Peru - Issues in Urban Management

Document of THE WORLD BANK FOR OFFICIAL USE ONLY CONFIDENTIAL Report No. 14515PE PERU ISSUES IN URBAN MANAGEMENT June 29, 1995 Environment and Urban Development Division Country Department M Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS Currency Unit - Soles (S/.) EXCHANGE RATE US$1.00 = S/. 2.25 (March 31, 1995) S/. 1.00 = US$0.44 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES The metric system has been used throughout this report. GLOSSARY OF ABBREVIATIONS AND ACRONYMS CBOs Community Based Organizations CONADE National Development Corporation (Corporaci6n Nacional de Desarrollo) COOPOP National Office for Popular Cooperation (Oficina Nacional de Cooperaci6n Popular) Cordecallao Callao Provincial Development Corporation (Corporaci6n Provincial de Desarrollo del Callao) Cordelima Lima Departamental Development Corporation (Corporaci6n Departamental de Desarrollo de Lima) CORTAPA Former Water and Sewerage Tariff Commission CTARs Interim Regional Administration Councils (Consejos Transitorios de Administraci6n Regional) ENACE National Construction Company (Empresa Nacional de Edificaciones) FCM Municipal Compensation Fund (Fondo de Compensaci6n Municipal) FINDETER Colombia's National Municipal Development Bank (Financiera Nacional de Desarrollo Territorial) FONAVI National Housing Fund (Fondo Nacional de Vivienda) FONCODES National Fund for Compensation and Social Development (Fondo Nacional de Compensaci6n y Desarrollo Social) INADE National Development Institute (Instituto Nacional de Desarrollo) INFES National Institute for Education and health Infrastructure (Instituto Nacional de Infraestructura Educativa y de Salud) INVERMET Metropolitan Investment Institute (Instituto de Inversiones Metropolitanas) MINSA Ministry of Health (Ministerio de Salud) NGOs Non-Governmental Organizations PRASBA National Water and Basic Sanitation Program (Programa Nacional de Agua Potable y Saneamiento Basico) PRODEIS Social Power Development Project (Proyecto de Desarrollo Elictrico de Interis Social) PRONAA National Program for Nutrition Assistance (Programa Nacional de Asistencia Alimentaria) PRONAP National Water and Sewerage Program (Programa Nacional de Agua Potable y Alcantarillado) SEDAPAL Lima Water and Sewerage Service Company (Servicio de Agua Potable y Alcantarillado de Lima) SENAPA Former National Water and Sewerage Service Company (Servicio Nacional de Agua Potable y Alcantarillado) SNSS National Superintendency for Sanitation Services (Superintendencia Nacional de Servicios de Saneamiento) TABLE OF CONTENTS Page No. 1. IN TRODUCT ION N............................................................................................................................................ 1 A. THE CoNTExT T.................................................................................................................................................... 1 B. SECTOR BACKGROUND ....................................................................................................................................... 2 C. THE M ANAGEMENT PROBLEM ............................................................................................................................. 4 2. STRUCTURE FOR THE PROVISION OF URBAN SERVICES.................................................................. 4 A. AN OvERviEw ................................................................................................................................................... 4 B. RECENT REFORMS ........................................................................................................................................-.... 7 C. INSTrrTUTIONAL IS SUES ...................................................................................................................................... 10 3. CAPITAL IN VESTMENT F IN ANC IN G ...................................................................................................... 13 A. THE PRESENT STRUCTURE ................................................................................................................................ 13 B. THE ISSUES ...................................................................................................................................................... 19 4. M UN ICIP AL F IN ANCE AND MANAGEMENT T......................................................................................... 2 0 A. DEFINING THE PROBLEM ................................................................................................................................... 20 B. M UNICIPAL FINANCE ISSUES .............................................................................................................................. 21 C. M UNICIPAL M ANAGEMENT ISSUES ..................................................................................................................... 25 5. D IR ECT IO NSFOR RE FORM ..................................................................................................................... 2 7 FIGURE 1 GRowTH IN URBAN POPULATION .............................................................................................................. I FIGURE 2 POPULATION OF SECONDARY CITIES .......................................................................................................... 2 FIGURE 3 REGIONAL DISTRIBUTION OF POVERTY Y...................................................................................................... 3 ]FIGURE 4 M UNICIPAL SHARE OF Ex]PENDIT`URE ......................................................................................................... 5 FIGURE 5 SOURCES OF M UNICIPAL REVENUE .......................................................................................................... 22 BIBLIOGR APHY ................................................................................................................................................. 30 This report is based on several missions that visited Peru between March, 1993, and March, 1995. It draws heavily on a report which resulted from a mission to Peru, in June 1993, and background studies undertaken as part of preparation of a proposed Bank operation in the urban sector. This report was initiated by William Dillinger (LA1EU) and completed by Eleoterio Codato (LA3EU), Caroline van den Berg (LA3EU) and James F. Ford (TWURD) also contributed to the report. The managing division chief is Eugene D. McCarthy, the lead Economist is Norman Hicks and the Department Director is Yoshiaki Abe. Report processing was handled by Ms. Ophelia Haase. ii EXECUTIVE SUMMARY Introduction This paper reviews the institutional and financial arrangements for the provision of urban infrastructure services in Peru and proposes a strategy for making them more efficient and responsive. It argues for extending the process of decentralization the Government of Peru has already initiated in the public utilities sectors into the relationship between central and local government. In order to take advantage of local government's comparative advantage in the coordination and prioritization of capital investment, cost recovery and the financing of operations and maintenance, the report suggests that the Government should strengthen the role of municipal government as the focal point for the provision of urban services. The Problem While recognizing that failures in urban service delivery reflect, in part, aggregate resource constraints (posed by the rapid rate of urban growth, the low incomes of urban households, and a lack of technical knowledge on the part of local government staff), the report partakes the view that such failures also reflect constraints and perverse incentives confronting local personnel and their political leadership, and that these, in turn, are often the inadvertent result of problems in the relationship between central and local government (Dillinger, 1994). Accordingly, the report examines Peru's institutional and financial structures of urban service delivery from a management perspective, that is determining the incentives, or otherwise, that such structures provide, and review them in the context of the relationship between central and local governments and their constituencies. Directions for Reform The report suggests that the Government should transfer management autonomy and authority for specific services to municipal governments, within a regulatory and financial framework that maximizes the likelihood that they will exercise that authority responsibly. Clarity in functional assignments This would require, first, some clarification in the division of functional responsibilities between central government, provincial municipalities and district municipalities. At present, the respective roles of these three entities are ambiguous and often overlapping. In principle, it would be desirable to devolve responsibilities to the jurisdiction that best incorporates the affected beneficiaries. In the Peruvian context, this might imply an expanded role for the district municipalities, while provincial municipalities would be responsible for provincial infrastructure and those in which externalities or economies of agglomeration and scale may be present. However, clarity will require, above all, that the central government refrain from ad hoc interventions in responsibilities that have been nominally assigned to local government. Revenue reform Reform is also needed in the structure of tax assignment and intergovernmental transfers. If local governments are to carry out the functional responsibilities that have been assigned to them, they require the financial resources to do so. Local resource mobilization should be deregulated. Provided the taxes and charges assigned to local government do not enable them to impose burden of services on their neighboring jurisdictions or to discriminate within their own jurisdictions, there is little justification for the present degree of central control over tax rates. If local governments are to be responsive to constituent preferences (and to meet their maintenance and cost recovery obligations) they require the power to adjust the rates of taxes that fall upon their constituents. There is also a case for adjusting the structure of the Fondo de Compensaci6n Municipal (FCM). In its present form, the FCM is a shotgun approach to poverty alleviation, distributing relatively small sums to local governments in jurisdictions that are predominantly poor (and rural) in the expectation that these funds will be used in ways that benefit low income populations. The assumptions behind this distribution system require reexamination, particularly given the urbanization of Peruvian poverty and the lack of any assurance that rural municipalities will, in fact, use transferred resources on services that benefits their poor constituents. Capital financing Finally, reform is required in the structure of capital financing. If municipal governments are to be the agents for capital investment coordination, for cost recovery, and for maintenance, then they must have a more prominent role in the process of capital allocation; but one which forces them to confront the operations and maintenance implications of proposed capital works, and their constituents' willingness to pay. What this implies, in more specific terms, is an integration or coordination of the various lines of capital financing that now exist into a system that offers local government a level playing field on which to compete for capital investment funds. While the terms of this competition may vary depending upon the sector, there is a strong case for using cofinancing schemes and interest rates as primary rationing mechanisms. The first would ration funds on the basis of the capacity and willingness of local governments to mobilize their own resources for cofinancing investments, while loans would do that on the basis of a borrower's willingness to service debt schemes. Both are an effective means of testing willingness to pay. Synchronizing Reform In pursuing such a strategy, the Government should observe the need to synchronize the various elements of reform. A rational assignment of revenues can only proceed once a clear definition of the respective responsibilities of each level of government is in place. A system of capital allocation based on willingness to incur debt can only be operable when local governments have the authority over tax rates with which to capture that willingness. 