocation. In 1993, for example, the central government's share of education expenditure was about 47 percent, while the remaining 53 percent was spent by regions, basically on primary, secondary, technical and higher non-university education. Nevertheless, over 91 percent of expenditures consisted of salaries and pensions, which are set by the central government. Similarly, in the health sector in 1994, direct expenditures by the central government were about 68 percent, while expenditures by the regions amounted to 32 percent for secondary and tertiary level hospitals (specialized hospitals are the responsibility of the Ministry of Health). However, about 73 percent of expenditure was for personnel (doctors, nurses, and pensions), whose salary scales are determined by the Ministry of Health. Moreover, there is little coordination between the regions and the line ministries, since the former negotiate budget allocations directly with the Finance Ministry. 10 FONCODES, the National Compensation Fund for Economic and Social Development, which also finances investments in basic infrastructure and social programs, used to belong to the Ministry of Presidency but now is under the Office of the President. -27- 3.8 While under the 1993 Constitution municipalities have the authority to organize, regulate, and administer "local public services" and to "participate in the management of the central government", the effective role of municipalities in public service provision of any kind is also limited. Until the recent decentralization of water services, virtually the only services in which the municipal government played a predominant role were solid waste management, street cleaning, public markets, cemeteries, and the maintenance of secondary roads. Even here, however, central government agencies, such as FONCODES and FONAVI, maintain a strong presence in financing capital investments. Municipalities have some responsibilities in the social sectors, but there is no clear definition of how these responsibilities are shared with the central government and regions. In education, for instance, municipalities have responsibility for the promotion of literacy programs and maintenance of schools, yet construction, repair and maintenance of schools are also done by central government agencies, such as FONCODES, INADE, INFES and the Program for Targeting Social Expenditure (Programa de Mejora del Gasto Social Basico), all of which prefer working directly with community groups. In the health sector, municipalities are responsible for the construction and equipment of medical posts, and other primary health care facilities. Municipalities, however, have no resources allocated for these responsibilities. 3.9 The relatively small role played by local governments in Peru's public sector is partly explained by their limited control over resources. In the present structure of revenue assignment, the central government administers and retains 100 percent of the revenue from three of the four principal sources of tax revenue (excises, foreign trade and income taxes) and approximately 90 percent of the revenue from the value added tax. In 1993, the central government's share of fiscal revenues was 93.5 percent. The central government also maintains a virtual monopoly over long-term borrowing--either domestic or external. 3.10 Local governments have not historically lacked for tax instruments. Until the enactment of Decree 776, in December 1993, twenty-one tax instruments were assigned to local governments. Today, the main sources of municipal revenue are: (a) local taxes, including taxes on property (a recurrent tax), property transfer (alcabala), vehicles, and other minor taxes on gambling, raffles and games; (b) non-tax revenues, including user charges and fees for municipal services and betterment levies; and (c) intergovernmental transfers, the largest of which is the Municipal Compensation Fund (MCF). The MCF is financed from a 2 percent surcharge (equal to about 10 percent of the receipts) on the national VAT, along with an 8 percent share of the gasoline tax (impuesto al rodaje) and two minor revenue sources (a tax on recreation boats and 25 percent of the tax on gambling). Municipalities are required to spend at least 80 percent of MCF funds on capital investments. 3.11 The reform brought about by Decree 776 also drastically changed the revenue sharing system in two respects. First, it reallocated the majority of -28- funding from provinces to districts, designating 80 percent of MCF resources to the district municipalities, and only 20 percent for the provincial municipalities. It also changed the geographical distribution of MCF, eliminating the special status of Lima and substituting a formula that targets resources on poorer, rural areas." The formula, which may be changed every year by the Ministry of Finance, does not provide incentives to reward fiscal effort of local governments. 3.12 The new arrangement has had substantial fiscal implications for individual municipalities. The principal gainers were small rural district municipalities in provinces with high rates of infant mortality. While the new MCF distribution formula improved the targeting of funds to jurisdictions where poverty is most heavily concentrated, it also substantially reduced the resources available to finance urban investment and did not provide a comprehensive solution to the existing problems. Tight constraints remain on local resource mobilization, while the fragmented nature of capital investment allocation that already existed under FONAVI and FONCODES has been extended to the MCF as well. B. INSTITUTIONAL AND FINANCIAL ISSUES AFFECTING PUBLIC SERVICE PROVISION 3.13 The brief overview presented in the previous section highlights several major decentralization issues regarding the roles and finances of central, regional and municipal authorities. These can be divided into institutional and financial issues. Institutional Issues 3.14 On the institutional side, the key issue is the proper assignment of service provision responsibilities among different jurisdictional levels (central, regional, municipal), which must be appropriately matched by the assignment of revenues. a) Lack of clarity in functional assignments among different jurisdictional levels. 3.15 Central versus Local. In spite of the fact that the 1993 Constitution recognizes the existence of two levels of government (central and municipal), the assignment of functions between these two levels of government is not clear. At the same time that the Constitution establishes that municipal governments have the authority to organize, regulate, and administer "local public services", it also " The new formula first divides the distributable pool among provincial municipalities, on the basis of population and infant mortality. Within provincial municipalities (except Lima) the funds are then divided among district municipalities on the basis of population ( with rural population given twice the weight of urban population). In the provincial municipality of Lima, where the rural/urban distinction would not accurately indicate poverty, funds are disturbed among district municipalities on the basis of housing quality indicators and illiteracy. -29- establishes that the regulation and management of public services are entrusted to the Council of Ministers and to each Ministry in their respective areas of competence. This ambiguity with regard to the functions of each level of government is reinforced by the Organic Law of the Ministry of the Presidency (1992), which establishes a Ministry mandate to satisfy the population's needs through the execution of basic infrastructure works and social programs. It also establishes that, in order to carry out its mandate, the Ministry will formulate, evaluate and supervise national policies whose implementation rests with the agencies, enterprises and institutions under its purview. While central governments are expected to perform policy and regulatory functions over the provision of public services, the economics of decentralization, as outlined earlier, would suggest that management functions regarding the provision of public services are better left to lower levels of government. 3.16 Central versus Regional. The 1993 Constitution recognizes the existence of regions as a jurisdictional level with administrative, financial, and political autonomy for discharging their responsibilities. The Constitution also establishes that regional responsibilities are limited to coordinating and executing regional socio-economic plans and programs, as well as "managing the activities and services inherent to the State". The Constitution, however, does not establish any other essential element for the creation of an intermediary level of government, such as assets and tax bases, specific functions, or governmental structure. A draft law on decentralization (Ley Marco de Descentralizaci6n) currently being discussed at Congress also fails to specify functions and resources for the regions. The establishment of regional administrative authorities with limited functions-- essentially those related to assisting the central government in the administration and implementation of national policies and programs--could be considered as an alternative to full-fledged regional governments. 3.17 Provincial versus District Municipalities. Both the Constitution and the Municipal Organic Law establish a distinction between provincial and district municipalities. However, functional assignments between them are ambiguous inasmuch as both types of municipalities are given largely the same set of responsibilities, including those for the provision of local public services. The legislation gives more prominence to the role of provincial municipalities insofar as they have the power to create delegated municipalities in any district municipality within their jurisdiction (thereby interfering with previous district authority) and to review decisions made by district municipalities regarding all areas of responsibility. Also, the ordinances of district municipalities are subject to approval by the provincial municipality. While the existence of provincial municipalities is useful for service coordination in metropolitan agglomerations consisting of two or more districts, or where economies of scale are present, they may be redundant in more dispersed areas, where district municipalities can coordinate services with each other if warranted. -30- 3.18 Another issue relates to the double role given to provincial municipalities. In addition to their governance responsibility over the province, provincial municipalities also function as governments of their central districts (provincial capitals). This situation creates a conflict of interest, especially in the allocation of resources, which tends to make provincial governments favor the central district over the rest of the province. b) Duplication and lack of coordination among central government institutions. 3.19 The centralization of operational institutions (such as the special funds mentioned before) under the Ministry of the Presidency was a sensible approach to deal with problems in an emergency situation characterized by a low executing capacity on the part of many government agencies (including line ministries) and an urgent need to implement poverty-reducing programs. As noted, however, this approach has resulted in duplication and overlap among the various funds and programs administered by the Ministry of the Presidency (such as, for example, that between FONCODES and INFES for educational infrastructure, and between FONCODES and FONAVI for urban infrastructure) as well as between them and line ministries. At the same time, it has created institutional uncertainties with regard to the role of line ministries and promoted parallel governmental structures at regional and local levels. In most cases, these funds and programs have no coordination arrangements with local authorities, who often have no information on investments made in their jurisdictions. 3.20 This approach has been very effective in achieving results, as verified by the large number of schools and other public facilities built and repaired throughout Peru during the last few years. A better balance between efficacy and efficiency of government in the long run will require that government activity, especially investments, be carried out in the context of more sophisticated sectoral policies and in coordination with local authorities. As noted before, local governments are well positioned to prioritize and coordinate investment across sectors. Also, if provided with the right incentives, they are in a better position to finance maintenance and operation costs, and recover capital costs, thereby reducing the need for capital subsidies. An option, explored below, would be to convert the existing special funds into matching grant funds for the cofinancing of regional and municipal projects. c) Political commitment to decentralization. 3.21 Even though decentralization can be justified on economic efficiency grounds, as it takes into account the comparative advantages of each government level in the provision of services, it also implies a new balance of power. For this reason, it requires the strong political commitment of the central government to share power with other governmental levels. At present, there is some hesitation about the advantages of decentralization, especially by central government -31- agencies that execute social programs directly with community based and non- governmental organizations (CBOs and NGOs). There is also concern that the local governments, with a history of inefficiency and corruption, are poorly equipped to take on the greater responsibilities implied by decentralization. Some interest groups also have pressed against decentralization. Teachers, for example, have opposed the implementation of an education reform that would delegate administrative responsibilities to provincial municipalities. 3.22 High degree of centralization of responsibilities and resources has contributed to inefficiencies and corruption in the past. The decentralization of governmental functions requires the strengthening of management and control systems at the local level, the training of local administrators, and improved oversight by the central authorities. At the same time, increased influence of local citizens over government decision-making and the increased interest that is engendered when it is their own resources (rather than those of a distant government in Lima) that are involved, should lead to closer monitoring at the local level and the more rigorous holding of local officials to account for their decisions. d) Low wages of municipal employees and rigid labor regime. 3.23 Municipalities are subject to the same labor legislation and salary structure as the rest of the public sector. On average, the wage of a public sector employee is currently equivalent to about 60 US dollars per month. The salary scale is also very flat, and the labor regime does not allow the introduction of incentives for performance. Little incentive is thus provided for highly qualified people to work in the municipalities or in the public sector generally. This situation could be improved if, as in Colombia and Venezuela, municipalities were allowed to have their own labor regime (similar to that of the private sector) and a salary scale of their own. Wages would be allowed to vary, within certain limits, across municipalities according to their respective fiscal capacities and their size and responsibilities. This possibility is allowed under the new Constitution, and it is recommended that the decentralization law address this issue. Financial Issues a) High level of expenditure and fiscal centralization. 3.24 As previously indicated, almost all expenditure decisions are made at the central level. About 82 percent of the total public expenditure is made directly by the central government. Adding expenditures made by regions, which have in fact little spending autonomy, central government spending reaches 94 percent of total public spending. At the same time, about 93 percent of tax revenues are collected by the central government. Local governments collect only a small portion (7 percent) of revenues, partly because of the reduced number of taxes and other revenue sources assigned to them, and partly because of their weak institutional -32- and administrative capacity to collect revenues. As will be seen below, municipalities have ample room for increasing revenues by improving collection of their own taxes and user fees, thus reducing the need for central government transfers. b) Limited municipal fiscal autonomy. 3.25 The fiscal autonomy of municipal governments is very limited. These governments cannot impose taxes or determine tax rates; these are determined at the central level, and the same tax rate structure applies to all municipalities. Municipalities can, generally, update tax bases, except for the property tax (the main municipal tax), which is updated by the National Council of Assessments (Consejo Nacional de Tasaciones) without any involvement by municipalities. Additionally, because most taxes are collected by central government agencies and are not distributed according to their origin, there are no incentives to mobilize revenues at the local level. 3.26 Finally, property values are based on self-assessments, but there is no municipal cross-check of assessed values. As a consequence, tax proceeds from this financing source are very low by international standards. Property tax revenues may be as low as one-fifth of their potential value as a result of outdated cadastres, low assessed values, evasion, and weak administrative capacity. Municipalities should have the responsibility to update cadastres and establish tax rates within a certain range, as they have in Colombia and other countries in Latin America. The National Council of Assessments should develop information systems (software) that can be used by municipalities, so that they can update and manage their own cadastres. An experiment of this type is currently being implemented in Costa Rica and Guatemala. c) Weak budgetary and auditing practices. 3.27 Municipal budgets are currently prepared with little regard for sound financial management principles. Budgeting practice is limited to recording and measuring the cost of inputs, but there is no record of budget execution by programs, or other aggregates that reflect municipal activities. The Municipal comptroller's office applies an ex-ante control and rarely makes ex-post auditing of accounts and results. A greater effort is needed to impose modern accounting systems at the local level and to assure regular and transparent presentation of accounts to the public. With the Comptroller General's Office now being decentralized, greater ex-post control and accountability can also be applied to municipalities by the central government. d) Local government's limited access to financial resources. 3.28 Peru's local fiscal resources, at about 1.5 percent of GDP and about 7 percent of total tax revenues, are low by Latin American standards. By contrast, -33- transfers to local governments in Colombia amount to 15 percent of the central government's total recurrent revenues for 1995 and are expected to rise to 22 percent in the year 2002. Following 1994's Constitutional reform in Guatemala, transfers amount to 10 percent. In Mexico, combined transfers to states and municipalities were about 18 percent of total tax revenues, in 1986. 