Peru - Pension Reform Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-7031-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ONA PROPOSED PENSION REFORM ADJUSTMENT LOAN IN AN AMOUNT OF US$100 MILLION TO THE REPUBLIC OF PERU November 25, 1996 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 - Nuevo Sol (S/.) EXCHANGE RkTE (as of October 11, 1996) US$1.00= S. 254 FTSCAL YEAR January I to December 3 1 ABBREVIATIONS AND ACRONYMS ADR American Depository Receipt AFP Administradora de Fondos de Pension (Private Pension Fund) BAC Bank Advisory Committee BCRP Banco Central de Reserva del Peru (Central Bank) BN Banco de la Nacion BR Bono de Reconocimiento (Recognition Bond) CAS Country Assistance Strategy CD Certificate of Deposit CONASEV Comision Nacional de Valores (Securities Commission) CV Cedula Viva (State Employees Pension System) DDSR Debt and Debt Service Reduction DL Legislative Decree DS Supreme Decree EFF Extended Fund Facility EPAL Electricity Privatization Adjustment Loan FCRP Fondo Consolidado de Reserva Pensiones (Pension Trust Fund) FONCODES Fondo Nacional de Compensacion y Desarrollo Social (National Fund for Social Compensation and Development) ESAL Financial Sector Adjustment Loan GDP Gross Domestic Product GOP Government of Peru IBRD International Bank for Reconstruction and Development IDB Inter-American Development Bank 11I Intemational Financial Institution IMF International Monetary Fund JEXIM Export-Import Bank of Japan LIBOR London Interbank Offer Rate MOP Memorandum of the President ONP Oficina Nacional de Pensiones (National Pension Administration) PAL Privatization Adjustment Loan SAL Structural Adjustment Loan SNP Sistema Nacional de Pensiones (National Pension System) SPP Sistema Privado de Pensiones (Private Pension System) TRAL Trade Reform Adjustment Loan Vice President Mr Shahid Javed Burki Director Mr Paul Isenman Division Chief Mr Dan Morrow Staff Mr Edgardo Favaro  FOR OFFICIAL USE ONLY PERU PENSION REFORM ADJUSTMENT LOAN TABLE OF CONTENTS Page LOAN AND PROGRAM SUMMARY .............................................................. iii I. MACROECONOMIC CONTEXT AND EXTERNAL FINANCING ....................................................I B ackground 1.......................................................I Economic and Public Policies After July 1990 ........................................................2 Bank's Support of the Reform Program ........................................................ 3 The Results of the Reform Program: 1990-1995 ........................................................4 Peru's Economic Outlook ........................................................8 II. THE GOVERNMENT'S STRUCTURAL ADJUSTMENT PROGRAM ..............................................9 O bjectives ........................................................9 The Macroeconomic Program ..................................................... 10 The Reforms to Consolidate a Dynamic Market Economy ..................................................... 10 The Pension Reform Program ......................................................11 Background ..................................................... 11 The First Stage of the Reform of the Pension System ................................................... 13 The Second Stage of the Reform of the Pension System ............................................... 13 Future Steps ..................................................... 17 Complementary Capital Market Reforms ..................................................... 17 III. BANK ASSISTANCE STRATEGY ..................................................... 19 Overall Assistance Strategy ..................................................... 19 IFC.,,19 Coordination with the IMF and the IDB ................................... 20 IV. THE PROPOSED LOAN ................................... 20 Origin ............................ 20 Objetives ............................. 20 Rationale for Bank Involvement ............................ 21 Description and Co-Financing ............................ 21 Technical Assistance ................. ___ .... . 23 Disbursements, Accounts and Audit ............................ 23 Monitoring and Reporting ............................ 24 Benefits and Risks ............................ 24 Environment Impact ............................ 25 V. RECOMMENDATION .................. 25 This docurnent has a restricted distiibution and may be used by recipients only in the performnance of their ofricial duties. Its contents rnay not otherwise be disclosed wiLhout World Bank authorization.  ii ANNEXES ANNEX 1: LETTER OF SECTOR POLICY ........................................................ 26 ANNEX 2: MATRIX OF POLICY ACTIONS ........................................................ 33 ANNEX 3: PENSION REFORM TECHNICAL APPENDIX ........................................................ 36 ANNEX 4: ECONOMIC INDICATORS ........................................................................................................... 