1. INTRODUCTION A. The Context 1.1 Peru has 'been undertaking a process of economic and political reform over the past three years. In contrast to the previous regime, the current government has adopted market-based strategies for economic management, and has acted to reduce the direct role of government in the economy. However, the results of a history of economic policy failures have left Peru with half the population below the poverty line, poor availability and quality of services, and substantial distrust of government. As a result, the Government of Peru (GOP) faces a complex task of restructuring and rebuilding the economy, mitigating the immediate effects of accumulated economic failures and the social costs of adjustment on the poor, defining the appropriate role of government and rebuilding its credibility. Figure 1 1.2 Among the issues which need to be considered in these reforms are new approaches to the management and Growth in Urban Population delivery of urban services. Effective and efficient delivery of urban services is 2s crucial to facilitating productivity increases in the economy that are necessary for sustaining growth in the 1s Peruvian context. These services also are essential to welfare improvements for the 10 majority of the population who live in .. ...... urban areas. Improvements in service delivery at this level are critical to 4 see 106 are 19o Seo restoring government credibility and legtimcy.Rural B Lbna E Otherura legitimacy. 1.3 This paper provides an overview of the institutional and financial arrangements for urban infrastructure provision in Peru, and the problems that appear inherent in it. Also, it proposes a strategy for improvement. -2- B. Sector Background 1.4 Peru is rapidly becoming an urban country. As shown in Figure 1, in 1940, Peru was still a largely rural nation: 35 percent of the population lived in urban areas, and Lima--the largest city- -had a population that barely exceeded 500,000. The following fifty years have seen Peru's transformation into an urban country. By 1961, nearly half the country's population was urban. By 1972, the proportion had increased to 60 percent, and by 1981, to 65 percent. At present, it is estimated at 70 percent of Peru's population lives in urban areas. As result, the total urban population--now 16.3 million--exceeds the rural population by a factor of 2.5. Figure 2 1.5 The geographical distribution of Peru's urban Population of Secondary Cities population is also changing. Thousand oulto s lochnig Traditionally, Peru's urban CtY population has been concentrated ruZil" in Lima. In 1940, Lima had 32 Chift percent of the urban population; at Iquito* present, it accounts for 45 percent ChIrobote- Cu... of the total. With a population of anae 6.5 million, the scale of Lima still Pucalip far exceeds that of any other sulans Peruvian city. The population of Jullan Human- Arequipa--Peru's second largest Arauche city--is one-fourteenth that of 0 100 200 800 400 500 600 700 Lima. Yet other cities are also growing rapidly. As depicted in Figure 1, the aggregate growth rate of urban areas other than .__Lima exceeded that of the capital during the 1980s. As a result, Peru now has 15 cities with populations over 100,000 (see Figure 2). Ten of these are growing at a faster rate than metropolitan Lima. 1.6 Peru therefore has two distinct sets of urban conditions. On one hand are the problems of Lima: the problems of managing a megacity, with an existing backlog of infrastructure deficiencies which is growing substantially in absolute terms, given Lima's large population base-- an average annual population increase of 250,000 even though its growth rate in percentage terms is relatively low. On the other hand are the problems of an emerging second tier of cities, many of which are growing at extremely high rates, albeit off a smaller population base. -3- 1.7 The country's ability to provide services to this growing urban population is constrained by the low incomes of urban households. Poverty is now a predominantly urban phenomenon in Peru. During the decade of the 1970s, Peru made substantial progress in reducing poverty. The share of households classified as poor or extremely poor had declined significantly by 1980. These gains, however, were largely in rural areas. In relative terms, the extent of urban poverty rose substantially. In the subsequent decade, these gains in rural incomes were completely wiped out, and the extent of urban poverty increased. As a result, the majority of poor households in Peru are in urban areas. As shown in Figure 3, 75 percent of the officially classified poor now live in urban areas. Figure 3 1.8 Due in part to the rapid rate of urban growth and Regionstribution of Poverty the low level of urban incomes, the quality of urban infrastructure services is low. In the water sector, for Lrna example, less than 60 percent of the population lives in dwellings connected to safe public water supply systems. Water service is provided on an intermittent basis even in Urban Coast major urban centers. In Lima, water pressure in 70 1 percent of the districts is below the minimum recommended pressure. In urban centers other than Lima, Arequipa, and Trujillo, about 30 percent of the Urban Sierra o6 population has water service less than 10 hours a day. Similarly, only about 45 percent of households has access to safe sanitation (in-house connections and septic tanks). 1.9 The coverage and reliability of electric power is also low, relative to other Latin American countries. Although access to electricity increased from 34 percent in 1980 to 44 percent in 1989, it is still low compared to Brazil (70%); Argentina (85%) or Mexico (75%). Per capita consumption, at 660 kwh/year, is also low compared with the South American average of 1,479 kwh per year. Coverage and reliability are considerably worse in low income areas. In Lima, 27.5 percent of pueblos j6venes does not have electricity service, while 31.2 percent has partial service and 41.3 percent has total service. 1.10 Inadequate solid waste collection and disposal is a source of public health problems, particularly in large cities. Metropolitan Lima produces between 3,000 and 3,500 metric tons per day. Of this total, it is estimated that 50 percent is collected and another 50 percent is burned, left on the streets, or informally recycled. 1.11 Traffic congestion is also a problem, particularly in Lima. The rapid growth of population and car ownership has placed tremendous demands upon the urban transport system. Traffic congestion, with ensuing delays in the movement of people and goods and excessive use of fuel, is common in the central area of Lima as well as its main access roads. In the older, built-up areas -4- of Lima and other larger regional cities, all main roads and most side roads are paved. In outlying pueblos j6venes, the majority of side roads are not paved and are generally in a poor state, discouraging the entry of buses, refuse collectors, and other service vehicles. C. The Management Problem 1.12 Failures in the coverage and quality of services reflect, in part, aggregate resource constraints. As mentioned above, the ability of the Peruvian economy to provide convenient, reliable urban services is constrained by the rapid rate of urban growth and the low incomes of urban households. But the available evidence suggests that the constraint on improved service delivery is not merely one of resources. For example, the unreliability of formal water services has resulted in involuntary self-provision as industries and households have been forced to drill wells and install pumps and storage tanks at high costs.' Also, households that have to buy water from private vendors pay between 10 to 30 percent more than those with piped service connections. 1.13 The deficiencies in urban services in the cities of Peru, therefore, seem to be not only a reflection of absolute resource constraint, but also of problems of management. As argued by Dillinger (1994), "failures in urban service delivery are not merely the result of a lack of technical knowledge on the part of local government staff, but also reflect constraints and perverse incentives confronting local personnel and their political leadership, and that these, in turn, are often the inadvertent result of problems in the relationship between central and local government" Accordingly, this paper will examine Peru's institutional and financial structures of urban service delivery from a management perspective, that is determining the incentives, or otherwise, that such structures provide, and review them in the context of the relationship between central and local governments and their constituencies. 2. ADMINISTRATIVE STRUCTURE FOR THE PROVISION OF URBAN SERVICES A. An Overview 2.1 In Peru, there are, in fact, only two government levels: the central goverinment and municipalities (provincial and district), since only these two have executive and legislative branches which are normally considered attributes of government. 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 The Bank's staff appraisal report for the Lima Water Rehabilitation and Management Project mentions that the total rationing costs-resulting from households having to install pumps and water tanks to deal with rationing-were calculated at US$0.38 per cubic meter. Such costs were higher than the average water tariff of around US$0.34 per cubic meter. -5- regions. The twelve regional governments were 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. 2.2 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. As shown in Figure 4 this is not only far below the levels of industrial countries, but also substantially below the level of other countries in Latin America. Figure 4 MunlopMal Share of Expenditure ment et Publio eMantar Country Japan U.KC. U.S. Franoe mail Colomble Chile Memloo Peru 0 10 so so 9o 0o so 70 Perent of Thatal 2.3 These figures, if anything, understate the degree of centralization in Peru. As a consequence of policies of previous regimes, the central government controlled--at the time the present regime took office--not only the on-budget expenditures of government (which are reflected in the figures) but also a range of off-budget parastatals, including national water and power utilities, giving it a virtual monopoly over urban service provision. 