3.29 As noted before, transfers from the central to the local governments in Peru are largely earmarked for capital expenditures. Investment responsibilities, however, are not well defined by sectors, and there is ample room for duplication and waste. Additionally, the distribution formula of the MCF does not provide incentives for fiscal effort on the part of municipalities. As suggested by experiences in other countries, it would be better to allow municipalities to raise revenues from their own sources rather than to increase transfers from the central government. Such an approach would preserve fiscal stability, while containing expenditures and increasing the efficiency of local spending. However, given the limited tax base of Peruvian municipalities, especially rural ones, and the high level of expenditure centralization, transfers will initially likely need to be increased at the same time that more autonomy is given to local governments to exploit their own sources of revenue. 3.30 Municipalities currently have limited access to borrowing, especially for capital financing. This is appropriate given their small revenue bases and the state of development of Peru's financial markets. As these conditions change, however, borrowing can become an important source of financing for municipal government investments, at the same time that the financial markets become an additional mechanism for monitoring and disciplining municipal government performance. Meanwhile, FONAVI, which is presently an important source of financing for local investments, prefers to lend directly to CBOs to the disadvantage of local governments. 3.31 The above analysis suggests that Peru could benefit from a significant delegation and devolution of responsibilities to local governments for the provision of many public services. To be effective decentralization in Peru should: (a) change the role of central government ministries from producers to regulators; (b) reform the mechanism to distribute intergovernmental funds and design a matching grant system; (c) improve the fiscal and managerial capacity of local governments. Strengthening central government agencies is a requisite for successful reform -34- 3.32 Decentralization should not result in a transfer of central government inefficiencies and bureaucracies to subnational governments. Much of today's deconcentration efforts by the Ministries of Health and Education, for instance, are a simple delegation of functional responsibilities to the regions, which themselves are bound by the same operating procedures, labor regimes and financing arrangements as the central government. Under such circumstances, few efficiency gains can be realized in the delivery of services. Moreover, if not properly designed such delegation could overburden subnational governments and result in a further deterioration of public services. 3.33 It is important to note that the design of a decentralized governmental system depends fundamentally on political decisions regarding the distribution of functional responsibilities among different government levels and how these responsibilities are to be discharged. For example, if the delivery of education and health services were to be contracted out to NGOs or private entities, then local governments would play essentially a managerial role, establishing and enforcing the level and quality of services. By contrast, if such services were to be delivered publicly, then local governments would also assume direct responsibilities for providing the services, for example, building, financing and operating health posts and schools. In either case, local governments, acting by delegation of the central government, could select beneficiaries of social programs, such as income support, according to national procedures. In any event, it is not necessary to impose a specific division of responsibilities at the local level. Rather, municipalities themselves could be left free to choose which specific functions to take upon themselves, guided by centrally determined incentives and their own capacities. Creating Incentives for Improved Performance Through A Matching Grant System 3.34 As discussed before, central government.investment funds, including FONCODES, INADE, INFES, and the targeting of social programs (Programa de Mejora del Gasto Social Basico), have been successful in meeting urgent community demands and have contributed to strengthening community and NGO participation. These funds are missing, however, an opportunity to strengthen local capacity, democracy and accountability at the local level. Unlike community organizations and NGOs, which are temporary by nature, local governments are permanent, democratic organizations institutionalized by popular vote. 3.35 One option, consistent with the model presented here, would be to convert FONCODES, INADE and INFES into either a single or separate specific matching grant funds, with project menus and operating schemes similar to those currently in place, to cofinance investment projects presented by municipal authorities. The special laws allowing FONCODES rapid project execution and contracting out could be preserved and extended to municipal project execution in order to make the scheme operative. NGO and community projects would then be presented through municipalities to the cofinancing funds. This would strengthen local -35- government's coordination of local investments and while promoting accountability of local governments to meet the basic needs of their constituents. At the same time, a matching grant scheme would motivate local governments to mobilize local resources to provide the necessary counterpart funds. In operating the proposed matching grant fund(s), the central government would (a) define the cofinancing arrangements (according to government, including line ministries); (b) establish the methodologies to be used for project evaluation, including computerized information systems for project evaluation; and (c) determine allocations by region. Reforming The Intergovernmental Transfer System (MCF) 3.36 The present formula for determining the allocation of MCF transfers among municipalities uses population and infant mortality as factors for allocating transfers to provincial municipalities; then, the allocation to district municipalities within a province is based on the split between urban and rural populations (except for Lima and Callao, where seven other social indicators are used). The Ministry of Finance has the authority to determine the specific formula components, based on the general criteria approved by the Council of Ministers. 3.37 As noted above, one factor responsible for low fiscal effort on the part of Peruvian municipalities is that transfers bear no relation to municipal fiscal effort. As an incentive measure, therefore, factors that reflect changes in the level of municipalities' own-source revenue collections and administrative efficiency from one year to the next could be introduced into the formula, along with poverty and population indicators, as proposed above for the block transfers to municipalities. A matching grant scheme would motivate municipalities to mobilize local counterpart funds. At present, however, municipalities have limited revenue- raising capacities from user fees, property tax and other fees and contributions. Such revenues, plus MCF's transfers, are barely enough to cover municipal personnel and operation and maintenance costs of basic municipal services (water and sanitation, street cleaning, etc.). If further responsibilities in the social sectors were assigned to municipalities, additional resources would have to be transferred to them as well. This could be achieved by increasing the funding of the existing MCF, with additional resources being transferred as block grants. All municipalities--with no exceptions--would be subject to the same formula, which would also not be subject to frequent changes. Changing the formula every year-- as is now possible--makes it impossible for municipalities to plan revenues and expenditures (either capital or recurrent), and makes the formula an easy target for political manipulation. Improving The Fiscal and Managerial Capacity of Local Governments 3.38 As noted earlier, municipalities in Peru have very limited fiscal autonomy. Tax bases and rates are determined by the central government. Under the reforms proposed here, rather than increasing unconditional transfers, municipalities should be allowed and encouraged to exploit their own revenue sources. This would -36- strengthen accountability at the local level and improve efficiency of investments. Municipalities would be given responsibility for developing and updating their cadastre systems, determining 'assessed values according to market prices, and determine tax rates within specified ranges. A well-designed technical assistance program and information system (software) would need to accompany such reforms. 3.39 Under the reforms being described, municipalities would play an important role in managing basic services, in designing and implementing social programs, in combating poverty in their jurisdictions. To be able to perform the functions associated with these roles, municipalities would need highly qualified and well- paid professionals able to plan, contract out, and oversee many typical municipal services, while also playing a direct role in designing and implementing social programs with central government cofinancing funds. In Chile, as an example of what can be done in this regard, professional staff accounted for only 8 percent of all municipal employees in 1975. By 1988, that proportion had increased to 33 percent, while that of support staff declined from 67 percent to 41 percent. Again, a well-designed technical assistance program, coupled with incentives to induce changes in the right direction, would be necessary. 3.40 Accountability of local authorities to their constituencies and to the central government is essential for realizing the benefits of decentralization. However, in order to hold local authorities accountable to their constituencies and to the central government, a network of information and control must be in place. This calls for systematic disclosure of government activities to the community and for an institutional setting that facilitates community involvement and control.12 It could also be facilitated by central government promotion of citizen supervisory boards or community entities actively involved in decision-making, such as school supervisory boards. Citizens belonging to these entities would need proper training and support in the areas of financial management and administration. The government could itself provide them with timely information on resources made available, quality standards, and coverage targets. Audit requirements would also be needed to assure that local authorities disclose relevant financial information. Complementary to these measures would be legislation enacting a strong code of ethics for local officials and a due process making them personally responsible and legally liable for failure to perform with diligence. Ultimately, however, the best way to induce community oversight is to insist that programs be cofinanced with local tax revenues, as has been proposed above. 3.41 Whatever decentralization strategy is pursued, there will be a need to synchronize the various elements of reform. A rational assignment of revenues, for example, requires a clear definition of the respective responsibilities of each level of government. A system of capital allocation based on local decision-making autonomy requires that local governments have similar control over tax rates with 12 Bolivia's experience with the Popular Participation Law is a good example. -37- which to exercise that autonomy. Many of the decentralization programs in the countries surrounding Peru have encountered problems resulting from a failure to coordinate the various parts of reform. Many countries, for example, have tended to decentralize revenue powers before decentralizing expenditure responsibilities. If the Government decides to pursue a decentralization program, as is suggested here, it will need to devise a time-bound strategy, in which the various elements are coordinated. -38- 4. REFORMING THE PERUVIAN PENSION SYSTEM 4.1 The reform of the social security system initiated in 1992 with the introduction of a fully-funded private pension system needs to be consolidated and extended to other important sectors. The reform was undoubtedly a major step towards improving income security for the elderly and addressing the well known structural problems associated with dominant pay-as-you-go pension schemes.13 Even so, today in Peru, there are still five main pension regimes, of which the newly created private pension fund is the only defined-contribution and fully funded regime. The functioning of these five regimes is summarized in Table 10. 4.2 The marked differences among these regimes in terms of financing, eligibility criterion and benefit level introduce efficiency problems (for instance, different marginal tax rates) and equity problems. Addressing these problems requires a move towards a uniform pension regime. This note provides a framework for selecting a unified pension regime and assesses the fiscal implications of the transition from the current combination of regimes. The focus will be on the national pension system, the civil servant pension system (i.e., cedula viva), and the capitalization regime (i.e., AFPs). The rest of the paper is organized as follows. Section A summarizes the main problems associated with the current combination of regimes. These limitations provide the background for Section B, which lays down three options of unified pension system. Section C gives an assessment of the new draft law for private pensions that is being discussed in Peru today. This new law provides a window of opportunity for strengthening the earlier pension reform. Section D contains estimates of unfunded liabilities associated with existing pension schemes and explores ways of financing them. Finally, Section E summarizes the main policy recommendations. A. WEAKNESSES OF THE CURRENT SYSTEM 4.3 The current system has at least five major drawbacks: (a) Except for the private pension regime, which covers 13 percent of the labor force, most pension schemes are unfunded and fiscally non-sustainable. 14 As shown in section C, the magnitude of these unfunded liabilities is very significant. This is particularly true for the civil servant pension system, which is financed out of general revenue. (b) The different pension regimes give rise to different contributions and benefits to individuals with the same socioeconomic profile, 1 The law was adopted in 1992 and the system started operating in 1993. 14 The coverage rate of 13 percent is based on total affiliates and therefore overestimates actual number of contributors because of multiple accounts and inactive affiliates. -39- hence violating horizontal equity (see Table 10). For instance, workers affiliated with the civil servant pension system can draw a pension after 30-25 years of service and irrespective of their age, whereas workers affiliated with the national public pension system receive a less generous pension and are subject to a minimum age for retirement of 60 (men) and 55 (women). (c) There are still strong disincentives for workers to join the private pension scheme because of its higher contribution rate (15 percent, including commissions and disability insurance) compared to that of the national pension scheme (9 percent) and its higher retirement age (the statutory retirement age that is 5 years older for men and 10 years older for women)." Clearly, these disincentives are not consistent with moving away from a pension system with a dominant pay-as-you-go pillar. Indeed, today there are still twice more contributors in the national pension system than in the private pension system. (d) In addition to generating significant unfunded liabilities, the civil servant pension system is holding captive any genuine reform of the state because of its indexation to public wages. Although wages are particularly low in the social sectors, because of the indexing mechanism, any extra US$1 spent on wages translates into a 30- cents increase in pension payments. The civil servant pension system is also hindering the privatization process because a funding mechanism for pension liabilities has not been put in place. It is therefore important to quantify the cedula viva pension liabilities, devise a funding mechanism, and phase out the regime. (e) Payroll taxes financing pensions contribute to the very high marginal effective tax on labor, which hinders competitiveness and is conducive to informalization. The combined taxes on labor funding pension schemes, health, and the housing fund (FONAVI) reach 18 percent for workers affiliated with the national pension system and 27 percent for workers affiliated with the private pension regime. B. THREE OPTIONS FOR A UNIFIED PENSION SYSTEM Pure Capitalization System 4.4 One option is to move totally to a capitalization scheme without any Government involvement in the provision or the guarantee of pensions. This entails phasing out both the civil servant and public pension systems and has the 15 Apparently this was done by the Central Bank. -40- attractiveness of eliminating the fiscal and incentive problems associated with pay- as-you-go systems. 4.5 There are, however, two limitations to adopting a pure capitalization regime. First, to the extent that redistribution remains an objective of the pension system, a pure capitalization will not be satisfactory since individual pensions would be determined by contributions and the average return on investments. Second, the principle of risk diversification across pillars is also absent since there is no mechanism to offset the investment risk factor. One must remember that the way the savings pillar works today, and despite the existence of a fluctuation rtserve, negative returns are not precluded. Capitalization with Minimum Pension Guarantee 4.6 In order to add redistribution to a defined-contribution scheme, the Government could provide a minimum pension guarantee financed out of general revenue. This option would also imply phasing out the public pension scheme as well as the civil servant pension system. In the case of Chile, the minimum pension guarantee is set at US$70 per month and requires 20 years of contribution. More recent Latin American reformers such as Colombia and Argentina also have a minimum pension that requires 20 and 30 years of contribution, respectively. It is therefore not surprising that Peru is considering following suit by inserting a minimum pension guarantee in the new draft pension law. 4.7 Cost estimates of the minimum pension guarantee are provided in Tables 11.1 and 11.2 for an average real return of 5 percent and 3 percent, respectively. The costs shown are for each eligible retiree and expressed as a multiple of the monthly average wage prevailing at retirement. The cost is the difference between the funds accumulated by a worker at retirement and the level that would be required to receive an annuity equal to the minimum pension. The unit cost of the minimum pension guarantee is higher for low income workers and for women (because on average they have a lower contribution density).'6 The fiscal burden of the minimum pension insurance also rises as the average return of the pension fund decreases. 17 Section D provides an estimate of the annual cost of a minimum pension guarantee and its associated implicit debt. By adopting a minimum pension guarantee that requires 20 years of contribution, payments would start 16 With a minimum pension guarantee of 20 percent of the average wage and an average real return of 3 percent, per-capita cost of the minimum pension guarantee would be roughly 22 times the monthly wage for a typical worker with an average starting salary of 15 percent of the average salary. The corresponding cost for a worker with a starting salary of 42 percent of the average wage falls to 11-12 average wages. 