2.4 It is important to note that, in addition to being concentrated at the central level, capital expenditure is mostly controlled by the Ministry of the Presidency. This Ministry has a virtual monopoly over investments in infrastructure and social programs: it controls fifteen public enterprises, programs, and decentralized public institutions. Among the most important are INFES (Infrastructure for Education and Health), INADE (National Development Institute), and FONAVI (National Housing Fund). FONCODES, the National Compensation Fund for Economic and Social Development, which also finances investments in basic infrastructure and -6- social programs used to belong to the Ministry of Presidency, but now is under the Office of the President. Most of these entities have a preference for allocating funds fragmentally and working directly with community and non-governmental organizations rather than local governments. As a result, coordination among these several entities becomes virtually impossible. Such a concentration raises an additional concern: it causes dissociation between the policy and regulatory functions of line ministries and the control over sector expenditures. 2.5 Some deconcentration of expenditure responsibility to the regions has occurred recently in the social sectors, notably, in education and health. In education, the central government's share of expenditure, in.1993, was about 47 percent, while the remaining 53 percent was spent by regions, basically on primary, secondary, technical and higher non-university education. In the health sector, 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, in 1994. Specialized hospitals are the responsibility of the Ministry of Health. 2.6 Regions have, however, little autonomy over expenditures. In education, over 91 percent of expenditures consists of salaries and pensions, which are determined by the central government. In the health sector, about 73 percent of expenditures is for personnel (doctors, nurses, and pensions), with salary scales determined by the Ministry of Health. To the extent that regional offices negotiate budget allocations directly with the Finance Ministry, this is cause for little coordination between them and line ministries. 2:7 The Peruvian constitution recognizes two levels of local government. The larger units are termed provincial municipalities, and number 189. These are in turn divided into district municipalities, numbering 1,794. Both provincial and district municipalities are governed by locally elected councils and mayors (alcaldes) who preside over the councils2. As mentioned before, the relationship between provincial and district municipalities is not well defined. Although the mayor of the district that is designated the provincial capital is also the mayor of the province, the councils and mayors of other district municipalities are not legally subordinate to provincial councils. 2.8 Both levels of local government enjoy a broad, but ambiguous mandate. 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 limited, and opportunistic. Until the recent decentralization of the water services, virtually the only services in which the municipal government played a predominant role was 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, have a strong presence in financing 2 The terms of the councils and the mayors are 5 years and are co-terminus. Unlimited successive terms are permitted for councils and mayors. Each council has representatives from the mayor's party in proportion to the votes he receives; others are in proportion to the votes of their mayoral candidates. -7- capital investments (see details in Chapter 3). In the social sectors, municipalities have some responsibilities, 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. 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 Bisico), all of which favor 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. 2.9 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. Municipal finance issues are further discussed in Chapter 4. B. Recent Reforms 2.10 The present Government is in the process of restructuring urban service delivery systems, as part of wider reforms in the structure of the economy as a whole. During the first stage of reform, the government took dramatic steps toward stabilizing the economy and rebuilding ties with the international financial community. The main components of the program aimed at eliminating the chief source of hyperinflation--the monetary financing of the fiscal deficit. The government also placed strict controls over public sector wages and salaries, and increased tariffs for water and electricity by about ten-fold. 2.11 A second stage of reform began in 1991, and has included various measures to restructure the public sector. Two distinct trends are evident in this part of the reform. On one hand, the government is reducing central control over public utilities; transferring water utilities to local governments and privatizing the power utilities. But at the same time, it is retaining and even centralizing control over tax-financed activities of the public sector, particularly the allocation of capital works. 2.12 These reforms are still in progress, and it is too early to assess the results. Nevertheless, some aspects of the reform process are cause for concern. While the direction of reform in the utilities appears promising, the merits of the government reforms in other sectors of urban service delivery are less clear. A brief discussion of such reforms is presented below. -8- Water Supply 2.13 Until 1989, urban water supply was the responsibility of the Servicio Nacional de Agua Potable y Alcantarillado (SENAPA), under the Ministry of Housing and Construction. Operating as a holding company, SENAPA supervised the operations of 14 subsidiary companies (SEDAs) in charge of operations in large cities or departments, and directly operated services in ten departments through ten operational units which provided services to small and medium sized towns. (Another 185 municipalities, with ten percent of the urban population, administered such services directly.) 2.14 Although the legal framework that created the operating companies gave them considerable independence, in practice their management autonomy was limited. Procurement procedures, tariff rates, budgets, personnel policies and salaries structures were tightly regulated by Government agencies. One such agency--CONADE--regulated salary levels and approved the annual budget of public enterprises; another--CORTAPA--regulated tariffs (although tariff decisions were ultimately made at a political level). 2.15 The Government is well embarked on a program of decentralization and deregulation in the water sector. In 1989, SENAPA was abolished, and--except in Lima and Trujillo--subsidiary operations of SENAPA have been transferred to municipal control. A new legal and regulatory framework for the water and sanitation sectors is being formulated under which these entities would operate. Under the proposed legislation, operating entities would be organized as autonomous commercial state enterprises. Municipal governments would be responsible for providing the service, although smaller cities would be encouraged to form regional water companies, in order to create a viable market for commercial operations. Municipal water companies would have substantial discretion over tariffs, and personnel management. 2.16 While the passage of this legislation would establish the legal basis for reform, its implementation will take some time and several key issues still remain to be addressed. Key among these is the question of tariff policies and rules for the allocation of funding for capital investment. While the Government has enunciated a policy of local management autonomy over tariffs, there is recognition that some degree of central tariff regulation may be needed, in order to prevent local operating companies from exploiting their position as monopoly providers of water services. The question of tariff subsidies also remains unresolved. While the government has enunciated its preference for full cost recovery through tariffs, the issue of how the new commercially oriented water utilities will provide service to low income populations remains unresolved. It is also recognized that, given past financial problems in the sector, and the lack of a financial track record on the part of the existing entities, some degree of central government participation will be needed in order to provide access to long term financing for major capital investment. Under the proposed legislation, both tariff regulation and capital allocation are largely the responsibility of the newly created Superintendencia Nacional de Servicios de Saneamiento (SNSS). How SNSS will perform these tasks is unclear. These issues are discussed in more detail in a separate study of Peru's water sector that is being prepared simultaneously. -9- Electric Power 2.17 The Government is also reducing its role in the power sector. Peru's power sector was nationalized in the early 1970's. Since that time, electricity service has been provided exclusively by government-owned utilities. These include Electroperu, a nationwide generation and transmission utility, which sells entirely in bulk to other utilities; Electrolima, the second largest generation company and the largest distribution company (serving the greater Lima region) and nine smaller regional utilities. 2.18 Since nationalization, Government interference and financial constraints have weakened sector management, impeded corporate efficiency and worsened employment conditions. According to a recent review of the sector' past governments considered the sector more as a vehicle for extending subsidies, controlling inflation, or creating employment, than as a public utility. Tariffs, which had been set by a quasi-autonomous regulatory agency, came under direct government control in 1985. 2.19 As in the water sector, the Government is now embarked upon a deregulation and transfer of ownership in the power sector. Under the framework enacted in 1992, power generation will be opened to private competition. While transmission and distribution will continue to be natural monopolies, tariffs will be set by an agency whose independence from Government will be legally and financially ensured. As a first step in the implementation of this new framework, Electroperu, Electrolima and the larger regional utilities have been segmented into independent companies for generation, transmission, and distribution, in order to make their corporate structure consistent with the new regulatory principles. 2.20 Like the decentralization of the water sector, the institutional reforms in the power sector are still in process. The Government's role in tariff regulation remains subject to dispute. Subsequent to the enactment of the new power sector law, the Government--concerned at the impact of electricity prices increases on inflation--created a technical commission with authority over electricity pricing, although it has subsequently communicated its intention to eliminate this authority, and maintenance of the autonomy of the electricity regulatory commission. Anti-trust regulations are also needed for the electricity sector, as the existing economy wide antitrust legislation does not specifically address issues that could arise from the abuse of market power in the electricity sector; an issue that is also addressed under the proposed adjustment loan. Other Urban Infrastructure Services 2.21 In what remains of the Government's direct involvement in urban infrastructure, an opposite trend is evident: the persistence not only of the central government's dominance of public sector spending, but also an increasing concentration of discretionary spending at the central level, and the continued tight regulation of local government. 3 Peru: Sector Reform and Investment Review (1990). -10- 2.22 Under the present Government's policy, a direct Government role in urban infrastructure persists, in two respects. First, the government continues to finance extensions to water and power networks in low income neighborhoods, as a tool of poverty alleviation. Second, the Government participates in the provision of other, more "public goods" type services--transport, solid waste management, public lighting, parks, sidewalks--in an uneasy relationship with local government and one in which the boundaries of respective responsibilities are unclear. C. Institutional Issues 2.23 The overview presented in the previous section highlights several major issues regarding the roles of the central and municipal governments in the provision of urban services. On the institutional side, the key issue is the assignment of functional responsibilities between the central and municipal jurisdictional levels which, in turn, must be appropriately matched by the assignment of revenues (see Chapter 4 for a discussion of municipal finance issues). The major institutional issues are as follows: a) Lack of clarity in functional assignments among different jurisdictional levels 2.24 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 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 latter directive clearly allows for a central government role in the provision of local public services, thus creating ambiguity with regard to the functions of each level of government. This ambiguity is reinforced by the Organic Law of the Ministry of the Presidency (1992) which establishes that the mandate of this Ministry is 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 it is reasonable to expect the central government to perform policy and regulatory functions regarding the provision of urban services, it should not assume any other functions, unless justified by the existence of benefit spillovers. As proposed below, the central government should decentralize to local governments all management functions regarding the provision of urban services, retaining only key policy and regulatory functions. 2.25 Central versus Regional. The 1993 Constitution recognizes the existence of regions as a jurisdictional level with administrative, financial, and political autonomy for discharging its responsibilities. Also, it establishes that their responsibilities are limited to coordinating and executing regional-economic plans and programs, as well as "managing the activities and services - 11 - 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 government structure. A draft law on decentralization (Ley Marco de Descentralizacidn) being discussed in Congress also does not specify functions and resources for the regions. So, while the responsibilities and functions of regions remain largely unclear, it is unlikely that they will become a government level because of the political opposition to it generated by the troubled establishment of regional governments, in 1989. In the short run, 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--should be considered as an alternative to full-fledged regional governments. 2.26 Municipal: Provincial versus District. Both the Constitution and the Municipal Organic Law establish a distinction between provincial and district municipalities. However, functional assignments between them are ambiguous to the extent that 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 to the extent that they have the power to create delegated municipalities in any district municipality within their jurisdictions 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 (charged with coordinating services which have an impact on two or more districts) is useful for minimal service coordination in metropolitan agglomerations 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 needed. While Decree 776 transfers funds directly to district municipalities, thus reducing their dependency on provincial municipalities, it reinforces a fragmented approach to the provision of public services. 2.27 Another issue is related to the dual role of provincial municipalities. In addition to governing the provincial jurisdiction, they also function as the government of the central district, i.e. the provincial capital. 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. Ideally, the central district should have its own municipal government like any other district. The provincial government would, therefore, have specific functions concerning the provincial jurisdiction. These functions would be limited to those necessary for dealing with situations where either externalities (both positive and negative) or economies of agglomeration and of scale are present. Examples of such situations are: the need to regulate and control traffic in large cities that extend beyond district boundaries so as to minimize problems associated with externalities, and the management of trunk infrastructure for water or any other service where economies of scale prevail. -12- b) Duplication and lack of coordination among central government institutions 2.28 The centralization of operational institutions (such as the special funds mentioned before) under the Ministry of the Presidency seems to have been a pragmatic response to dealing with problems in an emergency situation characterized by a weak executing capacity on the part of many government agencies (including line ministries) and an urgent need to implement poverty alleviation programs. This approach, however, 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) and between them and line ministries. Also, it has created institutional uncertainties with regard to the role of line ministries and promoted "parallel governments" 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. 2.29 Although such an approach can be very effective in delivering 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 action is needed in the long run. This means that government action, especially investments, will need to be made in the context of much more sophisticated sector 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. This could be achieved, for example, by converting these special funds into matching grant funds for cofinancing municipal projects. c) Lack of political commitment to decentralizing responsibility for urban services provision to municipal governments 2.30 Even though the decentralization of responsibility for the provision of urban services can be justified on production and economic efficiency grounds as it takes into account the comparative advantage of municipal governments in the provision of such services, it implies a new balance of power. For this reason, it requires strong political commitment of central government agencies to share power with municipal governments. At present, there is ambivalence about the advantages of a decentralized approach to the provision of urban services, especially by some central government agencies that execute investment programs directly with community based and non-governmental organizations (CBOs and NGOs). There is, in fact, mistrust between the central government and municipalities and mutual accusations of political maneuvering. This explains the marked preference of the special funds noted above to work with CBOs and NGOs directly, thus circumventing local authorities. - 13 - 3. CAPITAL INVESTMENT FINANCING A. The Present Structure 3.1 The major sources of capital financing for urban infrastructure are internal financing by local utilities, municipal government financing, central government financing and external forms of finance. Because it is most relevant to the water sector (which is the subject of a separate report as mentioned in para. 2.16), the internal financing by local utilities will be briefly mentioned here. This section will focus on the discussion of urban services financing by the central government due to its significance in the case of Peru. It also explores the possibility of using capital market financing. Municipal financing is discussed in Chapter 4. Internal Financing by Local Utilities 3.2 The financial position of many local utilities (either in the forms of municipal autonomous companies or municipal operating units) is still very weak due to lack of cost recovery policies, deficiencies in management and staffing, and political interference of the municipal governments in daily management decisions. The problems are partly due to the co-existence of the old and the new institutional and regulatory framework. The establishment of new institutions since the reform process started has not always coincided with the dissolution of older institutions that have a mandate that is not in line with the new policies. The co-existence of several agencies results in political interference at different government levels. At present, local service providers have to face not only interference from municipalities, but also from central government agencies. A prime example of this is CONADE, which tightly regulates procurement procedures, annual budgets, personnel policies and salary structures of the public sector. In local water companies, such an interference has resulted in a lack of highly qualified staff as CONADE regulations give professionals little incentive to work in the public sector. 3.3 In the case of water supply, the new Sector Law mentions full cost recovery as a basic principle for tariff setting. Since the enactment of the Sector Law, water rates in many local water companies have been raised and are increasingly in line with full cost recovery principles. In 1994, nine out of fourteen water companies surveyed used tariffs that were sufficient or exceeded full cost recovery4. Yet, for most other urban services full cost recovery is not yet a basic principle in government policies. Central Government Financing 3.4 The majority of funds for urban infrastructure investments are controlled by central government agencies. The concentration of urban infrastructure finance is shown in Table 3.1. 4 It should be noted that this figure could be slightly overestimated as many water utilities tend to neglect maintenance, while depreciation is based on historical costs. -14- This table shows that about 70 percent of all government budgeted investment in local infrastructure in 1993 is financed through central government agencies. If regional expenditures are includeds, then the central government's share of capital expenditures increases to 85 percent. As mentioned before, capital expenditure is mostly controlled by the Ministry of the Presidency (MIPRE). Except for FONCODES, MIPRE controls the most important funds for financing urban infrastructure. These funds as well as a multitude of smaller programs controlled by MIPRE can be seen in Table 3.1 where they have been depicted in bold. FONAVI and FONCODES, the two largest funds are examined below. Table 3.1 Budgeted Investment in Local Infrastructure (in US$ million) Financing Sources 1993 1994 1995 Local Government: Municipalities 120.2 174.3 267.8 Invermet (Metropolitan Lima Investment Fund) 21.9 37.2 n.a. Regional Government: CTARs 167.8 180.0 224.3 Cordelima 4.5 4.5 5.9 Cordecallao 39.1 20.9 25.4 Central Government: FONCODES 159.6 184.4 156.6 FONAVI - FONAVI 171.1 301.9 385.5 - ENACE 29.4 83.6 90.4 - Banco de Materiales 16.4 92.0 76.6 - PRONAMACH 24.1 57.3 60.7 - PRODEIS 0.0 34.2 n.a. - PRASBA 0.0 0.0 0.5 PRONAP 1.2 43.3 14.4 COOPOP 7.6 9.1 19.9 PRONAA 23.3 22.8 15.9 INFES 49.4 41.4 119.2 INADE 88.1 94.5 17.7 Saneamiento Basico Rural (MINSA) .1.3 1.9 2.4 Loc. de Salud (MINSA) 19.3 0.0 0.0 TOTAL 934.4 1,383.3 1,483.1 Notes: FONAVI as defined in this table finances investments in local infrastructure through direct credits, mortgages and loans to Sedapal and other Sedas. Loans to ENACE, Banco de Materiales and other public entities are mentioned separately. Source: Universidad del Pacfico, Centro de Investigaci6n, Financiamiento de Inversiones de Capital. Lima, February 1995. FONAVI 3.5 The largest fund for financing urban infrastructure is FONAVI. Its resources are derived from a 9 percent levy on the salaries of workers in governmental and formal private sector s All expenditures of the Consejos Transitorios de Administraci6n Regional (CTARs) are financed from government allocations. Moreover, CTARs have little autonomy over expenditures. - 15 - organizations.' Until 1992, FONAVI resources were managed by the Government-owned housing bank (Banco de la Vivienda), which financed the construction of serviced sites and completed housing units through the Government-owned housing construction agency (ENACE) and other associated agencies. 