1 As shown in Tables 2.1 and 2.2, when the average return goes down from 5 to 3 percent, the subsidy to workers with a starting salary of 15 percent of the average wage is increased by 22 percent for men and 19 percent for women. The methodology that we use to estimate the fiscal burden of a minimum pension guarantee does not take into account the variability of the return. This variability would have been taken into account by using an option-pricing method. For an illustration of this approach applied to Chile see Zurita (1994). -41- only 18 years from now, as the first contributions to the capitalization system took place two years ago. If the Government decides to have the guarantee apply earlier, the required years of contribution could increase gradually to its target. Multipillar with Public Provision 4.8 In many countries the option of phasing out the public pension pillar either runs against considerable resistance or is simply politically unfeasible. In the case of Argentina, for instance, the original draft made the savings pillar mandatory to new entrants into the labor market. By the time of final approval, the capitalization scheme was made optional. Thus, it would be wise to devise a strategy in response to a constraint of keeping the public pension system. Such strategy should ensure that the public pension system neither becomes a source of fiscal instability nor hinders the performance of the savings pillar. For instance, the need to correct the difference in contribution rates between the savings and public pension systems becomes even more pressing if new entrants into the labor market are allowed to opt between these two regimes. 4.9 A more fundamental question, however, is whether it would be desirable to retain some form of public provision even after adding a minimum pension guarantee to a mandatory capitalization scheme for new entrants. Militating in favor of such provision is the need to protect uninsured workers that remain outside the formal sector. One way of meeting this need would be to transform the national pension scheme into a social assistance scheme. Indeed, in a country such as Peru where a large fraction of the population is outside the formal sector, the minimum pension guarantee alone becomes a less effective tool for redistribution. Today, both the national pay-as-you-go scheme and the capitalization regime cover less than 40 percent of the labor force. By contrast, in Chile affiliates to the capitalization regime represent 94 percent of the labor force. 4.10 It is unlikely that such a broad coverage would take place in Peru in the near future. For this reason, Peru could consider providing a social assistance pension to the elderly in a context of a broader poverty alleviation strategy. In addition to an obvious vertical equity argument, the minimum pension guarantee might be politically easier to adopt in tandem with a social assistance pension. Of course, just like the minimum pension guarantee, the flat social assistance pension would be financed out of general revenue. It should be noted that the social assistance pension would have to be set at the level that is more or less equal to the subsidy that is implicit in the minimum pension guarantee.19 18 Vittas and Iglesias (1992) estimate the ratio of affiliates to the labor force at 79 percent in 1991. A more recent estimate by Powers and Terrin (1995) is 94 percent. 19 The social pension would have to be below the minimum pension guarantee itself since the subsidy element is the difference between this minimum and the annuity arising from the worker's savings. In Chile, for instance, there is a social assistance pension that represents 50 percent of the minimum pension guarantee. -42- C. A CRITICAL ASSESSMENT OF THE DRAFT PENSION LAW FOR PRIVATE PENSION FUNDS 4.11 The Government of Peru has recognized the need to correct some of the weaknesses of the current private pension system. As a result, a draft law modifying the original one was put together in April 1995.20 4.12 The new law contemplates changes in virtually all aspects of the functioning of pension funds. The importance of this law lies in the fact that in choosing a suitable uniform pension system, Peru seems ready to make the private pension scheme the most important pillar. This is confirmed by the proposed change in affiliation policy. 4.13 Affiliation. The draft law suggests making it mandatory for new labor market entrants to join the private pension system. This would certainly contribute to moving towards a unified pension system, but should be complemented by other measures discussed above, such as closing the civil servant pension system. 4.14 Minimum Pension Guarantee. This would be an important addition to the private pension fund, in particular given that affiliation to these funds would be made mandatory for new entrants. The draft does not specify the level at which the minimum pension guarantee would be set. As far as eligibility is concerned, it is proposed-that to qualify workers would need to have contributed a minimum of 5 years in the private pension system, and a total of 30 years in the combined private pension and public pension systems. This implies that payments arising from the minimum pension guarantee could start as early as 1998 for workers who joined the private pension system in 1993 and have contributed 25 years to the old system. 4.15 There is a growing consensus that when setting a minimum pension guarantee a principle of proportionality should be adopted. According to this principle, for workers who fail to meet the minimum years of contribution, the level of the minimum pension guarantee would be pro-rated by the number of years of contribution. At this stage, such proportionality is not included in the Peruvian reform proposal.21 4.16 Taxation. The draft law proposes changes regarding the personal income tax as well as the value added tax (VAT). Since June, contributions to private pension funds are no longer deductible from the personal income tax while pensions remain taxable, therefore creating an unjustified double taxation. The reason is that the original draft law allowed for a deduction of contributions during the first 30 months only. The draft law proposes moving to the other extreme by suggesting that both contributions and pensions be made deductible from the 20 Propuesta de Reforma Reglementaria del Sistema Privado de Pensiones Decreto Ley No. 25897, April 1995. 21 The Chilean minimum guarantee does not include proportionality either. -43- personal income tax. It is hard to justify on either equity or efficiency grounds the need to exempt both contributions and pensions. Given the importance of savings for economic growth, many countries opt for a tax treatment of pension accounts that eliminates the taxation of interest. This can be done by allowing deductibility of principal contributions and taxing all withdrawals, or, alternatively, by taxing principal contributions and leaving withdrawals untaxed.22 In accordance with this principle, Peru should consider applying deductibility to contributions but tax pensions. Under certain conditions, this arrangement could even lead to a net increase in government revenue and a lower stock of government debt.23 4.17 The draft law also suggests exempting the premium for survivor and disability insurance as well as the commissions paid to private pension funds from the VAT. As a general principle, the tax base for the VAT should be kept as broad as possible and applied to all goods and services. Usually goods and services are exempted or zero rated either for equity reasons (e.g., food products), because they are difficult to tax (e.g., some financial services, renting and leasing of movable and immovable property), or because they do not fall within the tax base of the VAT (e.g., exports). In principle, pure insurance naturally falls under the VAT net.24 Life insurance has an additional complexity because of its implicit saving component. Technically, a VAT can still be applied to life insurance by fully taxing the premium net of the saving component and paying a VAT on the claims less the cash surrender value of the policy (see Barham, Poddar and Whalley 1987). In practice, many countries do exempt life and pure insurance from the VAT. In Chile, for instance, there is a VAT exemption on life insurance and other pure insurance policies (e.g., earthquakes).25 Despite the fact that the EEC's Sixth Directive requires member countries to exempt insurance from VAT, many countries either have a stamp duties or a separate and lower rate for insurance premium.26 The first best solution for Peru seems to be to keep life insurance under the VAT net, but make sure that the base is properly defined i.e., excludes the saving component. If this turns out to be difficult to implement then the solution would be to follow Chile's route and exempt life insurance altogether. 22 These two forms of taxation are generally referred to as consumption tax treatment of savings accounts. 23 Feldstein (1995) shows that, once the effect on corporate income tax is taken into account, the fiscal incentives of IRA accounts in the US lead to a more favorable impact on government revenue and debt stock than previously thought. 24 The correct arrangement is that the "full value of the premium should be taxed at the VAT, and that insurance companies should increase claims paid by the VAT rate...At the insurance company level, VAT supplements paid when claims are made would be creditable as input taxes against VAT due on premium, and thus the net VAT remitted would reflect only its value added in providing financial intermediation services" (Barham, Poddar, and Whalley, 1987). 25 See Miguel Massone (1994). 26 In the Federal Republic of Germany, the tax on premium is 5%, in Greece 3-8-18%, in Italy 1-5%, and in France 2-30% (see A Tait, 1987). -44- 4.18 With regard to commissions paid to private pension funds, there is no good argument for zero rating or exempting them from the VAT. Unlike life insurance, commissions to private pension funds do not have any saving component. The only question that remains is to ensure that the tax base is the cost of intermediation rather than total revenues from commissions alone, which would turn the VAT into a cascading sales tax. 4.19 Contribution. Under the proposed new rules, the total contribution to the private pension fund system, including commissions and insurance premium would fall from 15.02 to 11.29 percent. This reduction would come partly by lowering the contribution channeled to the individual account from 10 to 8 percent. There is a danger that in trying to reduce the difference in contribution rates between the private pension fund and the public pension system, Peru would end up with a contribution rate that is too low to guarantee a meaningful pension at retirement. The actual contribution rate of 10 percent seems adequate to provide for a pension equivalent to 75 percent of pre-retirement salary.27 4.20 Given the possibility of early withdrawal when the accumulated funds can guarantee a pension equivalent to 50 percent of the worker's salary, there does not seem to be a compelling reason for reducing the contribution rate. Another important point is that, ceteris paribus, a lower contribution to the individual account increases the fiscal cost of the minimum pension guarantee. Lowering the contribution by 2 percentage points would increase the liabilities of the minimum pension guarantee from 4.7 to 5.8 percent of 1994 GDP (using a 4 percent discount).28 4.21 Peru, unlike most other Latin American reformers, does not apply any wage ceiling to contributions.29 The new draft proposes a ceiling of 4104.8 Soles (April 1995) that would be indexed to the consumer price index. The main rationale for such a ceiling is that high-income workers hold other assets and there are efficiency costs in having an excessive mandatory saving. It should be added that the existence of a ceiling is an additional reason for not reducing the contribution rate since it limits the possibilities of excess mandatory savings. 4.22 Investment regulations and Minimum Return. Two important changes are proposed in this area. First, the fluctuation reserve that was instituted to guarantee a minimum return would be eliminated.o The justification is that this 27 Assuming an average real return of 4 percent, a 6 percent probability of being unemployed, an average duration of unemployment of 2 months, and an average real wage growth of 2 percent. 2 The resulting elasticity of liabilities of the minimum pension guarantee to the contribution rate is -1.1. 29 This ceiling is US$1500 in Chile, US$2500 in Colombia, and US$3780 in Argentina (Towers Perrin/Marcu y Asociados, 1995). 30 In Peru and Chile, private pension return in excess of 150 percent of the industry average must be channeled to a fluctuation reserve, which guarantees a minimum return. This -45- arrangement penalizes good performers, since returns in excess of a threshold have to be channeled to this reserve rather than translate into an increased value of the fund to affiliates. It is important to realize that creating a minimum pension guarantee while eliminating the minimum return mechanism places more of the investment risk on the shoulders of the State. This risk would be exacerbated by barriers to moving across different private pension funds due to the existence of captive markets, or if workers do not have full information about the relative performance of different pension funds. As pointed out earlier, it is against this combination of factors that one must assess the full implications of reducing the contribution rate. For all these reasons, improving the fluctuation reserve to reward good performers might be more indicated than eliminating it altogether.31 An innovative approach followed by Colombia has been to take into account actual returns of different assets to determine the minimum return, hence allowing for more product differentiation by private pension funds. The second direction of change contemplated by the new draft law is related to investment regulations. For instance, the maximum portfolio share of central government and central bank papers would be reduced from 60 percent to 40 percent. There does not appear to be a convincing rationale for reducing the ceiling on government papers at such an early stage of the capitalization regime. Indeed, these are maximum rather than minimum limits.32 4.23 An important aspect of investment regulation which would remain unaltered under the new draft law is related to the ceiling on foreign assets. This ceiling would be kept at 5 percent, which is the lowest among Latin American reformers. 4.24 There is some evidence pointing to the desirability for Latin American pension funds to achieve a greater international portfolio diversification.34 Such evidence suggests that Peru should at least reach parity with other Latin American reformers and increase the ceiling on foreign assets to 10 percent. minimum return is set at 50 percent of the industry average return or 2 percentage points below the industry average, whichever is lower. 31 There seems to be similar dissatisfaction with the minimum return and fluctuation reserve in Chile (see Garcia, 1995). 32 Chile, for instance, had much higher ceilings on government papers at the beginning of the reform. Even today, 43 percent of investment by Chilean private pensions can be done in government papers. 33 The corresponding ceiling is 9 percent in Chile, 10 percent in Argentina, and 10 percent in Colombia. 34 Ricardo Garcia (1995) reports a very important finding regarding the optimal portfolio allocation in Chile. He shows that an efficient portfolio allocation based on observed performance and risk between May 1994 and May 1995 would have included only 5 percent of Chilean assets, 50 percent of European (G7 excluded), 24 percent of G7 assets, 2 percent of Other Latin American assets, and 19 percent of South East Asian assets. In practice, Chilean pension funds invested only 0.6 percent of their portfolios abroad (March 1995). -46- D. OVERALL UNFUNDED PENSION LIABILITIES AND CASH FLOW ISsuEs Consolidated Implicit Debt 4.25 All three pension regimes analyzed in this note give rise to liabilities. The importance of quantifying these liabilities lies in the fact that they shed light on the Government's intertemporal budget, hence allowing a better assessment of the sustainability of other planned investments. This highlights the importance of designing a financing plan for these liabilities by taking into account all resources available, including the proceeds of privatization. Indeed, sound fiscal management favors using the proceeds of privatization to reduce Government's liabilities rather than to finance recurrent expenditures. It is also important to analyze the cash flow implications of these liabilities because of their very different maturity structures. 4.26 The consolidated pension debt is shown in Table 12 under three assumptions about the discount rate.35 Using a discount of 4 percent, the consolidated implicit debt of all three pension systems is estimated at 51.2 percent of 1994 GDP. Of this debt, the largest proportion is attributed to the public pension system (33.3 percent of GDP). Within the public pension system, contributors' acquired rights account for 26.8 percent of GDP. In general, the Peruvian public pension debt is relatively low compared to that of countries with a much older population and wider coverage such as Uruguay (216-295 percent). The maturity structure of the implicit debt is shown in Table 13. About 34 percent of the public pension debt need to be serviced between 1995 and the year 2000. 4.27 The implicit debt created by the civil servant pension system with a discount of 4 percent is estimated at 9.9 percent of GDP. In sharp contrast to the public pension system debt, the civil servant debt is mostly (77 percent of total debt) due to actual pensioners rather than contributors. This is explained by the fact that the ratio of pensioners to contributors is 0.17 for the public pension system and 3.5 for the civil servant one. The civil servant pension system has the shortest maturity, more than half of the debt needs to be serviced between 1995 and the year 2000. This makes the civil servant pension problem a more pressing fiscal issue because it is financed out of general revenue. 4.28 The liabilities associated with the private pension fund have two components. The first one comes from the recognition bonds promised to workers who have switched from the public pension regime to the capitalization regime. The present value of these bonds with a 4 percent discount is estimated at 3.2 3 It should be noted that when estimating the size of the implicit debt, a "termination hypothesis" is adopted. Thus, it is assumed that all contributors are reimbursed starting today using a pension that is prorated by the worker's age to the normal retirement age. It is important to keep this hypothesis in mind when analyzing the maturity of the debt attributed to contributors because payments start prior to retirement. -47- percent of 1994 GDP." Because the recognition bonds do not bear any real interest and mature at retirement only 22 percent of the present value of this debt will be serviced between now and the year 2010. The second component of the liabilities associated with the private pension fund are the ones that would arise if Peru decided to implement a minimum pension guarantee. In other words, unlike the other sources of debt, the one arising from the minimum pension insurance has not been committed yet. 4.29 With a minimum pension of 20 percent of the average wage and a requirement to have contributed 20 years, the debt is estimated at 4.7 percent of GDP. It is important to note that this debt would have to be serviced at a time when both the public and the civil servant pension systems would be virtually phased out, provided (as recommended) all new entrants to the labor market are required to join the capitalization scheme. About 80 percent of the minimum pension liabilities towards current affiliates would need to be honored between 2011 and 2030 (see Table 13). Consolidated Cash-flow Accounts 4.30 The implicit pension debt gives a good indication of the intertemporal fiscal stance. It is important, however, to take into account cash-flow considerations as the Government faces obvious borrowing constraints. The cash flow needs are captured by Table 14, which shows the consolidated accounts of all three pension regimes. Throughout the projections real GDP growth and annual inflation are set at 3 and 10 percent, respectively. For the public pension system, it is assumed that the system is phased out, since all new entrants into the labor market would join the private pension system. The consolidated deficit of all three pension systems would average 0.7 percent of GDP in 1995-2000 and fall below 0.2 percent of GDP after the year 2040. Based on the existing pension systems, very few countries, if any, can expect a similar fiscal improvement. 4.31 Expenditures under the public pension system are separated into three components. The first component is attributed to the current stock of retirees. For these retirees, expenditures would gradually fall from 0.6 percent of GDP in 1995 to 0.3 in 1999. Given current life expectancies, these expenditures would disappear by the year 2023. The second component is attributed to future retirees from the current pool of workers affiliated with the public pension system. For this group, expenditures would average 0.05 percent of GDP a year in 1995-2000. 36 It should be noted that an earlier World Bank estimate for the present value of these bonds was 4.2 percent of GDP (see Peru: Public Expenditure Review, Report No. 13190-PER, October 31, 1994). The previous estimate, however, assumed that 1.25 million workers would be entitled to a recognition bond. In this case, because we are looking at the consolidated debt, we confine the calculation to the actual number of workers who have already switched. Workers who are expected to switch later are still taken into account in the public pension debt. 3 The debt calculation is confined to current affiliates rather than incorporating projections about future affiliates. -48- The third expenditure item represents the administrative cost that is kept at its current level relative to pension expenses (15 percent). Since pension expenditures gradually reduce to zero so does the administrative cost. This is an additional benefit of having minimum pension guarantee under the capitalization regime while phasing out the public pension system. Overall, the deficit in the public pension system would average 0.10 percent of GDP in 1995-1998. Provided that the administrative cost falls with pension expenditures, the public pension system will enjoy a period of small surplus in 1999-2020. Subsequently a deficit will take place as the pool of contributors disappears. In short, phasing out the public pension system does not represent a major source of fiscal imbalance as long as the administrative cost is reduced proportionately to benefit expenses. 4.32 The civil servant pension system is by far the biggest source of cash flow imbalance, since it is financed directly out of general revenue. Again, the fiscal accounts presented are based on the assumption that the civil servant pension system, just like the public pension system, would be phased out. This is relatively easy to do because there are very few active workers in this system compared to pensioners. The phasing out period could be accelerated through incentives given to active workers to opt out of the system. This could take the form of a recognition bond mechanism similar to the one that has been designed for workers shifting from the public pension system to the capitalization regime. Pension expenditures of the civil servant system would average 0.5 percent of GDP in 1995-2000. Most of this cost would be attributed to the existing stock of pensioners. For state-owned-enterprises that have been or are in the process of being privatized the management and payment of future pensions could be shifted to private pension funds by transferring to them some of the privatization proceeds necessary to continue paying pensions through the already existing mechanism of phased withdrawals. This would help boost the industry in a relatively small market while removing the temptation for the Government to either use these funds for other purposes or force investment into low or even negative returns. 4.33 Annual Government expenditures arising from the private pension system appear in the lower panel of Table 13. The first component is made of recognition bonds, which would average 0.03 percent of GDP in 1995-2000. The payment of these recognition bonds would reach a peak of 0.17 percent of GDP in the year 2014 and fall gradually to zero by the year 2042, which is the expected date of retirement of the last recognition bond beneficiary.38 It is important to include these payments into the budget planning process to avoid unnecessary delays. If the Government decided to adopt a minimum pension guarantee, then an additional source of expenditures would be created. But as shown in the table if eligibility to a minimum pension requires 20 years of contribution, then the first outlays would appear only in the year 2013. 38 It is important to note that annual expenditures implied by the minimum pension guarantee take into account the fact that new entrants into the labor market would be required to join the private pension system. -49- E. SUMMARY OF RECOMMENDATIONS AND TRANSITION ISSUES Adopt a Unified Pension System 4.34 This entails making the capitalization scheme mandatory for new entrants, adding a minimum pension guarantee to the capitalization regime, transforming the national pension regime into a flat social assistance scheme, and phasing out the civil servant pension scheme. If Peru decided instead to keep an earnings-related public pension scheme, then the need to equalize contribution rates and statutory retirement ages would become even more pressing. Accelerate the Phasing-out of the Civil Servant regime 4.35 This can be done at least in two ways. First, for enterprises that.have been or are in the process of being privatized, pension payments to current retirees could be shifted to private pension funds. In principle, the Oficina de Normalizacion Provisional (ONP) is responsible for managing pension payments of privatized companies by creating appropriate reserves. International experience indicates that partial funding managed by the public sector is very likely to fail. A better approach would be to shift the reserves backing the cedula viva to private pension funds, which could use them to design individual accounts of phased withdrawals (retiro programado). This has the added advantage of not requiring any heavy administrative structure and new investment regulations. The allocation of reserves to private pension funds should be done through a bidding process in which group policies would be designed, but a single private pension fund should not be allowed to have more than a certain proportion of total reserves and affiliates. Because of the magnitude of the funds involved, allocating them to a single private pension fund would undermine the competitive nature of the industry. The estimated reserves for pension payments are estimated at US$108 million for only three privatized enterprises that would be good candidates for a pilot program.9 The relative size of these reserves becomes obvious by noting that total accumulated funds by private pensions are estimated at US$253 million (1994). 4.36 Another way of accelerating the phasing-out of the civil servant pension would be to design a recognition bond mechanism similar to the one adopted for workers shifting from the national pension system to the capitalization regime. The dilemma is that making the bonds actuarially fair would induce more workers to opt for it, but at the risk of being too costly. One could argue, however, that there is risk premium attached to any implicit government promise that would 3 According to the Government's actuarial studies, the reserves required for pensioners associated with Electrolima and EMSAL are US$45.2 and US$7.9 million, respectively. The new owners of the privatized telephone company (Telefonica) have also estimated the reserves necessary to meet future pension payments that fall under the Government's responsibility at US$55.3 million. The total for these three companies alone is therefore US$108 million. -50- induce workers to accept an explicit recognition bond maturing at retirement rather than a promise of a full pension over an entire retirement period. Fiscal Incentives 4.37 Starting in June, contributions to the private pension fund are no longer deductible from the personal income tax while pensions would remain taxable, therefore creating an unjustified double taxation. Notwithstanding the need for Peru to improve its tax ratio, the personal income tax should be applied to either contributions or pensions but not both. A better approach would be applying deductibility to contributions and taxing pensions. This deduction, however, should apply only to the mandatory contribution component (10 percent). Any contribution in excess of the mandatory level would be taxed. 4.38 The VAT base should be kept as broad as possible. For this reason, commissions to private pension funds should be included in that base. Life insurance should also enter the VAT base provided the necessary adjustments are made not to tax its saving component. Contribution Level and Structure 4.39 The new draft law suggests reducing the contribution rate to individual accounts from 10 to 8 percent. This appears to be an attempt to close the gap in contribution rates between the public pension system and private pensions. There are, however, many reasons for keeping the contribution rate at 10 percent. First, after taking into account unemployment and other sources of non-contribution, the 10 percent rate does not appear to lead to excess savings. Second, the new draft law suggests implementing a ceiling on contributions that would limit further the possibilities of excess savings. Third, the pension law allows for the possibility of early withdrawal when the accumulated fund reaches a certain level. It is therefore preferable to keep the current contribution rate of 10 percent until there is clear evidence that the rate is not satisfactory. The difference in contribution rate between the two regimes should not dictate such a change. 4.40 The differences in the structure and level of contributions between the two main pension regimes require an adjustment. Currently, the entire contribution to the private pension fund is deducted from the worker's salary whereas contributions to the national pension scheme are nominally shared by the employer (6 percent) and employee (3 percent). Removing this asymmetry, by shifting the entire contribution to the national pension system to the worker, would contribute to eliminating the perception that the private pension system is too costly. This would need to be accompanied by an increase in the salary such that take-home income remains unchanged. In the same spirit, if Peru decided to keep the one percent solidarity contribution, then it should be applied to all workers. -51- Investment Regulations and Minimum Return 4.41 Peru has a more restrictive policy regarding investment in foreign assets than other Latin American reformers. To achieve greater international portfolio diversification the ceiling on foreign assets could be increased to at least 10 percent. Although, the minimum investment return penalizes good performers, improving its mechanism along the lines of the Colombian scheme seems preferable to eliminating it altogether. Appropriate Budgetary Allocations 4.42 Moving towards a unified and improved pension system entails recognizing current and future liabilities and funding them. This is very obvious, for instance, in the creation of a minimum pension guarantee, which should be explicitly inserted in the budget as soon as it is adopted rather than waiting for the first payments to be due. The same holds about the recognition bonds. It is important for Peru to make provisions for these liabilities by using, among other sources of revenues, the privatization proceeds. Only then, would the budget contain the intertemporal flavor that contingent liabilities call for.40 40 See Blejer and Cheasty (1991). -52- TABLE 10: PERU'S MAIN PENSION REGIMES PROGRAM DESCRIPTION RETIREMENT PENSION YEAR LAW SCOPE BENEFITS OFFERED ELIGIBILITY FINANCING AND FUNDING CREATED 1965 DS 04-65-TR WORKERS OF THE FISHING HEALTH, WIDOW'S PENSION, ORPHAN * 55 YEARS OF AOE THE MAXIMUM AMOUNT OF THE INDUSTRY ALLOWANCE, AND OTHERS * MINIMUM 15 WEEKLY CONTRIBUTIONS PER RETIREMENT PENSION IS EQUAL TO 80% OF THE FIVE YEAR AVERAGE SALARY * REGISTERED IN THE CBSSP RECEIVED DURING THE LAST FIVE YEARS. * HAVE FISHER ID 1973 DL19990 ALL WORKERS AND SELF- RETIREMENT, SURVIVAL, DISABILITY. * 60 YEARS OF AGE FOR MEN AND 55 FOR WOMEN 50% OF THE SALARY OF THE FIRST (UNDER ONP'S EMPLOYED * 20 YEARS OF CONTRIBUTION TWENTY YEARS OF SERVICE, AND AN JURISDICTION) ADDITIONAL 4% FOR EVERY YEAR OF SERVICE. BY LAW, THE MAXIMUM PENSION IS STIPULATED IN S./600. THE WORKER CONTRIBUTES 30%, AND THE EMPLOYER ANOTHER 6%. 1974 DL21021 MILITARY AND POLICE RETIREMENT, WIDOW'S PENSION, ORPHAN * AFTER 15 YEARS OF SERVICE FOR MEN AND 12.5 FOR 15-20 YEARS OF SERVICE, THE PERSONNEL ALLOWANCE, (ASCENDVIENTS) PENSION WOULD EQUAL 1/30 OF THE SALARY CORRESPONDING FOR EVERY OF SERVICE. AFTER 30 YEAR OF SERVICE THE AMOUNT OF THE PENSION WILL EQUAL TO THAT OF THE SALARY. FOR 35 YEARS OF SERVICE OR MORE, THE PENSION WOULD INCREASE DEPENDING ON THE NUMBER OF YEARS OF SERVICE, AND THE PENSION REMUNERATION IS IN RELATION TO THE REMUNERATION OF THE TOTAL SALARY OF THE IMMEDIATE HIGHER GRADE. THE WORKER CONTRIBUTES 6% AND THE EMPLOYER ANOTHER 6%. 1974 DL20530 PUBLIC SECTOR WORKERS NOT RETIREMENT, PENSION OF THE * 30 YEARS OF SERVICE FOR MEN AND 25 FOR FINANCED BY GENERAL REVENUES, THE (UNDER ONP's INCLUDED IN DL 19990 SUSPENDED OFFICIAL, WIDOW'S PENSION, AMOUNT OF THE PENSION EQUALS TO THAT JURISDICTION) ORPHAN'S ALLOWANCE, SURVIVOR, OF THE SALARY OF AN ACTIVE WORKER. DISABILITY THE WORKER CONTRIBUTES 6% AND THE EMPLOYER ANOTHER 6%. 1992 DL25897 WORKERS OF THE PUBLIC AND RETIREMENT, SURVIVOR, DISABILITY, * 65 YEARS OF AGE FOR MEN AND WOMEN THE CONTRIBUTION SCHEME IS THE PRIVATE SECTOR, AND THE OTHER BENEFITS FOLLOWING: 10% FOR THE SELF EMPLOYED CAPITALIZATION ACCOUNT, 1.9% FOR THE VARIABLE COMMISSION, S./ 1.45 OF FIXED COMMISSION, AND 1% FOR THE IPSS. -53- TABLE 11.1: THE COST OF A MINIMUM PENSION GUARANTEE WITH AN AVERAGE RETURN OF 5% (AS A MULTIPLE OF THE AVERAGE WAGE AT RETIREMENT) STARTING WAGE (% OF AVERAGE FREQUENCY COST OF MINIMUM PENSION GUARANTEE WAGE) MP = 20% MP =25% MP = 30% MEN WOMEN MEN WOMEN MEN WOMEN 14.8 0.132 18.1 19.1 25.2 26.2 32.2 33.3 25.2 0.177 10.9 12.6 18.0 19.7 25.1 26.8 42.0 0.165 0 2.1 6.5 9.2 13.6 16.3 58.8 0.096 0 0 0 0 2.0 5.8 75.6 0.075 0 0 0 0 0 0 92.4 0.055 0 0 0 0 0 0 117.6 0.08 0 0 0 0 0 0 NOTE: MP = MINIMUM PENSION AS A PERCENTAGE OF AVERAGE WAGE TABLE 11.2: THE COST OF A MINIMUM PENSION GUARANTEE WITH AN AVERAGE RETURN OF 3% (AS A MULTIPLE OF THE AVERAGE WAGE AT RETIREMENT) STARTING WAGE (% OF AVERAGE FREQUENCY COST OF MINIMUM PENSION GUARANTEE WAGE) MP =20% MP = 25% MP = 30% MEN WOMEN MEN WOMEN MEN WOMEN 14.8 0.132 22.1 22.7 29.1 29.8 36.2 36.9 25.2 0.177 17.7 18.8 24.8 25.9 31.8 32.9 42.0 0.165 10.7 12.4 17.7 13.1 24.8 26.5 58.8 0.096 3.7 5.9 10.7 6.7 17.8 20.1 75.6 0.075 0 0 3.7 0.28 10.8 13.8 92.4 0.055 0 0 0 0 3.7 7.4 117.6 0.08 0 0 0 0 0 0 NOTE: MP = MINIMUM PENSION AS A PERCENTAGE OF AVERAGE WAGE KEY COMMON ASSUMPTIONS REAL WAGE GROWTH = 2% MALE CONTRIBUTION DENSITY 61% FEMALE CONTRIBUTION DENSITY 56% AGE OF ENTRY TO LABOR MARKET = 20 -54- TABLE 12: IMPLICIT PENSION DEBT (AS A PERCENTAGE OF 1994 GDP) DIScoUNT FACTOR D=2% D=4% D=8% CONSOLIDATED LIABILmEs 68.91 51.20 32.46 I PUBLIC PENSION SYSTEM 42.431 33.351 22.429 1.1 STOCK OF PENSIONERS 7.875 6.581 4.869 1.2 ACQUIRED RIGHTS CONTRIBUTORS 34.556 26.770 17.560 II CIVIL SERVANT PENSION SYSTEM 11.995 9.878 7.249 1.1 STOCK OF PENSIONERS 9.058 7.636 5.783 GENERAL GOVERNMENT 6.271 5.287 4.004 NON-FINANCIAL INSTITUTIONS 0.995 0.839 0.635 FINANCIAL INSTITUTIONS 1.791 1.510 1.144 1.2 CONTRIBUTORS 2.937 2.242 1.466 GENERAL GOVERNMENT 2.658 2.028 1.326 NON-FINANCIAL INSTITUTIONS 0.045 0.034 0.022 FINANCIAL INSTITUTIONS 0.235 0.179 0.117 III PRIVATE PENSION FUNDS (AFPS) 14.48 7.968 2.783 1.1 RECOGNITION BONDS 5.183 3.226 1.426 1.2 MINIM um PENSION GUARANTEE 9.30 4.743 1.358 TABLE 13: MATURTY STRUCTURE OF THE IMPLICIT DEBT 1995- 2000 2001-19 2011-20 2021-30 2031-40 2041-50 2051+ TOTAL I PUBLIC PENSION 33.87 40.77 18.74 5.84 0.75 0.02 0.00 100 SYSTEM - PENSIONERS 46.40 39.90 11.70 1.83 0.14 0.02 0.00 100 - CONTRIBUTORS 30.79 40.99 20.47 6.82 0.90 0.02 0.00 100 II CIVIL SERVANT 50.40 35.99 11.25 2.11 0.23 0.02 0.00 100 PENSION - PENSIONERS 50.40 35.99 11.25 2.11 0.23 0.02 0.00 100 - CONTRIBUTORS 33.05 36.07 19.73 8.58 2.32 0.25 0.00 100 III PRIVATE PENSION 0.31 0.89 19.55 39.08 37.74 2.43 0.00 100 FUND - RECOGNITION BONDS 5.73 16.56 40.59 26.37 10.68 0.06 0.00 100 - MINIMUM PENSION 0.00 0.00 18.36 39.80 39.28 2.56 0.00 [ 100 -55- TABLE 14: CONSOLIDATED ACCOUNTS OF THE THREE MAIN PENSION SYSTEMS (AS A PERCENTAGE OF GDP) 1995 1996 1997 1998 1999 2000 2020 2040 2060 2075 I PUBLIC SYSTEM 1.1 EXPENDITURES& COMMITMENTS 0.725 0.662 0.588 0.519 0.451 0.394 0.091 0.033 0.001 0.000 - CURRENT PENSIONERS 0.573 0.509 0.451 0.400 0.347 0.307 0.009 0.000 0.000 0.000 - FUTURE PENSIONERS 0.058 0.067 0.061 0.051 0.045 0036 0.070 0.029 0.001 0.000 - ADMINISTRATIVE COSTS 0.095 0.086 0.077 0.068 0.059 0.051 0.012 0.004 0.000 0.000 1.2 REVENUEs 0.504 0.488 0.476 0.465 0.453 0.434 0.143 0.000 0.000 0.000 1.3 DEFICIT -0.221 -0.174 -0.113 -0.054 0.002 0.041 0.053 -0.033 -0.001 0.000 11 CIVIL SERVANT PENSION SYSTEM 2.1 EXPENDITURES& COMMITMENTS 0.639 0.621 0.576 0.533 0.493 0.454 0.065 0.009 0.001 0.000 2.11 CURRENT STOCK OF PENSIONERS 0.629 0.584 0.540 0.500 0.461 0.424 0.035 0.000 0.000 0.000 GENERAL GOVERNMENT 0.435 0.404 0.374 0.346 0.319 0.294 0.024 0.000 0.000 0.000 NON-FINANCIAL INSTITUTIONS 0.069 0.064 0.059 0.055 0.051 0.047 0.004 0.000 0.000 0.000 FINANCIAL INSTITUTIONS 0.124 0.115 0.107 0.099 0.091 0.084 0.007 0.000 0.000 0.000 2.12 FUTUREPENSIONERS 0.011 0.037 0.036 0.034 0.032 0.030 0.030 0.009 0.001 0.000 GENERAL GOVERNMENT 0.010 0.034 0.032 0.031 0.029 0.027 0.027 0.008 0.001 0.000 NoN-FINANCIAL INSTITUTIONS 0.000 0.001 0.001 0.001 0.000 0.000 0.000 0.000 0.000 0.000 FINANCIALINSTITUTIONS 0.001 0.003 0.003 0.003 0.003 0.002 0.002 0.001 0.000 0.000 2.2 DEFICIT -0.639 -0.621 -0.576 -0.533 -0.493 -0.454 -0.065 -0.009 -0.001 0.000 III PRIVATE PENSION FUNDS (AFPs) 0.018 0.017 0.016 0.049 0.032 0.031 0.383 0.192 0.088 0.038 1.2 RECOGNITION BONDS 0.018 0.017 0.016 0.049 0.032 0.031 0.080 0.002 0.000 0.000 1.3 MINIMUM PENSION GUARANTEE 0.000 0.000 0.000 0.000 0.000 0.000 0.302 0.190 0.088 0.038 1.4 GOVERNMENT DEFICIT -0.018 -0.017 -0.016 -0.049 -0.032 -0.031 -0.383 -0.192 -0.088 -0.038 IV CONSOLIDATED DEFICIT -0.878 -0.812 -0.705 -0.636 -0.522 -0.444 -0.395 -0.234 -0.090 -0.038 NOTE: USING SNP ADMINISTRATIVE COST = 15% OF PENSION EXPENSES -56- 5. THE DEVELOPMENT OF REAL PROPERTY RIGHTS IN PERU 5.1 Peru instituted a radical program of economic reform from 1990. It has now begun to bear fruit in the form of a swift economic recovery, substantial progress in the fight against poverty, and the country's reintegration into the world economy. But much of the country is still excluded from even the most basic benefits of a modem society--half the population is still below the poverty line. 5.2 Thus, the government must now address ways in which the poor can be integrated into modem Peruvian society. Integrating the less privileged will require finding ways of extending basic services of law and order, education, health, and communications to the whole population. It will also require giving these people the instruments to earn a better living. 