3.6 The housing bank was liquidated in 1992, leaving behind an inventory of some 30,000 unsold completed units, and a housing loan portfolio with an estimated default rate of 40 percent. The fund, however, was allowed to persist. It was transferred to MIPRE, and given a fundamentally new role. Under its new orientation, lending for serviced sites and finished housing has been substantially reduced. FONAVI is now charged with the responsibility for financing water and sewerage as well as electrification projects in squatter settlements (pueblos j6venes) through loans either to local community groups or public enterprises. In 1993, roughly half of FONAVI's lending was under the new program: NS/. 114 million was lent to individuals for electrification; another NS/. 103 million was lent to individuals for water and sewerage. Lending to government agencies constituted the remainder (although lending to ENACE shrank to 15% of the total). 3.7 In principle, the reoriented FONAVI is a complement to the reforms in the water and power utilities, financing network extensions in neighborhoods that might not otherwise be attractive the new commercially oriented water and power utilities. According to its regulations, FONAVI's direct lending is carefully targeted at the poor: beneficiaries must reside in pueblos j6venes, and potential beneficiaries must organize as community groups, and prepare projects that meet the eligibility criteria of the program. It is also not heavily subsidized: in principle, FONAVI's role is not that of a subsidy provider, but strictly that of a financial intermediary-- providing low-income households with a means of stretching out the substantial capital costs of water and power connections and thereby rendering what would be unaffordable as a lump sum charge, affordable as a series of monthly payments. Loan terms are normally five years for electricity projects and seven years for water projects, with interest equivalent to bank deposit rates. As this was below the rate of inflation (in 1993), it represents a subsidy, but not a major one. 3.8 Although FONAVI is an important fund for financing urban infrastructure, it has some major weaknesses. These are chiefly related to FONAVI's source of funds and the coordination and sustainability of its investment programs. The 9 percent payroll levy that finances FONAVI is regressive as it affects the relative price of labor in the formal sector, and subsequently affects investment decisions and the generation of employment in the formal sector. It has contributed therefore to the rise of the informal sector in the economy. 3.9 A second issue concerns the repayment of FONAVI loans. Bad debt rose significantly in 1994. Households benefiting from FONAVI loans are essentially composed of the poor and the extremely poor. For these groups, FONAVI loan repayments can amount to 10 to 51 percent of 6The 9/. FONAVI 'contribution' is formally a forced savings scheme. Because there is no linkage between a workees contribution and the benefits he receives, it has the attributes of a tax. -16- their monthly household income. These high repayment rates are partly due to the specific nature of FONAVI operations in which contractors and suppliers can act as promoters of FONAVI investments. This procedure is not likely to result in a preference for least-cost solutions. As a consequence of the high repayment rates, FONAVI has received only 24 percent of its total loan repayments between 1993 and 1994. FONAVI is planning to take measures to reduce its number of non-performing loans by increasing its collection effort, adjusting the repayment schedule of its loans and transferring responsibility for recovering existing loans to the water utilities. However, these measures will not resolve the structural problem caused by the poor's low ability to pay for water. The current problem of non-performing loans is not only limited to the repayment problems of local communities. Utilities, especially water supply companies, also have serious problems in repaying FONAVI debts due to their weak financial performance. 3.10 A third issue includes the lack of coordination of urban infrastructure investment projects. Although working with the local communities has the advantage of guaranteeing that investments are demand-driven, it also results in a serious fragmentation of efforts at the central level. Coordination between FONAVI and local governments is almost non-existent. FONAVI has a preference to work directly with local community groups, bypassing local governments in investment allocation decisions and, therefore, undermining their authority in urban planning and development. FONCODES 3.11 The second major program of centrally controlled capital financing is the Fondo de Compensaci6n para el Desarrollo Econ6mico y Social (FONCODES). FONCODES was established in 1991 as a temporary emergency social fund to address the immediate impact of the economic crisis and the social costs of the Government's adjustment program. The fund, financed from general government revenues and donor assistance, provides capital for small civil works projects in a variety of sectors, in rural and peri-urban areas. These include infrastructure--water supply, sewerage, and electrification--but also investments in the social sectors: health promotion and disease prevention campaigns, school rehabilitation and equipment. Since its inception, FONCODES has approved projects with a total worth of US$ 418 million, of which nearly 69 percent was proposed by community groups and another 17 percent through non-governmental organizations. 3.12 FONCODES and FONAVI are rather similar in their set-up in that they both finance demand-driven investments in basic infrastructure. Direct applicants for FONCODES projects can be grassroots organizations, native and rural communities, religious organizations located in low- income communities, NGOs, provincial or district municipalities, or any representative organization seeking social benefits. Like FONAVI, FONCODES is subject to an appraisal process intended to ' Between 1992 and 1994, FONAVI lent US$ 273 million to the water and sanitation sector, which benefited 211,656 households. Assuming a monthly interest rate of 1% and a repayment period of 5 to 12 years for local community groups, and monthly household incomes ranging from US$ 60 to US$ 180, this results in total monthly cost of 10 to 18% for the poor and 30 to 51% for the extremely poor. -17- elicit beneficiary commitment: at the heart of the project identification and approval process are nucleos ejecutores. These are small committees of potential project beneficiaries who formulate their demands for a specific service (e.g., a new community health post) and, with the assistance of an appointed "inspector' present their proposal to FONCODES' regional offices. These offices provide preliminary analysis and refer projects to Lima for centralized approval. Unlike FONAVI, FONCODES is explicitly grant-financed.8 3.13 FONCODES is considered to be an expedient mechanism for social spending. However, it suffers from some of the same weaknesses as FONAVI's. Specifically, these are related to the coordination and sustainability of its investment program. Due to its specific set-up in which almost anyone--including contractors--can act as promoters for projects financed by FONCODES, it is possible to create a demand for certain investments which do not necessarily reflect the most urgent needs, thus affecting the sustainability of such projects. Also, because investments are grant financed, there is no incentive to opt for least-cost solutions. 3.14 The coordination issue arises from the fact that many other government programs besides FONCODES are meant for poverty alleviation. Hence, there is ample room for duplication of efforts. FONCODES' investment program overlaps potentially with those of PRONAA, INFES, COOPOP, INADE and FONAVI. To avoid duplication, inefficient use of resources, and inter- institutional conflict, a commission has been set up to coordinate policies and programs of FONCODES, and other sector ministries and government agencies. However, because this commission does not include all the organizations operating in the urban sector, there is doubt about its effectiveness. FONCODES and FONAVI have decided informally to reduce the overlap between the two agencies by having FONCODES target its interventions mainly to rural and small urban areas, whereas FONAVI aims at bigger cities. It is not yet clear how successful this informal division of responsibilities is. In addition to the coordination problems among central government agencies, coordination of investments between FONCODES and the local governments is poor. The emphasis on local community groups has caused FONCODES to bypass local governments in the allocation of investments. Thus, like FONAVI, FONCODES tends to undermine local government's authority in urban planning and development. External Financing 3.15 There is little data available about the extent of external financing in urban infrastructure. Multilateral organizations, such as the Bank and the IDB, have committed directly to financing specific urban infrastructure services (such as water supply and sanitation), while they also have lent indirectly through FONCODES. Bilateral donors are also financing urban infrastructure, either directly or indirectly through several government agencies involved in urban infrastructure finance. 8 FONCODES does operate a line of credit for small enterprises which is disbursed a loan, however. - 18 - 3.16 The basic issue with regard to external finance is the lack of coordination. Neither the Ministry of Economy and Finance nor any other institution have mechanisms to coordinate external funding. Also, there are no provisions for assessing urban infrastructure projects, once external financiers ask for government guarantees. This situation leaves open the possibility for inefficient allocation of resources and unsustainable investments. It can also adversely affect an equitable distribution of resources. Finance through Capital Markets 3.17 Financing for urban infrastructure investments has been the domain of the government, mainly the central government. However, in view of the large financing requirements needed for the rehabilitation and expansion of urban infrastructure, and the global trend towards privatization, private financing for infrastructure investments could account for a much larger share than in the past. 3.18 Private sector participation in the financing of infrastructure investments can take many forms. Concession agreements and BOOT9contracts, for example, can directly mobilize private capital for investments in infrastructure. Also, infrastructure funds and domestic capital markets can play an important role in mobilizing private capital for infrastructure financing. 3.19 Infrastructure funds can be used as temporary mechanisms to provide infrastructure finance until capital markets are more developed. Such funds have two major advantages. First, they can provide leverage inasmuch as government finance and/or official aid flows are complemented with private capital. Second, these funds allow its borrowers to develop a credit history and, therefore, gain direct access to capital markets in the future through the issuance of bonds, for example. Yet, to enable these infrastructure funds to be successful, they have to price their loans according to market rates. An example of a successful infrastructure fund is FINDETER (in Colombia) which is a municipal rediscount facility-- FINDETER finances commercial bank loans to municipalities up to 85 percent of the loan value, with the same maturity. 3.20 Yet, the domestic capital market also constitutes an important source of funding for infrastructure investments. In Peru, however, the domestic capital market is still small and not very deep. Privatization has given a boost to the local stock markets. Its capitalization soared between 1990 and 1994. In addition, new investors, such as pension funds and insurance companies, have emerged in the market. It is estimated that these new investors will bring approximately $800 million to the market, annually. Although the bond market is still underdeveloped at present, in the longer run this market could become an important new source for financing municipal infrastructure projects. * BOOT is Build, Own, Operate and Transfer (to Public Authority) Contracts. -19- B. The Issues 3.21 In order to consolidate and improve the reform process initiated in 1990, new approaches to financing urban infrastructure are needed which will lead eventually to a greater reliance on private capital markets. However, before such new approaches can be defined, a number of issues concerning the present structure of capital financing for urban infrastructure needs to be addressed so as to guarantee a satisfactory and efficient delivery of urban services in the meantime. The key issues are as follows: a) Capital investment financing for urban infrastructure is extremely dependent on central government funding. The present system allows an undesirable concentration of discretionary power over investment allocation at the central government level while also lacking any mechanism for coordinating and prioritizing capital investments. 3.22 Together, FONAVI and FONCODES represent the vast bulk of central government expenditure on urban infrastructure services. This approach to the financing of urban infrastructure is subject to several criticisms, however. The most striking deficiency of the present system is the absence of any mechanism for coordinating and prioritizing capital investments. Decision making power ultimately rests with the Office of the President, which reviews each project in isolation, on the basis of whether it meets with program rules. Authority to initiate projects, in general, lies not with local governments, but with ad hoc community groups as discussed above. As a result, program funds are dissipated on small capital works, which may be successful in responding to immediate demands, but fails to fit into an overall strategy for a given infrastructure service in a given jurisdiction. Thus, one observes new extensions to water lines while existing networks are deteriorating. b) The present system is biased against maintenance and rehabilitation. 3.23 Central funding is relatively plentiful for capital investment, but is largely unavailable for operations and maintenance. While the central government is liberal in its own funding of capital investment, it tightly controls local governments' ability to raise revenues for operation and maintenance of urban services (see Chapter 4). Consequently, operation and maintenance of the works financed by the central government tends to be underfunded. This, in turn, undermines the sustainability of such investments. c) The system is rife with superfluous subsidies 3.24 How large these subsidies are depends, in the case of FONAVI, on the magnitude of the gap between its interest rate and the opportunity cost of capital, and more importantly, on how well its portfolio performs under the new rules. How superfluous the subsidies are depends upon how effective these programs are at targeting poor people. Much has been made of the effectiveness of both FONCODES and FONAVI in targeting poor households through community based organizations. Nevertheless, it is not clear that the present level of subsidies is -20 - sustainable, given the tight budget constraint under which the Government of Peru must operate over the long term. In particular, the justification for subsidies in sectors such as water supply, in which cost recovery is both feasible and desirable (from an economic standpoint), is not clear. 4. MUNICIPAL FINANCE AND MANAGEMENT A. Defining the Problem 4.1 From a public economics perspective, local governments are well positioned to prioritize and coordinate infrastructure investments across sectors, as they have a cross-sectoral mandate and a localized geographical frame of reference. By virtue of their ability to tax, local governments are in a position to finance maintenance costs, and to recover capital costs, thereby reducing the need for capital subsidies. These potential benefits are not now exploited in the Peruvian structure of government. As noted before, local governments do exist and enjoy a broad mandate under the present legal framework. In practice, however, the effective role of the municipalities is restrained by a number of institutional issues (as discussed in Chapter 2) as well as their limited control over resources. 4.2 Many would argue that the limited role of Peruvian local governments in the provision of urban services is also the result of a lack of technical knowledge on the part of municipal staff. Indeed, the lack of technical knowledge is a shortcoming that needs to be addressed if municipal governments are to play a more prominent role in the provision of urban services. Evidence suggests, however, that local governments will likely respond positively to the challenge of capacity building, if provided with a clear mandate and an adequate system of incentives. A recent Bank studylo of local government capacity in Colombia infers that competition for public office opened, in many cases, the doors to responsible and innovative local leadership that, in turn, became the driving force behind capacity building efforts. It also infers that wide-spread community participation--voicing demands, making choices, being involved in projects--provide the basis to sustain local government capacity over time. It is important to note, however, that in Colombia (unlike Peru) the decentralization process is advanced and provides a clear division of functional responsibilities between the central and local government. 4.3 Though competition for public office and community participation exist in Peru, as mayors are elected by popular vote and many government funded programs work with community groups, local governments are not likely to develop their own capacity unless constraints and perverse incentives resulting from problems in the relationship between central and local government are addressed. In the previous chapters, institutional and capital investment financing issues affecting the relationship between central and local governments were examined. To 1o Colombia - Local Government Capacity: Beyond Technical Assistance. Report No. 14085-CO. - 21 - complete the analysis, it is important to study the structure of municipal finance since this is a critical element in such a relationship. So, while touching upon internal management problems of local governments, this chapter will focus on municipal finance issues. B. Municipal Finance Issues a) Limited municipal fiscal autonomy 4.4 Fiscal autonomy of municipal governments is very limited. These governments cannot impose taxes or determine tax rates; they are determined by the central level. The same tax rate structure applies to all municipalities. In general, municipalities can update tax bases, except for the property tax which is updated by the National Council of Assessments (Consejo Nacional de Tasaciones) without any involvement of municipalities. 4.5 Ironically, the Peruvian municipalities have not historically lacked tax instruments. Until 1994, 21 tax instruments were assigned to the municipalities. In the more urbanized municipalities, the highest yielding of these was (and continues to be) a recurrent property tax. Although proportionately large, the yields of the property tax are unimpressive in per capita terms, falling behind international standards. As shown in Figure 5, property tax yields per capita ranged from US$1.30 to $6.70 (in 1991) in Peru's largest municipalities. While this is partly a result of poor local tax administration, it is also the result of central regulation. Both the pricing factors used to determine property tax assessments, and the nominal tax rate, are fixed by the Government--pricing factors for land vary by region, while pricing factors for construction are nationally uniform as are the tax rates. It is estimated that property tax revenues may be as low as one fifth of the potential value due to outdated cadastres, low assessed property values, and evasion. Municipalities should have the responsibility to update cadastres, and establish tax rates within a certain range, as in many 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, autonomously. 4.6 The importance of other taxes varied among municipalities. The alcabala--a property transfer tax--tended to be the second highest yielding tax. In Cuzco, however, the largest local source of revenue was a tax on beverages and cigarettes, while in Chiclayo it was a property- based business tax. 4.7 User charges, in various forms, tended to yield as much revenue as taxes in the larger municipalities. The most important of these were garbage collection fees, to a lesser extent, charges for street cleaning and public lighting fees. The relatively high yields of user charges was largely attributable to the practice of imposing them as surcharges on electric bills, where the threat of disconnection was an effective enforcement mechanism. ELECTROLIMA, for example, collected garbage collection and public lighting fees on behalf of municipalities in metropolitan Lima through a 24 percent electricity bill surcharge. - 22 - 4.8 Effective in 1994, the Government imposed a major restructuring of the system of local finance. The new law--Decreto Ley 776--abolishes the property-based business tax, along with a variety of smaller local taxes. While--with the exception of Cuzco and a few other cities that relied disproportionately on the abolished taxes--the law does not substantially reduce local revenue, neither does it give local governments any latitude to increase the yields of the major taxes that remain. While it leaves intact the taxes on property, property transfers, and vehicles, the central government controls on the basis of tax assessments and tax rates also remain in force. Under separate legislation adopted in connection with the power sector reform, moreover, the use of surcharges on power bills as a means of imposing user charges is no longer permitted. As a result, substantial declines in this source of revenue are also expected. Figure 5 Sources of Municipal Revenue (1681, UaS