5.3 Formalizing property ownership is one of the most important ways in which a government can arm poor people in their struggle for a better life.4' Property formalization also has a particular role to play in agricultural investment and modernization. If property ownership were formalized, through proper titling and registration, there would be greater security of ownership. As experience has shown in other countries, they would then benefit from a higher value of what they own and from greater choices in how to use it. They could invest more in the property and have better access to credit. Or they could sell or lease the property to others who could make better use of it. 5.4 In Peru, the rights of individuals, families, or groups to ownership of property are often well recognized at the local level, within communities.42 But this ownership is not fully recognized at the broader level of society. Much land in Peru is formally in public ownership and the government wishes to pass it legally into the hands of those occupying it, yet the government does not have the institutions capable of completing the formal steps of transfer. As a result of this informality, about half of all properties in Peru lack a formal title (i.e.. document of ownership), and more important, 90 percent of rural properties and 70 percent of urban properties in Peru are not inscribed in the property registry. These informal properties are typically very small and their owners poor. 4' This note uses "ownership" to denote a full set of rights over a property (including the right to dispose of it) whether these rights are merely customary, i.e. informal, or whether they are legally recognized. This concept may differ from a legal definition, where "ownership" is more likely to refer to legally recognized rights and customary ownership is more akin to "possession". 42 Common property is important in many of Peru's indigenous communities, especially in the sierra. But practically all urban land and a large amount of agricultural land in the costa--Peru's most productive land -- is used and owned, formally or informally, on an individual or family basis. This Note discusses ways in which this latter kind of property can be formalized and does not address the issue of whether and how to formalize ownership of common property. -57- 5.5 For over a century, Peru has had a system to provide legal recognition to real property rights. But this system has only worked for a privileged minority, mostly in urban areas, and done nothing for the poor majority. The system has complex and demanding procedures to establish ownership. Poorer and informal owners cannot afford these or are simply unable to comply with them: government agencies are inefficient and slow in issuing private titles to publicly owned land; similarly, the courts have rarely been able to validate these titles as the law requires; and the property registry has proven similarly inefficient. These failures of government agencies are symptomatic of a broader failure in Peru's machinery of government. 5.6 Meanwhile, Peru initiated in 1988 a new system of property administration which is able, unlike the old, to reach poorer, informal owners. This new system has so far operated on a limited scale, but it has registered effectively, and the economic benefits of formalization are already evident. The new system was able to by-pass most of the problems of the traditional system through a new legal framework, a field campaign which is both educative and makes registration cheaper, an inexpensive cadastre-based information system, and good management. The old system is moribund, while the new system holds the promise of an effective and inexpensive instrument that could formalize property at the national level in Peru. 5.7 This note looks in greater detail at why the traditional system does not work and the new one does. The note also examines the issues and challenges that remain to be solved in the formalization of real property rights in Peru and proposes the establishment of a National Program for Property Formalization based on the new system. A. OWNERSHIP, SECURITY, AND FAIRNESS 5.8 In most countries of the world, the pattern of customary land ownership that emerges over time tends to reflect arrangements that are socially efficient. In other words, the land regime--private versus common ownership or large versus small land holdings, and so on--comes to reflect the economic needs of a community. The regime thereby attains a legitimacy in society. Of course, this does not always mean a regime free of conflict between individuals or communities, especially when social and economic changes create pressures to change the pattern of ownership. 5.9 In this concept of property, the role of the State and the law is not to mandate patterns of ownership, but to assist in administering the social record of ownership. The law is the servant of society's arrangements, not the originator. In this context, a State's system of property administration should be able to: (a) formalize socially recognized ownership (normally by seeing that owners are issued with titles); (b) maintain, through a property registry, a public information system about ownership, changes in ownership, and claims on owners; and -58- (c) provide, whether by administrative or judicial means, the authority for verifying ownership and resolving disputes. 5.10 However effective the State, security of ownership--the degree of certainty that the right cannot be successfully disputed by physical or legal means--is extremely costly to achieve, especially where patterns of property ownership have been changing. By the same token, fairness, or justice, in the State's decisions relating to property is costly--and absolute fairness unattainable. Thus, in practice there is always a need for a trade-off between the achievement of fairness and security in property administration--both highly desirable in themselves--and the cost of achieving these. A land administration system that, for instance, sets standards so costly that it provides some security and fairness for a minority of the population but nothing for the majority makes a trade-off which does not serve society well. This is the case with Peru's traditional system. B. RURAL AND URBAN PROPERTY OWNERSMP IN PERU 5.11 Rural property. Historically, the best rural land in Peru was owned in the form of large estates, often administered in a semi-feudal way. This system began to break down long before the Agrarian Reform of 1969. By the 1960s, the discontent of landless farmers had increased to the point of substantial unrest. A military government came to power in 1968 and passed an Agrarian Reform Law in 1969 which executed a massive, largely uncompensated expropriation of larger holdings. This accounted for over 40 percent of agrarian land. The reform put a definitive end to the feudal agricultural system and set out to collectivize much of Peruvian agriculture. 5.12 The reform was disorganized. Land was adjudicated with unclear priorities--rules were established, but then substantially ignored--and titling was incomplete. Resistance to collectivization then grew as farmers found that it did not work and productivity fell. They started informally subdividing the cooperatives among themselves. Thus, land holding, especially in the costa, evolved into a predominant pattern of private small- holding, with some transfer of ownership, but all this in the context of an informal, unofficial system of property rights. 5.13 Through a series of laws, the government gradually came to accept the validity of these informal arrangements, but it has remained unable to make much progress in the formalization process. This partly reflected the problems of the traditional registry, as we shall see, but it also reflected the failure of another part of government, the Ministry of Agriculture, which since. 1969 has been responsible for issuing titles for rural land belonging to the government. There were huge bureaucratic delays and considerable corruption in the issue of titles. Titles became political currency: in many cases more than -59- one title was issued for the same piece of property. Even today, titles continue to be * 43 issued without an updated cadastre. 5.14 In 1991 the Fujimori Administration formally abrogated the Agrarian Reform Law and restored freedoms to own and dispose of most rural land. The 1993 Constitution additionally allowed the possibility of removing the constraints on transactions relating to the smallest and largest holdings. But these reforms cannot have their full effect all the time, as the traditional system of land administration continues to impede formalization of ownership. 5.15 Urban property. In the last half century there has been a massive migration from the rural sierra to urban areas and the costa. This came about because of the collapse of the rural estate system, better communications, and the growth of industry and government in the main cities. As a result, there was a substantial growth in informal land ownership (human settlements) in the cities which occurred mostly through systematic and organized "invasions" of land and sometimes through cooperative purchases of land. Virtually all the invaded land was publicly-owned land on the periphery of cities, already designated for urban expansion. Only four percent of the invaded land was private. 5.16 The invasion process has been more systematic and "legitimate" than might at first appear--and probably much more so than in other poor countries. At first, the government and municipalities tried to resist the land invasions. But the invaders and the authorities moved to a political accommodation. Starting with regulations issued from.the late 1950s onwards, a legal framework was established which enabled all human settlements to start their lives with the expectation of later becoming formal and therefore of following, from the beginning, the existing zoning regulations for urban expansion." Similarly, as a part of this political accommodation, individual informal owners (who have the same legal tax obligations as formal owners) have tended to pay their property taxes since this is seen as an "investment" in the formalization process. 5.17 Thus, as with rural property, the State came to acquiesce in a new pattern of ownership. But, as in the rural area, it has been unable to complete the process of formalization, for two reasons. First, the municipalities, who own public urban land, normally take, according to one study, anything from seven to 20 years to issue titles in a bureaucratic process requiring over 200 steps. The municipalities thus exhibit the same failings as did the Ministry of Agriculture. Second, the traditional land administration system has been able to register virtually none of the titles, or else only able to register them at a huge cost. 43 A cadastre is an official record of the quantity, value, and ownership of real property, basing the record on a geographic map with property delineations. 44 Some of the original settlements occurred before zoning laws were introduced in 1963 and then had to comply with these ex post. -60- C. THE TRADITIONAL SYSTEM OF PROPERTY ADMINISTRATION 5.18 The traditional and new systems of property registration each require the combination of three public agencies to work if property is to be formalized: the government agency (Ministry of Agriculture or municipalities), which issues titles to publicly-owned land; the courts, which usually play a role in declaring a property formalized and in resolving disputes about ownership; and the registry.45 5.19 The traditional system has systematically discouraged formalization of property in several ways. In the rural areas land transactions were curtailed by the terms of the Agrarian Reform law and, when titles were issued, the information base was so poor that they had a dubious value. In both rural and urban areas, three common factors were at play: the administrative inefficiency of government agencies in issuing titles, the inefficiency and costs of the judicial system, and the inefficiency and costs of the registry. 5.20 The innovation of the new system is that, through new laws and a "pro-active" approach, the registry is able to circumvent many of the problems confronting the traditional system. In the following paragraphs, we principally compare the two registries. The registry in the traditional system is Registro Publico de la Propiedad Immueble (RPI) and in the new system Registro Predial (RP). But it should not be forgotten that these registries are each part of a larger system. 5.21 The two registries share common ground. In both systems, registration is voluntary, though a registered title has a prior claim to an unregistered one. With small exceptions, they register the same rights of ownership and claims on ownership (such as mortgages),4 while they cover separate jurisdictions. RP is responsible for urban human settlements (asentamientos humanos, including pueblos jovenes) and urban housing associations (urbanizacionespopulares) and for any rural area where it is given jurisdiction. RPI is responsible for other (i.e. "formal") urban areas and other rural areas. 5.22 RPI was established in 1888, largely to serve the interests of a small class of owners of formal property, and its procedures reflect in part the simple information needs of a small system with few transactions. The information registered takes the form of a narrative of civil and physical information about the,owner and his or her property, without the use of any universal parcel-based locator system such as a cadastre would provide. As a result, information is not archived by geographical regions but by the owner's name. RPI mostly operates manually, storing all information in large books 45 By "property formalization" in the context of the traditional system in Peru, we mean either the registration of a title for the first time (usto titulo and titulo suppletorio) or the registration of an ownership through adverse possession (posesion adquisitiva)' Both require a judicial declaration prior to registration and, in practice, both are submitted to the same criteria of proof. 46 Under the new system, possession can, under certain restricted circumstances (see paragraph 29), be registered. Under the old system, agricultural holdings of less than three hectares cannot be registered. -61- (tomos) and/or index cards (fichas). The registry verification of an application to register a title consists of a check that the personal and locational information in the application precisely matches the information of the last entry in the registry. 5.23 Transactions with the RPI require the services of a notary. By putting her or his name to a document, the notary elevates it to a public document (escritura publica), thereby endowing the document with a presumption of veracity which can only be rebutted by a court proceeding. The notary does not usually provide legal and physical verification of a title, but verifies the contents of a document prepared by a lawyer by checking its correspondence to antecedents in the registry (the chain of title) and the standing of those who signed it. Notaries in Peru are a tightly regulated monopoly--until recently, there were only 40 of them in Peru--and their fees are correspondingly high. 5.24 To apply for registration of a title never previously registered or of ownership based on adverse possession (continuous, pacific and public possession for a specified period), the applicant must first obtain a judicial declaration of ownership (which then becomes the title). 5.25 The traditional system creates a very large disincentive to register, a disincentive bearing heavily on informal owners to the point where many land owners perceive that registration will prove impossible for them. The general disincentive has several causes. First, the documentary and notarization requirements are expensive in themselves (and in many cases impossible to fulfill). The average cost of a registration, including fees to notaries and lawyers, is about US$340. Second, the Registry's internal processing methods are inefficient, given its antiquated methods and organization (including the absence of maps). Third, documentary requirements and inefficiency allow Registry employees to create bureaucratic obstacles to registration, while there is little countervailing incentive for them to register. These obstacles occur when information from the last entry (on names or boundaries, for instance) is found not to match, when the previous registration cannot be found, when more than one title has been issued, and so on. 5.26 For the overwhelming majority of informal owners, this general disincentive to register is compounded by the specific problems of informality. First, Peru's laws and a badly functioning judicial system are in practice unable to convert adverse possession and ownership without title into valid titles at an acceptable cost. Registration of an adverse possession could cost about US$2,000 and could typically take six years. Second, particularly as the pattern of ownership in Peru's economy has become more complex, the inefficient operation of other relevant public agencies--the execution of the Agrarian Reform, the Ministry of Agriculture's subsequent adjudication activities, and the cadastre-- has not helped either. 5.27 Under this system, only about 105,000 of Peru's estimated 2,400,000 rural properties have been registered. In the towns, RPI has been unable to respond to the needs of marginal settlements, while even with more conventionally titled urban -62- properties, the registry is costly and difficult to deal with. The traditional system's inability to address the problem of informality and its general inefficiency now have important distributional effects. Most small farmers and the urban poor are excluded from the advantages of registered ownership, while only the better-off are able to navigate their way through a rent-seeking system. D. THE NEW SYSTEM OF PROPERTY ADMINISTRATION 5.28 The informal sector became the subject of intense study by the Instituto Liberdad y Democracia early in the 1980s. In the specific area of real property rights, ILD's analysis pointed to a failure of political will on the government's part to build adequate mechanisms to transfer information on ownership from the informal to the formal level. This led ELD to design a mechanism to collect information at the grass-roots (community) level and convey it to a new registry, Registro Predial. This registry was established by Laws 495 and 496 in November 1988 to register informal urban areas. In September 1991, Law 667 also established RP as a rural registry. These laws created a distinctly new system of property administration characterized by: (a) a new legal framework to by-pass institutional rigidities in the traditional system; (b) a pro-active campaign approach to educate beneficiaries about the benefits of property formalization, to use local information and authority to identify ownership and resolve conflicts, and to gain the economic benefits of mass- registration; (c) an inexpensive information system using a universal parcel-based cadastre; and (d) an autonomous agency status. 