equlvalent. per capita) Country Lima - Cuzco Trujillo Chielayo Pucallpa AvScucho Plura Huancayo CajamarcaE 0 10 20 80 40 0 s0 70 80 Percent of T1tal property E other taxes EMOharges FCM S other tranoters = other b) In spite of having improved the targeting of transfers on poorer rural areas, the FCM has important implications for the financing of infrastructure investments in larger urban areas because it shifts funds from the provincial to the district municipalities, thus fostering the same fragmented capital investment allocation process that characterizes other central government programs. Its distribution formula does not provide any incentives for rewarding fiscal effort on the part of local governments. And, finally and more importantly, it creates ample room for inefficiency in public spending by requiring local governments to allocate at least 80 percent of FCM transfer funds for capital investments. - 23 - 4.9 The provincial and district municipalities also derive revenies from a program of intergovernmental transfers, the largest of which is termed the Fondo de Compensaci6n Municipal (FCM). The FCM is funded from a 2 percent surcharge (equal to about 10% of the receipts) on the national VAT, along with a share of the vehicle tax, and two minor revenue sources. It generates roughly the equivalent of US$300 million per year. Prior to the imposition of Decreto Lei 776, transfers were largely allocated to the provincial municipalities. The formula allocated 30 percent of the total transfer funds to the provincial municipality of Lima; the remainder was distributed among all the other provincial municipalities, half on a unit basis (an equal amount to each province) and half on the basis of population. Provinces were required to share a proportion of the transfers received with the district municipalities within their jurisdiction, although this was subject to some discretion. In the large provincial municipalities, transfer funds were a major source of capital investment. 4.10 The 1994 reform--Decreto Ley 776--also drastically changed the revenue sharing system, in two major respects. First, it reallocated the majority of funding from provinces to districts, designating 80 percent of FCM resources to the districts, and only 20 percent for the provinces. It also changed the geographical distribution of the fund, eliminating the special status of Lima, and instead substituting a formula that targets resources on poorer, rural areas. The new formula first divides the distributable pool among provinces, on the basis of population and infant mortality. Within the provinces (except for Lima) the funds are then divided among districts on the basis of population (with rural population given twice the weight of urban population). In the province of Lima (where the rural/urban distinction would not accurately indicate poverty), funds are distributed among districts on the basis of housing quality indicators and illiteracy. The formula--which may be changed every year by the Ministry of Finance--does not provide, however, for incentives that reward fiscal effort on the part of local governments. Moreover, by requiring local governments to allocate at least 80 percent of the funds received through FCM for capital investments, it creates ample room for inefficient public spending decisions. 4.11 The new arrangement has very substantial fiscal implications for individual municipalities. The principal loser in this scheme is the provincial government of Lima--which has seen its allocation drop by about 80 percent largely due to reallocation of the FCM from provinces to districts. Much of this is made up by the increases in the FCM received by the districts which comprise metropolitan Lima, although in aggregate, the metropolitan area stands to lose about 33 percent of the transfer. The principal gainers are small rural districts in provinces with high rates of infant mortality. 4.12 While one can argue that the present FCM distribution formula improves the targeting'of funds on jurisdictions where poverty is most acute, it clearly comes at a cost. What it has done is very substantially reduce the resources available to finance infrastructure investment in the larger urban areas, without providing a substitute. Moreover, by shifting the funds from the provincial to the district municipalities, it fosters the same fragmented capital investment allocation process that already characterizes central government programs, such as FONAVI and FONCODES. -24- Under the previous system, funds were divided up among only 190 jurisdictions; now they are divided among 1,700 separate districts. 4.13 Overall, the impact of the Government's most recent municipal finance reform is to exacerbate the problems that already existed in the provision of infrastructure in the larger urban areas which concentrate most of the urban population and the country's GDP. Constraints on local resource mobilization remain intact; and the fragmented nature of capital investment allocation that already existed under FONAVI and FONCODES has been extended to the FCM as well. c) Local governments have limited access to financial resources 4.14 Peru's local fiscal resources, at about 1.5 percent of GDP and about 7 percent of total tax revenues, are considered low by Latin American standards. By contrast, 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. In Guatemala, transfers amount to 10 percent, after a 1994 Constitutional reform. In Mexico, combined transfers to states and municipalities were about 18 percent of total tax revenues, in 1986. 4.15 As noted before, transfers 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 FCM does not provide incentives for fiscal effort on the part of municipalities. As suggested by experiences in other countries, it is much better to allow municipalities to raise revenues from their own sources rather than to increase transfers from the central government. Such an approach has the virtue of preserving fiscal stability, while containing expenditures and increasing efficiency of local spending. However, in the case of Peru, given the limited tax base of municipalities, especially the rural ones, and the high level of expenditure centralization, transfers will likely need to be increased at the same time that more autonomy is given to local governments to exploit their own sources of revenue. 4.16 Additionally, municipalities have limited access to borrowing, especially for capital financing. Even though borrowing should not be allowed indiscriminately, it is indeed an important source of financing for municipal governments in well developed revenue systems. Prudent borrowing should be encouraged as loans--by rationing funds on the basis of a borrower's willingness to service debt--are an effective means of testing willingness to pay. FONAVI, an important source of capital investment financing from which municipalities could borrow, is funded inappropriately and biased against local governments to the extent that it prefers to lend directly to CBOs. - 25 - C. Municipal Management Issues a) Most municipal governments lack adequate capacity to implement projects and manage local public services. 4.17 Given the limited de facto resource endowment and genuine authority of municipalities in Peru, it would be unusual for them (except for Lima) to have significant capacity to implement projects and manage local public services. A survey of municipalities carried out recently" indicated significant weaknesses in the professional and technical staff complement of municipalities and in the equipment needed for that. The ratio of municipal employees to population varied from an average of 1 per 666 for district municipalities to 1 per 780 for provincial municipalities. A higher proportion of the staff of the smaller district municipalities were in the professional grades (10.5%) than was the case for provincial municipalities (7.2%). As may be expected, there was a steady decline in staff complement as municipal population levels declined. All municipalities reported significant deficiencies in their complement of machinery, equipment and vehicles, ranging from 70 to 100 percent for some of the smallest municipalities. These numbers, while indicative of existing capacity weaknesses, given the present structure of assignments and financing, should not necessarily be interpreted as binding constraints on the ability of municipalities to perform effectively under a reformed regime. If provided with the right incentives, local governments should be able to address this issue. b) Wages of municipal employees are very low and the labor regime is very rigid. 4.18 Contributing to the capacity problem is the fact that municipalities are subject to the same labor legislation and salary structure of the public sector. On average, the wage of a public sector employee is equivalent to about 60 US dollars per month. The labor regime does not allow the introduction of incentives for performance. Also, the salary scale is very flat, providing little incentives for highly qualified people to work in the public sector and municipalities. As in other countries in the region (such as Colombia and Venezuela), municipalities should be allowed to have their own labor regime (similar to that of the private sector) and a salary scale of their own. Wages should be allowed to vary, within certain limits, across municipalities according to their own fiscal capacity and the size and responsibility of the municipality. This possibility is allowed in the new Constitution and the decentralization law should address this issue. c) Weak budgetary and auditing practices 4.19 Municipal budgets are prepared with no regard for sound financial management principles. The current budgeting practice is limited to recording and measuring the cost of inputs (items) but there is no record of budget execution by programs, or other aggregates that reflect municipal priorities. Additionally, since the municipal comptroller's operating budget is approved by the municipal council, there is not a strong auditing and budgeting control. The Municipal " Estudio de las Finanzas y Administracion Municipal en el Peru, INICAM, April 1995. -26 - comptroller's office applies an ex-ante control and rarely makes ex-post auditing of accounts and results. Now that the General Comptroller's Office is being decentralized, more ex-post control should be applied to municipalities. d) Deficient accountability at the local level 4.20 The present political and administrative systems do provide for a basic level of accountability at the local level. The fact that both mayors and council members are elected by popular vote and can stand for reelection makes it possible for the local constituency to express their satisfaction with their local government. However, the system could be enhanced by having council members be elected individually instead of as part of party slates. Also, there should be a clear separation of responsibilities between the executive and the legislative branches of local government. According to the present system, the mayor presides over the council which has representatives from the mayor's party in proportion to the votes he (or she) receives; others are in proportion to their party mayoral candidates. This inescapably means that all mayors have a majority in local councils. While this may result in a more expeditious relationship between the two branches of local government as far as legislative approval of matters of municipal interest is concerned, it may also reduce the transparency of the relationship between them. Ideally, the legislative branch of local government should be able to exercise control over the executive branch. 