5.29 The new legal framework. The new laws innovate in two areas. (a) RP can register properties for the first time, under certain circumstances, without the need for a judicial declaration. First, the claim must be uncontested. Second, this facility applies to all previously unregistered titles and to cases of adverse possession of publicly-owned land and rural privately-owned land (i.e. excludes adverse-possession cases for privately- owned urban land). Third, such registrations require the presentation of a variety of documents that provide evidence of ownership or possession for the required time.47 Fourth, registration of adverse possession requires 47 Tax receipts can be used as part of this evidence, but unlike RPI, RP does not require proof of payment of property taxes as a condition of registration. -63- prior notification to the owner and neighbors, as well as publications in newspapers. (b) Notaries are no longer required in any transactions with RP (though nothing prevents them being used). Instead, certified private agents (lawyers and engineers) must carry out legal and physical verification, in the field, of applications to register. 5.30 The field campaign. In 1992 ED devised a practical process of property regularization in the field (baptized as "PROFORM"). The field work is a long and crucial process starting from the identification of an area (for instance a valley) and of grass-root organizations (or community representatives) through to helping beneficiaries resolve the problems they may have with the supporting documentation. This process is meant to build a relationship of greater trust between a state institution (RP) and the beneficiary and thereby to contribute to greater security of ownership. 5.31 A field campaign in a specific area first contacts grass-root community organizations to explain the benefits and user costs of registration through RP. It uses simple, standardized application forms to collect information. It uses community knowledge and leadership to resolve, on the spot, as many property conflicts as possible. This information is then legally and physically verified in the field by the certified verifiers. Verification helps resolve any conflicting ownership claims. 5.32 The cost advantages to large-scale registration through area-based campaigns are substantial: handling a large number of properties with common boundaries leads to economies of scale in data collection and verification. In addition, this efficient form of data collection is vital in providing the information that the municipalities and the Ministry of Agriculture need for the issue of titles. 5.33 The information system. Registration itself is a simple process of final verification of ownership information, its entry into the computer, and the issue of a registration certificate. The heart of the registry's information system is an index-based legal cadastre in which each plot has a unique numerical location. Information from the physical verification--basically a land survey of the individual property and of the whole area (for example the valley)--is used to update the cadastre. Computers greatly facilitate a parcel- based system, but RP does not require expensive hardware, software, or mapping systems. 5.34 The autonomous agency. RP was established as an autonomous agency of the government. This gave it substantial managerial freedom. Employees were subject to the private labor regime and enjoyed wages set at a competitive level. In the pilot phase of the registry, it was substantially managed by LD personnel. LD itself was supervised by USAID and the World Bank, both of which provided technical assistance. -64- 5.35 Security of ownership. There has been much discussion in Peru of the security that the new system offers48 of which most has been narrowly based on finer points of law. This note has taken the broader view (paragraph 8) that property rights are rooted in social norms and that the State's role is to assist in administering the social record. By this token, it is difficult to defend the legal security of a traditional system which was only ever able to register a small minority of properties. Among the majority, on the other hand, are a great many with strong custom-based claims to ownership. What is more, for those of them who occupy public land, government agencies are often committed to transferring full ownership. A system that is not able to accommodate the interests of the majority fails to serve the country. 5.36 Even on narrower, more technical grounds, it is simply not clear that the new system lacks security compared to the traditional one. First, the new system is characterized by secure, standardized, and accessible records. Second, property information is professionally verified in the field and stored in a cadastre-based system. Third, the new system has not resulted in cases of dual registration (i.e. competing ownership claims for the same property in the two registries). Fourth, only a very limited number of uncontested claims of possession have in fact been registered without a judicial procedure.49 5.37 In general, it can be said that the Government has in effect declared its view that the new system is acceptable by incorporating RP into a new Superintendency of Registries for five years (see paragraph 46 below). What is more, the market is already "testing" the new system (see also paragraphs 38 to 43 below): financial intermediaries have so far shown no reticence in accepting the collateral value of properties registered in RP. Of course, the passage of time will shed firther light on the issue of security under the new system since security is as much a matter of the public's confidence in the system as it is of legal procedures. The New System of Property Administration: Some Initial Results 5.38 Registro Predial was first tested in urban informal areas in Lima through a USAID- financed pilot (1991) and in urban and rural areas in Lima through a World Bank pilot project (financed by a Bank-administered Japanese Grant Facility) in 1992-93. The results are impressive. RP has so far registered about 150,000 properties, more than half of this under the 13-month pilot with the World Bank. The average cost of registration is about US$12 and the average time to register is at most a week. Clearly, the new system has shown significant cost and time advantages over the old, and it is not surprising that it has proven far more effective at producing registrations. There are some indicators that formalization of property rights is beginning to bring the expected benefits. These indicators come from preliminary and partial studies and recent market developments. 48 There has been particular criticism from the notaries, who no longer enjoy a monopoly under the new system. 49 In practice, in almost all cases so far, the municipalities and the Ministry of Agriculture were able, thanks to the help of PROFORM, to issue titles before registration took place. -65- Thus, individually, the indicators may not yet provide robust evidence of benefits. But taken together, they strongly suggest that the new system is beginning to bring important benefits. 5.39 Urban property. In urban areas several private banks and some private companies (supplying construction materials and financing consumer durables) have started to provide credit on the basis of mortgages on RP-registered property. They have been attracted by the low cost of transacting in the RP and the access to new markets. From 1990 to 1995, 1,123 mortgages (94 percent of them urban) were registered in RP, for a total value of US$4.5 million. One firm which sells construction materials financed a recent field campaign to register 23,000 new properties (operating in areas where a field campaign had already laid the groundwork). Its intention is to offer mortgages and then trade these in a secondary market for mortgages. 5.40 A current study uses a small sample of 175 properties in two human settlements in Lima (Huaycan and Villa El Salvador) to trace the effects of registration over the last few years. Preliminary results have found that registration has increased property values by 60 to 250 percent over what they would have been if the property had remained untitled, while the additional fixed investment encouraged by formalization has added another 20 to 80 percent. 5.41 Formalization has not led to any increase in property taxes collected. Statistics for different tax districts in Lima indicate that informal urban owners are more assiduous in paying their taxes than formal owners. This is probably because informal owners are anxious not to compromise their chances of formalization. 5.42 Rural property. The RP pilot project in rural areas was smaller than in urban areas, resulting in fewer new registrations. Private commercial banks had abandoned the rural areas in the 1980s as the Banco Agrario increased its subsidized operations. These banks have proven understandably timid in returning, but RP registrations are beginning to be used in bank lending. One company involved in agricultural extension is exploring the possibility of lending for agricultural equipment and supplies on the basis of RP registrations. 5.43 A recent study analyzed the effect of registering 286 individual plots of citrus farmers who formerly constituted a cooperative in Huaral. In 1994, the first year in which the plots were operated fully individually for the first time, the following changes could be measured: the volume of output increased by around 50 percent over 1993; investment became positive after having been non-existent for several years; and the average working day reached eight hours, compared to an average of four hours in recent years. 5.44 Rural-urban migration. There is no evidence in Peru that would link property formalization to the rate of migration. (In any case, there has been too little formalization for any measurable effect to be isolated.) Since the mid-1980s, there has been a sharp decrease in the rate of migration. The rate of migration is mostly affected by levels of -66- education and relative urban and rural employment opportunities, and even a significantly higher rate of property formalization in the future is unlikely to have a large effect on migration. The Challenges and the Options 5.45 Recent developments. When funding for the pilot project was terminated at the end of 1993, RP was no longer able to continue its field campaigns and reverted to passively providing, like RPI, services at the request of the public. In fact much of the technical team that had designed and run the field campaigns was following ILD's withdrawal of support. 5.46 1993 and 1994 also witnessed a period in which alternative initiatives to strengthen, weaken, or unite the two real property registries were expressed in a succession of draft laws. The dispute involved a number of different public and private interests. In October 1994 Law No. 26366 brought all Peru's registries together under one Superintendency of Public Registries. It provided for RP to maintain its autonomy within the Superintendency and to continue to provide registry services for five years, operating in parallel with RPI but in different jurisdictions. RPI would take over at the end of this period. The new law formally resolved some past issues (about the legal security of the new registry, for instance). However, the law did not resolve the dispute. RP's autonomy within the Superintendency was recently removed. 5.47 An effective new system. There is widespread acceptance of the need to formalize property ownership in Peru. The country has the means to do this through its experience with the new system of property administration. As this note has shown, the new system has proven effective because it created a strategy to circumvent most of the obstacles facing the old system. It created a new legal framework to circumvent problems in the legal system, used a field campaign to educate the beneficiary (and to reduce the costs of registration), adopted an innovative, but inexpensive cadastre-based information system, and was managed efficiently (outside the traditional structure of government). All these elements explaining the success of the system are important: the system not work without them, nor can any of them can be individually applied in an attempt to "patch up" the traditional system. 5.48 The potential of Peru's new system is consistent with what the World Bank has learned about property administration systems in other countries. Traditional forms of titling and registration (involving expensive cadastral surveys, for instance) have proven costly and ineffective in tackling the pervasive problem of informal ownership. On the other hand, titling and registration systems that proceed area by area, that are based on information held by the local community, and that settle all ownership claims simultaneously have proven effective in formalizing ownership." Box 1 recounts some of so Another prior condition for developing land markets, according to this same experience, is to establish policies which eliminate the major market distortions, in particular laws allowing freedom -67- the experience the World Bank has gained about the relationship of effective titling in rural areas to economic benefits. Box 1. The benefits from rural land titling The World Bank's experience suggests that, in situations where rural land has been titled and registered in response to a clear demand from beneficiaries and has been conducted in the framework of a favorable overall land policy, this has increased farmers'.access credit and their incentive to invest. Thus agricultural productivity has been enhanced as a whole. The most rigorous confirmation is available from a World Bank study conducted in Thailand (Feder et al. 1988) that came to three main conclusions. 5.49 The challenges. If Peru's new system is to be exploited, two particular challenges must be mentioned. The effectiveness of the registry. The new system has been in large part deactivated. Without the field campaign (PROFORM), the technical team which ran the pilot project, and the managerial style it previously enjoyed, the new system is no longer fully operational. Even if the registry itself remains open for business, it faces an uncertain future because of the five-year limit placed on its life. To play its role in property formalization, the new system needs to be revived. Political commitment and policy direction. Property formalization is clearly an area where the Government has not yet committed its authority to any particular strategy or system and where no sense of policy direction is apparent. The Government needs to commit itself to a clear and determined line of action to create credibility and to maintain the progress that Peru has made in this area. 5.50 The options. It is useful to consider the range of possible reforms by characterizing three reform options. - Full reform. A first option--a full reform--would be to revive the new system and replace, area by area and as rapidly as prudence permits, the traditional system by the new. (This would not preclude, for instance, the new registry using some of the human or physical assets of the traditional registry.) - Limited reform. A second option would be to keep the traditional system intact in terms of its rules and procedures and the existing organizations applying these rules (agencies issuing titles, the registry, and the judiciary), but to modernize the system through investment in better infrastructure (typically better equipment) and organization (managerial procedures). to transact (without punitive constraints on the size of plots that can be traded) and the removal of taxes and subsidies that distort land values. Peru fulfills this prior condition. -68- * Half-way reform. A third, compromise option would be to merge the traditional and new systems in terms of rules and procedures and/or the organizations running them. For instance, the new rules might be applied by the old registry. Or else the new rules might be modified by reintroducing the requirement of notarization. 5.51 We would expect the three options to lead to quite different outcomes. - Under the second option of limited reform, modernization might lead to some improvements, but only at the margin. This option would not alter the fundamental constraints resulting from inappropriate laws, inappropriate incentives, and poor coordination between agencies. Under this circumstance, there would be little progress in the formalization of property. * Under the third option of half-way reform there is a great risk that elements of the traditional system could asphyxiate the new. This can already be seen in the way that RP has, within the new Superintendency, lost its autonomy and ceased to mount field campaigns. - Following the analysis in this Note, there are few reasons why Peru should not contemplate the first option, afull reform of the system of property administration. This technique of institutional reform would be similar to that successfully followed in other areas since 1990--for instance the creation of COPRI to oversee privatization or the complete overhaul of SUNAT to revolutionize tax administration. 5.52 A National Program for Property Formalization. To pursue this preferred option, we recommend that the Government establish a National Program which would lay out a strategy and a timetable for the formalization of rural and urban property in Peru. * The Program would adopt, and as necessary adapt, the new system of property administration that has been described in this note. This would require the re- establishment of RP as an active agency combining registration with field campaigns. - The Program would take over jurisdiction from RPI on a progressive basis (using RPI's facilities and resources as appropriate), concentrating first on rural and urban areas where informality and individual or family land-holding predominate, then, in a second stage, extend its jurisdiction to other areas. In this progressive process, we would expect the new system to clearly outperform the old and gain substantial public support. We would also expect the new system to learn as it tackles new problems (collective ownership of land, for instance) and adapt its procedures accordingly. In this scenario, the formal merging of the two registries is not an issue since the new system would progressively take over. -69- 5.53 We would recommend that the National Program be established in the following way. * The National Program would require, in the first instance, a clear statement of authority from the Government, endorsing the application of the new system and committing itself to the resources necessary to implement the National Program. This would ensure coherence and consistency in policy. * This statement of authority would then need to be translated into a mechanism that gave the new system the kind of accountability and management structure that programs like FONCODES and COPRI have enjoyed. Clearly, the new system could not flourish as a subordinate part of the Superintendency of Public Registries, as is now the case with RP: the new system would need the authority to coordinate jurisdictional questions with RPI and to secure the cooperation of the public agencies issuing titles. - The first job of this team would be to lay out the details of the National Program (including geographical strategy, decentralization strategy, implementation timetable, coordination with titling and cadastral agencies, training and organization of field teams, an appropriate fee structure and financing plan, and research on new problems of tenure and ownership security likely to arise as the Program expands into areas beyond Lima and the costa). 5.54 In the course of time, the National Program will no doubt need to face a number of new problems that may require changes in the nature of the field campaign or in the legislation itself Such problems could include common property, possible difficulties in registering some rural areas after easier areas are registered, appropriate mechanisms for security of ownership, mandatory versus voluntary registration, and problems in transferring records from the traditional to the new system. There is also a need for further study of the gains from formalizing ownership. 5.55 There is no need to wait a long time to initiate a National Program for Property Formalization. Peru has a proven instrument in its new system for property administration and the technical expertise to turn the pilot experience into a National Program. The Program will not require the commitment, immediately or over the longer term, of large amounts of money. Quick action can be expected to bring tangible results in the fight against poverty. Finally, quick action is also essential if RP, with less than five years left of its legislated life, is to prove itself -70- *eProperly titled land was associated with statistically significant increases in land prices to a level between 47 and 80 percent above the value of untitled land, even after accounting for land quality attributes such as natural fertility (soil type, slope, and irrigation), land improvements, and location (distance to roads). eLand titling induced higher levels of land improvement and, in three out of four provinces studied, was associated with significant increases in the capital stock, to a level between 50 and 200 percent higher for titled than for untitled farmers, even after accounting for individual-specific factors such as education, experience, wealth, and the initial level of land ownership. *Productivity, as measured by revenues from farm- and non-farm activities, was between 12 and 20 percent higher on titled than on untitled farms, even after all exogenous factors had been adjusted for. Studies from Honduras and Paraguay currently being analyzed by the World Bank point in the same direction. They confirm that properly titled land was associated with higher investment and greater productivity, although precise quantitative estimates are not yet available. Less rigorous anecdotal evidence suggesting the positive effect of titles is available from studies in Costa Rica, Brazil, and Ecuador (reported in Binswanger, Deininger, and Feder 1995). By contrast, in a number of African countries where credit markets were not available even to farmers with title, titling failed to have any appreciable effect on investment and productivity of agricultural production (Migot Adholla et al. 1991). Thus international experience suggests that, in areas and situations where titles provide access to credit markets, titling is associated with potentially very high benefits. -71- 6. PRECING, TRADE, AND MARKETING IN THE AGRffCULTURE SECTOR Background 6.1 In 1990, President Fujimori inherited a country in the throes of hyperinflation, stagnation, and violence in rural areas. Government policy regarding agriculture was characterized by an array of selective interventions on factor and product markets; policy objectives were often ambiguous and contradictory, and a situation of great insecurity regarding property rights of land existed. Terrorism and illegal cocoa exports were rife, having taken their toll on lives and public property. Furthermore, agricultural production was taxed heavily, albeit indirectly, as a result of the high level of industrial protection and exchange rate misalignment. Overall, extraordinarily adverse conditions existed hindering private investment in agriculture. 6.2 Since 1991, the Government of Peru has carried out a series of far reaching economy-wide reforms, oriented towards macroeconomic stability, trade liberalization, privatization and deregulation. 6.3 The main thrust of the Government's strategy towards agriculture has been (a) elimination of the major distortions in agricultural markets via a bold program of trade and price liberalization; (b) improved security of property rights on land, having established the enabling legislation and initiated its implementation; (c) virtual elimination of direct subsidies and interventions in input markets, and (d) helping the disadvantaged amongst the rural population as a result of controlling violence and the implementation of targeted programs for the rural poor. 6.4 As a result, agricultural growth is recovering and security in rural areas is greatly improved, despite the fall in (real) farm prices at the outset of the Fujimori administration and the elimination of selective input and marketing subsidies. 6.5 While the reforms carried out to date are impressive and the agricultural sector has begun to recover, poverty remains widespread in rural areas; implementation of land and water rights legislation is progressing at a slow rate, and private sector investment in agriculture remains low. Exacerbating the problem is that the Government and private actors have not reached consensus regarding strategic issues and policy options for the sector. Strategic Context and Role of the Bank 6.6 Without seeking to provide herein a comprehensive sector strategy, in general, we suggest that a strategy for rural areas in Peru should focus on (a) enhancing agricultural competitiveness fostering efficient sector growth, (b) alleviating rural poverty, and (c) sustainable management of natural resources, including water. The identification of -72- appropriate options to respond to these three challenges, while facilitating ongoing structural adjustment, demands an understanding of the Peruvian rural economy which is still quite inadequate even when compared to several other LAC countries, and thus requires continuing substantial analytical effort. 6.7 A strategy to enhance competitiveness within Peruvian agriculture should focus on (i) a removal of possible remaining distortions affecting the sector output and input markets; (ii) the development of a public sector role limited to those actions which are appropriate for the public sector by virtue of externalities, and/or inherently high private transaction costs which, in turn, lead the private sector to respond in an inappropriate manner from a national perspective. Key issues to examine related to enhancing competitiveness would include: (a) appropriate rights, titles, and regulatory framework for land and water markets, particularly regarding security of property rights; (b) trade and pricing; (c) rural financial markets; (d) market development; (e) labor productivity (training, labor legislation); (f) infrastructure (rural roads, irrigation, electrification); (g) agricultural research and technology dissemination; and (h) environmental management. Some of these issues are already part of the Government's agenda, such as land and water rights markets. 6.8 Dealing appropriately with these issues related to enhancing competitiveness will also help reduce rural poverty; but this alone is not sufficient. It will also be necessary to implement a range of additional measures as part of a strategy addressing rural poverty and easing the cost of adjustment for the most vulnerable groups. Such a strategy would include continued attention to rural education and health, increased focus on off-farm income and rural diversification, management and natural resource conservation technical assistance, access to rural financial services, and the special needs of indigenous population. 6.9 The Bank has played an active role in contributing to the policy dialogue on many of these strategic issues. In particular, the Bank has collaborated with the Government in producing numerous formal and informal studies. In recent years, these include: "Peru: Agriculture Policies for Economic Efficiency" (Report No. 10605-PE, 1992), "Peru: A User Based Approach to Water Management and Irrigation Development" (Report No. 13642-PE, 1995), a Peru Poverty Assessment Report (1993), and a policy note on land titling and registration (1995). Together, these reports address many of the competitiveness and poverty issues mentioned above. Additionally, the Bank's ongoing sector work will address key issues, such as rural finance, which currently remain inadequately addressed. The Bank is also supporting the Government's effort to address important sector issues by helping to prepare and considering financing potential projects in irrigation, natural resources and community development in the Sierra, watershed management, and extension. -73- Policy Note Objective 6.10 In view of the wide range of strategic issues already or currently being addressed by the Bank, the objective of this note is to focus selectively on only a few sector issues; namely, pricing, trade, and marketing. These are not covered in other current Bank work and they are issues where past policies were particularly distortionary and significant reforms have been implemented. The note reviews both past policies and empirical evidence, as well as reforms implemented since 1991, assesses the current Government approaches, and provides policy implications and recommendations regarding each of these areas. A. IMPROVING PRICES AND TRADE Evolution of Prices 6.11 The evolution of incentives for agriculture contains factors which are common across subsectors and which are specific to subsectors. The former include changes in the real exchange rate (RER), border prices and general import tariffs (reduced after 1991). The Sobretasa (surcharge) scheme is specific to a subsector. The combined effect of these factors is to affect the on-farm profitability in the production of tradables, which (with the exception of potatoes and some meats) represents a large segment of Peruvian agriculture. 6.12 What has evolved regarding farm prices since the mid-1980s and, in particular, what has occurred during these last years? Which changes in agricultural prices can be attributed to exogenous factors (border prices), and which are the result of domestic trade and price policy? What has been the influence of macroeconomic policy (RER)? 6.13 A 'decomposition' analysis of the determinants of changes in real producer prices (border prices, real exchange rate and direct intervention), reveals that in 1987-1989 the most important factor affecting domestic prices was real exchange rate appreciation (adjusted for the fact that agricultural imports were carried out at preferential - low - exchange rates). In 1990-1991, the recovery (or reduced decline) in the domestic price of importables is the result of increase in the RER. As the real exchange rate is relatively more stable over 1992-1994, reduced protection seems to explain the continued decline in prices for wheat, rice and milk while the increase in coffee prices is directly related to increase in world prices and those of maize and cotton to increased protection and lower export taxation, respectively. 6.14 Appendix Table 1 presents the evolution of real prices for four importables (wheat, yellow maize, rice, and milk) and two exportables (coffee and cotton)." These numbers 5' Real prices are defined as the domestic farmgate price (reported as 'precio de chacra') at the time of harvest for crops, and is defined as the annual average for milk, deflated using the GDP implicit deflator, as it seems that the CPI overestimates inflation rates for the period of hyperinflation in 1987- 1989. -74- have two interesting implications. First, the evolution of real farm prices for importables indicate a large decline in prices throughout a period of nine years, a phenomenon which must have had a strong adverse effect on profits and private investment in farming between approximately 1986 and 1994 (period averages Appendix Table 2). Second, the major decline occurred between 1986 and 1991. Since 1992, Peru's overall economic recovery program has become more consolidated and prices have fallen for some and risen for others. Prices for maize, cotton and coffee have increased 8.7%, 3% and 21.2% respectively on average for this period (coffee mostly due to an increase in border prices). However, average annual declines of 4.8% for wheat, 15.0% for rice and 4.7% for milk as observed during 1992-1994, imply a considerable decline in profitability for these activities, productivity increases notwithstanding. 6.15 Regarding the Sobretasa scheme, Peru currently has a scheme of minimum import prices for five basic agricultural products and sixteen subproducts and substitutes, based on variable levies (surcharges) computed from a moving average of world prices, not tied to a domestic target price. The latter is important because otherwise it would not be GATT legals2. The surcharge is applied when the import price for a product is lower than its floor price, and has been a means of stabilizing the minimum import price and also of raising the level of protection for agricultural importables, based on the arguments that world prices are volatile and artificially low for some products due to subsidies in OECD countries53. 6.16 The surcharges lead to greater stability in domestic prices (a lower coefficient of variation) because the lower end of the distribution is eliminated. Of course, this raises the average domestic price and hence the protective effect of the scheme. Although up-to- date calculations of protection rates are not available, nominal and effective rates of protection have fluctuated widely in the period 1991-92 as a result of the frequent modifications of the floor price scheme, and beyond what is explained by movements in border prices. For example, the import price of wheat in June 1991 was US$110 per metric ton and the corresponding surcharge was US$31 per metric ton; in September 1991 the import price fell to US$109 while the surcharge increased to US$ 74 per metric ton.54 These differences in the surcharge can only be explained by modifications in the computations. Escobal and Bricefio (1992) have estimated that nominal protection rates in March 1991 to June 1992 for wheat have ranged from 31 to 83 percent and from 31 to 62 percent for wheat flour. Nominal protection rates for rice and maize have fluctuated 52 Fortunately, Peru has not yet endorsed the Junta de Acuerdo de Cartagena (JUNAC) proposal on price bands and surcharges for agricultural products. JUNAC's proposal is ill conceived, and its application would result in a most arbitrary profile of effective rates of protection for more than 100 activities (basic farm products and their substitutes and derivatives). s3 The surcharge S is computed as follows: S=(1+t+c)(Pf-Pr), where t=15% tariff, c= 3% import costs, Pf is the floor price based on a 60-month moving average of world prices and Pr is the FOB reference or import price. 54 See Appendix Table 2. -75- between 15 and 32 in the same period, while for powdered milk the range has been 15 to 52 percent.55 6.17 The surcharge scheme is now being used in a less discretionary manner than in the past due mainly to adjustments in the methodology for calculating floor prices. For example, currently the relevant floor price and corresponding surcharges for each product are calculated every six months, compared to a much greater frequency at the beginning of the scheme. However, the possibility of discretionary adjustments to the scheme still exists by modifying any of the following: the world reference market for each product, calculation of the floor price, conversion factor for related subproducts and substitutes and frequency of change of the surcharges. 6.18 For this and other reasons the true protection effect of the surcharge scheme is not just the specific surcharge itself but the combined effect of the latter together with the rest of the elements that can be modified arbitrarily. Furthermore, the final effect of the surcharge on the domestic price will of course also depend on the domestic market structure and business practices of the commodity in question. 6.19 The welfare effect of the current surcharge scheme on consumers was not analyzed and earlier studies by Escobal and Briceno were inconclusive since they showed that while the static impact of the scheme produced a consumer welfare loss, the price variability reductions of the scheme (ignoring the frequent changes of the system) produced significant benefits for the economy. Nevertheless, in general, it could be argued that the increase in protection to farmers would lead to a rise in domestic retail prices and thus to a decline in the real household income of urban consumers. Trends in Production and Trade 6.20 After several years of slow agricultural growth, including negative growth from 1990 to 1992, real agriculture GDP grew by over 6 percent in 1993 and by 13 percent the first half of 1994. The recovery observed during 1993-1994 is encouraging and hopefully will be sustained during the coming years as it implies favorable social and economic consequences, not only for agricultural employment and income but also for the growth of related activities such as agro-industry and rural services. 6.21 Although production of crops recovered in 1993, levels of production in that year were still below average levels for 1986-1989 for cotton, milk, and most crops. Figures for 1994 indicate subsector production growth rates of 15.7 percent for crops and 8.1 percent for livestock. What explains this recovery is of course an important question. Better climatic conditions, some price recovery since 1992 and increased rural security during these last years seem to be major underlying factors for the recovery. ss J. Escobal and A. Briceno 'El Sistema de Sobretasas Agricolas en el Peru: Evaluaci6n y Recomendaciones" World Bank, July 1992. -76- Table 15: Growth of Production in Agriculture (average annual percent variation in each period) 1987-89* 1990-91 1992 1993 1994 Real GDP (1979 soles) -4.3 -1.4 -2.5 6.5 12.9 Agriculture GDP** (1979soles) 2.3 -2.0 -7.3 6.2 13.2 Production of selected crops Wheat 9.6 -10.7 -42.1 47.1 20.0 Maize 4.9 -21.1 -18.7 49.8 -8.6 Rice 14.6 -13.6 1.6 17.0 43.8 Milk -0.7 -1.0 -2.2 4.5 3.4 Coffee 3.3 -11.6 4.2 -0.9 6.3 Cotton 1.9 -25.9 -38.8 -9.4 71.7 * 1989 production levels were exceptionally high. * * Crops, livestock and forestry Source: Banco Central de Reserva del Peru 6.22 Regarding trade flows during these last years, the official data show that export volumes of both coffee and cotton, the two main agricultural exports, have fallen during 1990-1993 (particularly during 1992). Non-traditional exports remain extremely low and limited to very few products. On the other hand, import volumes of maize and rice, and dry milk to a lesser extent, have risen significantly over 1990-1992 (volume data for 1993- 1994 not available). The situation of wheat during 1993-1994 is not yet documented;' wheat is the single most important agricultural import (one-fourth of imported foodstuffs and 3% of total imports), and, at least until 1992, wheat imports were below 1985-1991 levels. 