4.21 The present administrative system, as established by the Municipal Organic Law does provide for the auditing of municipal administrations. This law requires that the organizational structure of municipalities include a mechanism to exert independent and autonomous financial control through tlie office of a municipal comptroller12 (contralorias municipales). These offices oversee and audit all financial operations, including those related to local revenues, expenditures, assets, and liabilities. In practice, however, internal auditing is most frequently done on a ex-ante basis, while ex-post auditing (when done) is limited and superficial. 4.22 In addition, the Republic's Comptroller General may, in coordination with the municipal comptroller carry out ex-post auditing of municipal administrations. Fiscal and audit controls over decentralized agencies, including municipal associations for the provision of specific services, are the responsibility of the municipal comptroller. Findings are supposed to be reported to the mayor and the municipal council, with the corresponding indication of cases of non-compliance, negligence, violations of norms, etc., as well as the correction mechanisms and/or sanctions. In practice, external audits are rare, and municipal comptrollers are virtually on their own. Some assistance may be received from the provincial comptrollers who usually act, in such cases, upon delegation from the Comptroller General. 4.23 Peru has a strong tradition of community participation as evidenced by the programs operated by the central government, such as FONAVI and FONCODES. In addition to strengthening the mandatory audit and reporting requirements to improve accountability at the 2 The local comptroller is elected by the municipal council. -27 - local level, the government should foster direct community participation in the decision making process at the local level. This could be done by requiring municipal governments to secure the participation of beneficiary communities of municipal projects that receive financial assistance from the central government. Many would argue that the best mechanism to elicit community participation is to ask the beneficiaries to contribute to the funding of municipal projects. By doing this, local governments would allow beneficiaries to decide on the level and quality of services based on their own tastes and preferences. 5. DIRECTIONS FOR REFORM 5.1 In the long term, there is a strong case for extending the process of decentralization that the Government has already initiated in the public utilities sectors into the relationship between central and local government. In order to take advantage of local governments' comparative advantage in the coordination and prioritization of capital investment, cost recovery and the financing of operations and maintenance, the Government should strengthen the role of municipal government as the focal point for the provision of urban services. This shift in roles should not be construed as a wholesale abrogation of responsibilities for certain sectors by the central government, however. Instead, the Government should pursue the model it has initiated in the water and power sectors; transferring management autonomy and authority for specific services to provincial and district municipalities, but within a regulatory and financial framework that maximizes the likelihood that they will exercise that authority responsibly. Clarity in functional assignments 5.2 This would require, first, some clarification in the division of functional responsibilities between central government, provincial municipalities and district municipalities. At present, the respective roles of these three entities is ambiguous and often overlapping. In principle, it would be desirable to devolve responsibilities to the jurisdiction that best incorporates the affected beneficiaries. In the Peruvian context, this might imply an expanded role for the district municipalities. The role of provincial municipalities, therefore, would be limited to the provision of provincial infrastructure (such as provincial roads, for example) and those in which externalities or economies of agglomeration and scale may be present. Hence, while the legislation should provide a clear division of functional responsibilities, it should also maintain enough flexibility (without the risk of being ambiguous) to allow municipal governments to work arrangements that best suit a particular situation, including the possibility of involving CBOs, NGOs, and the private sector. 5.3 Clarity, however, will not achieved by a simple act of legislation or a constitutional demarcation of functions between levels of government. It will require, above all, that the central government refrain from ad hoc interventions in responsibilities that have been nominally assigned -28 - to local government--to observe the hard budget constraint with respect to local functions, no matter how disagreeable the outcomes. Revenue reform 5.4 Reform is also needed in the structure of tax assignment and intergovernmental transfers. If local governments are to carry out the functional responsibilities that have been assigned to them, they require the financial resources to do so. The nature of revenue sources that should be assigned to each of the two levels of local government will depend upon the functions that have been assigned to them: the mix of local taxes and charges should be one that permits local governments to impose costs on beneficiaries as specifically as possible. Charges may therefore be preferable to taxes; and direct taxes to indirect taxes. 5.5 Local resource mobilization should also be deregulated. Provided the taxes and charges assigned to local government do not enable them to impose burden of services on their neighboring jurisdictions (as the highway tolls once did) or to discriminate within their own jurisdictions (as an overly progressive property tax might do), there is little justification for the present degree of central control over tax rates. If local governments are to be responsive to constituent preferences (and to meet their maintenance and cost recovery obligations) they require the power to adjust the rates of taxes that fall upon their constituents. 5.6 There is also a case for adjusting the structure of the FCM. In its present form, the FCM is a shotgun approach to poverty alleviation, distributing relatively small sums to local governments in jurisdictions that are predominantly poor (and rural) in the expectation that these funds will be used in ways that benefit low income populations. The assumptions behind this distribution system require reexamination, particularly given the urbanization of Peruvian poverty and the lack of any assurance that rural municipalities will, in fact, use transferred resources on services that benefits their poor constituents. Capital financing 5.7 Finally, reform is required in the structure of capital financing. If municipal governments are to be the agents for capital investment coordination, for cost recovery, and for maintenance, then they must have a more prominent role in the process of capital allocation; but one which forces them to confront the operations and maintenance implications of proposed capital works, and their constituents' willingness to pay. 5.8 What this implies, in more specific terms, is an integration or coordination of the various lines of capital financing that now exist--principally FONAVI, FONCODES, and that part of the FCM that finances capital investment--into a system that offers local government a level playing field on which to compete for capital investment funds. While the terms of this competition may vary depending upon the sector, there is a strong case for using cofinancing schemes and interest rates as primary rationing mechanisms. Cofinancing schemes, based on the use of matching - 29 - grants, force municipalities to come up with counterpart funds of their own. This, in itself, is a desirable feature of matching grants to the extent that it makes municipalities mobilize additional resources. Also, by requiring that investment proposals meet certain criteria in order receive financial support, matching grant schemes require municipalities to develop their capacity to design and manage the implementation of investment projects. This in fact could be an effective means of promoting capacity building efforts on the part of local governments. 5.9 By rationing funds on the basis of a borrower's willingness to service debt, loans are an effective means of testing willingness to pay. And, by requiring the repayment of principal (along with the cost of capital) they also eliminate defacto subsidies. The specific mechanism by which such a reform might be introduced in Peru requires further study. In the long run, it might be desirable to adopt the model used in industrial countries--in which local governments borrow directly from the private capital market. At present, this is clearly not feasible. There is little private long term capital available in Peru, and private savers are justifiably wary of municipal governments as borrowers. The alternative--a Government-owned first-tier lending institution-- has an unhappy track record, in Peru, however. With taxpayers bearing the risk of imprudent lending, the pressure on government to use credit for political purposes has proven difficult to resist. There may therefore be a case for experimenting with the kind of hybrid entity--a municipal development fund--in which a fixed share of the risk is borne by the Government, and the remainder by the private banking sector. If the Government is serious about eliminating the weaknesses of FONAVI, then it could eventually be reformed along these lines and make an important contribution to bridging the gap between the present system of capital financing and a future one which would rely more heavily on capital markets. Synchronizing reform 5.10 In pursuing such a strategy, the Government should observe the need to synchronize the various elements of reform. A rational assignment of revenues can only proceed once a clear definition of the respective responsibilities of each level of government is in place. A system of capital allocation based on willingness to incur debt can only be operable when local governments have the autonomy over tax rates with which to capture that willingness. Many of the decentralization programs in the countries surrounding Peru have encountered problems, due to the failure to coordinate the various parts of reform. Latin American countries have tended to decentralize revenue powers before decentralizing expenditure responsibilities. To date, the Government of Peru has avoided these problems, by failing to decentralize at all. If the Government wishes to pursue a reform along the lines suggested here, it will need to devise a time bound strategy, in which the various elements are coordinated. -30- BIBLIOGRAPHY Alvarado P6rez, Betty M. (1994). "Relaciones Fiscales entre el Gobierno Central y los Gobiernos Locales". Lima, Peru: Fundaci6n Friedrich Ebert. Bird, Richard (1994). "Decentralizing Infrastructure for Good or for Ill?". Policy Research Working Paper No. 1258. Washington, D.C.: World Bank. Casas, Carlos et al. (1995). "Marco Normativo e Institucional de los Servicios Ptblicos Locales: incentivos y desincentivos para la descentralizaci6n - Anilisis y Propuestas para la Rehabilitaci6n y Gesti6n Urbana" (mimeo). Lima, Peru: Universidad del Pacffico. 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