6.23 If the current overall growth rate in Peru continues, one should expect a significant demand expansion for dairy products, meats and feedgrains, and probably wheat, which could result in higher import volume levels. The food import bill in Peru is a very small share of the total import bill and Peru's imports represent a very small share of world trade in these commodities. Thus, no major issue of food insecurity (access to imports) is anticipated for the future. Challenges Ahead and Recommendations 6.24 The surcharge scheme represents the primary policy agenda to be addressed. The key issues are: (a) the scheme is not only stabilizing domestic producer prices; it also acts as a price support mechanism, increasing protection for producers of these products and thus taxing consumers; -77- (b) the coverage ofproducts subject to the floor price seems excessive - 5 basic products and 16 subproducts and substitutes. In addition to its effects on higher prices for consumers, surcharges on so many products affect the competitiveness of producers of processed goods (in this case, agroindustry), and could reduce their effective rate of protection, unless they are "compensated" by a higher import tariff on their products. This is in fact what the surcharge scheme tries to do by applying surcharges on some processed goods. However, it would be realistically quite unmanageable to try to compute the effect of surcharges on all processed products, and thus the scheme leads to an arbitrary profile of effective protection in the sector; (c) surcharges on sugar are justified as sugar world prices are extremely volatile. In the case of maize, although its world price is less unstable, its production by many small farmers may justify price stabilization and protection. Also, sugar and maize have well established world reference prices, unlike rice and milk; thus, the application is transparent; (d) there have been modifications of the floor price scheme since it began in 1991, and although most changes have tended to improve the transparency of the mechanism (such as unifying the markets from which floor and reference prices are taken) there still seems to be room for discretionary action on the part of the government. In particular, if changes to current regulations on surcharges are made by decrees rather than by law, it is relatively easier to modify the rules, reducing its transparency. 6.25 In short, as the surcharge scheme is applied to an excessively large number of selected products, it could introduce a very disperse and uncertain profile of effective protection amongst the different agricultural subsectors, between agriculture and agrobusiness, and also within agro-processing activities. As such, the best solution would be to eliminate or phase out the surcharge scheme in favor of a fully market-driven pricing regime with complementary safeguards. Short of that, the surcharge scheme should be revised and its coverage reduced, from twenty-one products now in the scheme to perhaps a few products, such as maize and sugar, and possibly rice (depending on the definition of the world reference price, which is currently not well established, and the level of rice production by poor farmers), and the scope for discretionary adjustments in the rules of the scheme should be eliminated. 6.26 On the foreign trade side, from an agricultural growth and employment perspective it would be particularly relevant in the future to examine what the major constraints are (economic policies, infrastructure, technology, markets, etc.) to a more rapid expansion of non-traditional agricultural exports. -78- B. REDEFINING THE STATE'S ROLE IN MARKETING AND INPUTS Reducing Intervention in Commercial Activities and Focusing on Poverty Issues 6.27 Prior to 1990, part of the Government's interventionist approach included the development of two state marketing agencies, ECASA (the State Marketing Enterprise) and ENCI (the National Inputs Marketing Agency). They were highly subsidized and given monopolies to purchase domestic food crops as well as to import farm products and inputs. Both ECASA and ENCI provided marketing subsidies to producers, thus discouraging the development of private sector participants in these activities. The cost of these government operations was extremely high and fiscally unsustainable. 6.28 As part of the Fujimori Administration reforms, ECASA has been fully liquidated and ENCI slated for privatization. While this process is not yet complete, ENCI's staff have been reduced, subsidies virtually eliminated, and assets are being sold to the private sector. Preliminary evidence suggests that ENCI's primary functions are now being performed to a limited extent by the private sector, although mainly in the more commercial coastal areas and for the more profitable traditional and non-traditional export-oriented products. 6.29 The Government has established a presence in rural areas to assist small and poor farmers who lack access to adequate marketing services, by providing, on a grant basis, a limited amount of inputs to producers. These inputs are primarily targeted towards the very poor located in the Sierra and some parts of the Selva, as well as the coastal poor. In any case, a reduction in public funds allocated to agriculture from an average of about US$400 million per year in 1985-90, to US$325 million since 1990, with the bulk of those resources still being used to finance investments in large irrigation schemes, has left fewer resources to be allocated to producer assistance programs. 6.30 During the most recent period for which sufficient data is available (1992 - 1993), average investments in large-scale irrigation remained at about 60 percent of overall average public funds allocated to agriculture. Of the remaining public funds allocated to the sector, US$63.5 million per year, was distributed on a grant basis by MAG (the Ministry of Agriculture) in the form of improved seeds, fertilizers, and tools to producers. In monetary terms, the bulk (over 65 percent) of these inputs were distributed to the poor in the Sierra and parts of the Selva.56 6.31 About 50 percent of MAG inputs have been financed from the Government budget and 50 percent from revenues generated by the price support mechanism (sobretasas). The inputs are typically allocated indirectly in that MAG distributes various inputs to 56 See Appendix Table 3 for details. -79- Fondos Rotatorios (community in-kind rotating funds). These associations then allocate the inputs directly to local producers. 6.32 Finally, MAG, in the past year, has also received foreign donations from China in the form of tractors. In 1994, MAG distributed on a grant basis about US$9 million worth of tractors, again mostly (over 70 percent) throughout the poor regions of the Sierra and parts of the Selva". MAG hopes to distribute about US$20 million in tractors by the end of the calendar year 1995 but this depends entirely on foreign donations from China. 6.33 While tractors and inputs programs are not particularly significant in comparison to public expenditures on large-scale irrigation and recent findings which suggest that Peru's highly inefficient and unsustainable" large-scale irrigation investments deserve primary attention, such grant programs do not constitute an efficient mechanism for dealing with poverty issues. A rough estimate of the annual per capita grant/cost of the tractors and inputs programs yields about US$20-25, a figure which at face value does not appear to be overly significant relative to household incomes (even for the poor) or commodity and related product markets". 6.34 Nevertheless, Government involvement in rural areas through these programs has been beneficial in developing and maintaining a strong State presence in areas previously dominated by terrorists and illegal drug trafficking. In the long term, these programs can be distortionary by promoting cultivation of crops which would not be produced without subsidies and it is unlikely that private sector delivery of inputs will fully develop where the Government continues to provide the same inputs on a grant basis. As such, the Government should establish an objective to eliminate these subsidy programs and focus on how to make the transition from the present to the future without subsidies, more specifically, how to make the transition while encouraging private sector participation and maintaining a Government presence in rural areas. Ultimately, investments in rural infrastructure (e.g., roads, electrification, water supply, etc.), education, and health represent a more efficient and transparent means for addressing poverty issues, promoting private sector development, and maintaining stability in rural areas 5 See Appendix Table 4 for details. 5 World Bank 1995 sector work entitled "Peru: A User-Based Approach to Water Management and Irrigation Development" analyzes Peru's record on irrigation investments. To enhance efficiency and reduce public spending in the susbsector, it recommends implementation of a water rights system and privatization of most large-scale schemes, except in select cases where significant externalities exist. 59 Since the programs are targeted to the poorest regions on a national scale, a conservative assumption is that half of the rural poor are covered. Peru's population of 22 million is about 30% rural, of which about half are poor or very poor. Coverage of one-half this latter group yields about 3 to 3.5 million people. -80- Challenges Ahead and Recommendations 6.35 The significant reforms in reducing State intervention in marketing notwithstanding, an efficient and dompetitive market for these services may not develop in the absence of appropriate selective government initiatives. An uncompetitive private sector may emerge in some markets, information systems may be inadequate, the price formation process could be made more transparent etc. While private enterprise may develop independently, the Government can enhance such development by becoming directly involved in the following activities: (a) creating an enabling regulatory framework for the private sector regarding storage transactions, market entry and concentration, quality standards, and legitimate exchange transactions; (b) providing for adequate physical infrastructure (e.g., transportation and communications); (c) providing benchmark data on agriculture products and services (e.g., agriculture census); (d) creating mechanisms to help the private sector manage some of the unduly high risks inherent in the development of new markets; (e) countering unfair trade policies of other countries; and (f) providing appropriate assistance in research and training. The Government can further facilitate private sector development by providing enabling legislation for the development of commodity exchanges and producer organizations, as well as assistance with access to financial services and export markets. C. CONCLUSION 6.36 By successfully implementing a series of broad-based reforms, the Government has made considerable progress in what is necessary to create an enabling environment for the private sector in agriculture. Early results are promising: agriculture production is showing signs of significant recovery and prices have stabilized in recent years. Improvements in the economy, macroeconomic framework (e.g., RER), climatic conditions, and stability in rural areas are all closely linked to such success. 6.37 Nonetheless, poverty remains widespread in rural areas and private firms have been slow to invest in the agriculture sector. As such, the Government is likely to come under increasing pressure to revert to pre-1990 interventionist policies. That would be a mistake. It is critical that the Government stay the course vis-A-vis the reforms carried out to date. Additionally, while it should continue elimination (or reduction) of remaining distortions in the incentives framework and maintain stability in rural areas, the Government should begin to shift its focus more towards enhancing private sector development in the agriculture sector and further reducing rural poverty. 6.38 The surcharge scheme and the subsidized inputs programs represent the principal remaining distortions in the incentives framework. The surcharge scheme is applied to an excessively large number of selected products and could introduce a very disperse and uncertain profile of effective protection amongst the different agricultural subsectors, 6 A more comprehensive treatment of these issues can be found in a report prepared by the World Bank entitled "Developing the Regulatory Environment for Competitive Agricultural Commodity Markets" (Hill and Bender, 1995), LATAD. -81- between agriculture and agrobusiness, and also within agro-processing activities. The scheme should be revised and its coverage reduced, from twenty-one products now in the scheme to only a few products, such as maize, sugar, and possibly rice, and the scope for discretionary adjustments in the rules of the scheme should be eliminated. The inputs programs also tend to be distortionary: they promote cultivation of the "wrong" products and "crowd out" the private sector. These programs should be phased out. 6.39 Eliminating (or reducing) remaining distortions, while an important prerequisite, does not ensure the development of an efficient and competitive private sector. In the areas of marketing and rural finance, the Government should increasingly focus on assessing the private sector's development and establishing select policies and investment programs which extend the reach and development of the private sector in even remote rural areas. This will entail direct Government involvement in such activities as the: (a) creation of appropriate regulatory frameworks; (b) creation of mechanisms to help the private sector manage high risks inherent in developing new institutions and markets; and (c) provision of adequate infrastructure, information services, and research and technical assistance. 6.40 At the same time, to effectively address poverty issues, the Government should shift its focus away from inefficient, distortionary, or wasteful spending and more towards investments which are well known to have a significant impact on poverty reduction. This means phasing out public expenditures allocated to large-scale irrigation schemes (except in select cases where significant externalities exist) and subsidized inputs programs. Instead, public spending to reduce poverty should be targeted largely towards investments in small-scale rural infrastructure, health and education which represent a more efficient mechanism for addressing poverty issues, promoting private sector activity, and maintaining stability in rural areas. -82- Table 16: Real Agricultural Prices in Peru (in November 1994 New Soles per metric ton) IMPORTABLES EXPORTABLES WHEAT YELLOW RICE MILK COFFEE COTTON MAIZE 1986 1,148 724 956 912 8,317 2,024 1987 783 662 895 952 2,539 2,398 1988 387 186 398 947 2,169 1,295 1989 704 155 438 641 1,154 925 1990 777 27 249 781 420 500 1991 645 327 558 625 1,667 1,499 1992 528 396 462 602 1,039 1,112 1993 612 326 511 561 1,327 1,568 1994 557 420 343 541 2,970 1,637 Period averages 1986-89 756 432 672 863 3,545 1,661 1990-91 711 177 403 703 1,043 1,000 1992-94 566 381 439 568 1,779 1,439 Source:LATAD, World Bank. Based on data from the Ministry of Agriculture of Peru, given by AgroData-CEPES, Lima Peru. Annual average prices for crops correspond to harvest months, milk prices are annual averages. * Nominal farmgate prices deflated by the revised implicit GNP deflator for 1987-93 (period for which it is available) and using the CPI variation for 1986 and 1994. Table 17: Surcharges for Agricultural Importables in Peru Wheat Wheat Flour Rice Yellow Maize Powdered Whole Milk Reference Surcharge Reference Surcharge Reference Surcharge Reference Surcharge Reference Surcharge Price Price Price Price Price (USs/tn) (USS/tn) (LS/tn) (Usshn) (USSin) (US$/tn) (USs/tn) (US$/tn) (USsin) (FSs/tn) 1991 March 21 87 50.0 190 75.0 245 41.0 109 5.0 1460 540.0 May 2 112 29.0 190 38.0 238 0.0 107 0.0 1510 540.0 June 30 110 31.0 210 43.0 230 30.0 104 12.0 1503 0.0 September 109 74.0 220 103.0 245 15.0 111 10.0 1475 0.0 16 1992 March 25 129 20.6 268 42.9 237 11.9 105 4.2 1475 496.0 March 28 129 46.4 268 96.5 237 23.7 105 17.9 1475 496.0 June 5 128 48.0 220 67.0 230 30.0 105 18.0 1475 496.0 Source: Escobal, J. and Bricefio, A. ' El Sistema de Sobretasas Agricolas en el Peru: Evaluaci6n y Recomendaciones', World Bank, July 1992, ppl7-18. Note: The dates reported correspond to successive modifications of the decree-law that regulates the surcharges. -83- Table 18: Public Funds Allocated for Agriculture Campaigns 1992-93 &1993-94 (in US$1993) Purpose Seeds, Fertilizers, Credit Other Total Average Per Year Tools Total Allocated (US$) 127,050,917 56,075,000 46,881,961 230,007,878 115,003,939 Total Allocated (%) 55% 24% 20% 100% By Location Sierra/Selva RENOM 17,585,864 6,500,000 4,199,138 28,285,002 14,142,501 CHAVIN 8,369,456 2,575,000 2,734,396 13,678,852 6,839,426 LIBERTADORES 18,879,717 3,575,000 5,532,292 27,987,009 13,993,505 WARI JC MARIATEGUI 9,948,378 2,075,000 2,011,559 14,034,937 7,017,469 INKA 8,197,298 2,575,000 2,568,277 13,340,575 6,670,288 UCAYALI 1,012,576 7,250,000 504,587 8,767,163 4,383,582 LORETO 1,090,518 1,575,000 137,614 2,803,132 1,401,566 AA CACERES 15,778,873 4,075,000 5,828,192 25,682,065 12,841,033 SAN MARTIN 3,047,137 3,075,000 1,573,408 7,695,545 3,847,773 Total 83,909,817 33,275,000 25,089,463 142,274,280 71,137,140 Allocated (US$) Total 66% 59% 54% 62% Allocated (%) Coast GRAU 13,787,460 12,150,000 3.765,034 29,702,494 14,851,247 LA LIBERTAD 10,014,117 4,575,000 2,850,957 17,440,074 8,720,037 AREQUIPA 4,438,119 2,075,000 1,549,152 8,062,271 4,031,136 LIMA CALLAO 14,901,404 4,000,000 13,627,355 32,528,759 16,264,380 Total 43,141,100 22,800,000 21,792,498 87,733,598 43,866,799 Allocated (US$) Total 34% 41% 46% 38% Allocated (/0) Notes: 1) Other = complementary campaigns and land titling 2) Credit represents proceeds mostly from the former Agrarian Bank; the Bank was abolished in 1992 3) Totals do not include at least USS25 million allocated to FONCODES for credit and fertilizers and seeds Source: MAG, OIA; Bank analysis -84- Table 19: MAG Tractors Program (in US$1994) By Location Total Units Total Cost % of Total Sierra/Selva AMAZONAS 45 5% ANCASH 51 5% APURIMAC 27 459,000 3% AYACUCHO 66243,000 7% CAJAMARCA 134 594,000 13% CUZCO 52 1,206,000 5% HUANCAVELICA 50468,000 5% HUANUCO 57 450,000 6% JUNIN 90513,000 9% LORETO 31 810,000 3% MADRE DE DIOS 7 279,000 1% MOQUEGUA 1563,000 2% PASCO 25 135,000 3% PUNO 32 225,000 3% SAN MARTIN 13 288,000 1%. UCAYALI 15 117,000 2% SUBTOTAL 710 71% Coast AREQUIPA 21 2% ICA 83 8% LA LEBERTAD 38747,000 4% LAMBAYEQUE 32342,000 3% LIMA 46 288,000 5% PIURA 59 414,000 6% TACNA 11 531,000 1% SUBTOTAL 290 29%1 Source: MAG -85- REFERENCES ALESINA AND PEROTTI. 1994. "THE WELFARE STATE AND COMPETITIVENESS." NATIONAL BUREAU OF ECONOMIC RESEARCH, WORKING PAPER No. 4810, JULY. BARHAM, PODDAR, AND WHALLEY. 1987. "THE TREATMENT OF INSURANCE UNDER A CONSUMPTION TYPE DESTINATION VAT." NATIONAL TAX JOURNAL VOL. 40, JUNE. FELDSTEIN MARTIN. 1995. "THE EFFECTS OF TAX BASED SAVING INCENTIVES ON GOVERNMENT REVENUE AND NATIONAL SAVING." THE QUARTERLY JOURNAL OF ECONOMICS, MAY. GARCIA RICARDO. 1995. "ADMINISTRACION DE INVERSIONES EN FONDOS DE PENSIONES LATINOAMERICANOS". REALIZING THE FULL POTENTIAL OF REFORM: SECOND HEMISPHERIC CONFERENCE ON SOCIAL SECURITY, PENSION REFORM AND CAPITAL MARKETS DEVELOPMENT. SPONSORED BY THE INTER-AMERICAN DEVELOPMENT BANK AND THE INSTITUTE OF THE AMERICAS, JUNE 12-13. 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Feder (1993), Power, Distortions, Revolt, and Reform in Agricultural Land Relations, Policy Research Working Papers, WPS 1164, World Bank Feder G., T. Onchan, Y. Chalamwong, and C. Hangladoran (1988), Land Policies and Farm Productivity in Thailand, Baltimore, MD: Johns Hopkins University Press Migot-Adholla, S., P. Hazel, B. Blarel, and F. Place (1991), "Indigenous land rights systems in Sub- Saharan Africa: a constraint on productivity?", World Bank Economic Review, 5:155-175 ·勰不惡日一兀化’一： 《領：C叮玲 兀：兀；二斗茫 排拙叩’n) r：一：一細方一 于計’衫細二 曄馴勿吃凡 刀江叩二：二 ：兀一j日渭 二：訐一；法 ：二『 必：; 日→ 斗‘：鄴兀 :& 斤