43 SCHEDULES SCHEDULE A: DISBURSEMENT AND RETROACTIVE FINANCING ........................................................ 44 SCHEDULE B: TIMETABLE OF KEY PROJECT PROCESSING EVENTS ........................................................ 45 SCHEDULE C: STATUS OF BANK GROUP OPERATIONS IN PERU (BANK AND IFC) ......................................... 46 SCHEDULE D: PERU AT A GLANCE ........................................................ 48 Map --IBRD No. 26572R  iii PERU PENSION REFORM ADJUSTMENT LOAN LOAN AND PROGRAM SUMMARY Borrower: Republic of Peru Executine Aeencv: Ministry of Economy and Finance Poverty: Not applicable. Amount: US$100 million Terms: Repayable in 17 years, on level repayments, including five years of grace, at standard interest rate for LIBOR-based US dollars single currency loans. Commitment Fee: 0.75% on undisbursed loan balances, beginning 60 days after signing, less any waiver. Financin2 Plan: See Schedule A. Staff Appraisal Reoort: Not applicable. Proiect Identification Number: PE-PA-8064  I  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PENSION REFORM ADJUSTMENT LOAN TO THE REPUBLIC OF PERU 1. I submit the following report and recommendation on a proposed loan to the Republic of Peru for US$100 million to support measures deepening the reform of the pension system and improving the efficiency of its capital market. The loan would be payable over 17 years, on level repayments, including five years of grace, at standard interest rate for LIBOR-based US dollars single currency loans, and would be disbursed in a single tranche. Fifty percent of the loan amount would be set aside to finance Peru's Debt and Debt Service Reduction (DDSR) operation with its commercial bank creditors. The proposed Pension Reform Adjustment Loan (PRAL) would be presented to the Board together with a free-standing DDSR loan of US$183 million. 1. MACROECONOMIC CONTEXT AND EXTERNAL FINANCING REQUIREMENTS Background 2. In the three decades before 1990 the Peruvian economy moved from feast to famine. From 1950 to 1966 when government intervention policies were limited (and property rights were well established), per capita GDP increased at 3 percent a year, exports increased by 8.4 percent, productivity increased at 1.7 percent, and the average income of the poorest 40 percent of the population rose by 1.2 percent a year. 3. Such policies were gradually abandoned, on the grounds that they did little to help the poor. In their place came a poorly managed agrarian reform, administered prices and overexpansion of state-owned enterprises. The results for economic growth and poverty relief were disastrous. 4. Policies aimed at social reform worsened and perpetuated poverty. Repeated experiments in social engineering created economic and institutional uncertainty and a prolonged decline in governance. That, in turn, undermined productivity, fostered anarchy and public turmoil, and, ultimately, made poverty reduction impossible. Per capita GDP in 1967-90 declined by 0.7 percent per year, exports grew at only 1.4 percent per year, productivity fell by 2.9 percent per year, and the average income of the poorest 40 percent dipped by 0.1 percent per year. 5. By 1990, per-capita income was below that of 1966; political violence was claiming 3,000 lives each year; tax collections were less than 5 percent of GDP (in July 1990); and prices had increased by a mind-boggling factor of 27 million over three decades. In fact, Peru's economy had all but collapsed. It was the finale on more than  2 two decades of misguided policies, economic mismanagement, and since 1980 rampant and escalating terrorism Economic and Public Policies After July 1990 6. The government which came to office in July 1990 faced a country in political disarray and an economy in tatters. It strengthened the authority of the state throughout the countryside, defeating terrorism and fighting drug trafficking. It also implemented a deep program of stabilization and structural reforms. The main objectives of the stabilization-structural reform program introduced after July 1990 were to lower inflation and transform the state-dominated economy into a market-oriented one. 7. The stabilization program included stringent fiscal and monetary measures. A cash management committee maintained public expenditure in line with tax collection, credit from the Central Bank to the public sector was eliminated, the tax system was reorganized, and public sector employment reduced. 8. Structural reform called for liberalization at both national and sectoral levels. It strengthened the role of market mechanisms in the allocation of resources and, implicitly, defined a subsidiary role for the Peruvian state in the economy. From 1990 to 1994 structural reform included: * liberalizing the interest rate and the exchange rate; * eliminating price controls and public monopolies; * increasing competition by opening the economy to trade with the rest of the world and eliminating barriers to domestic trade; * improving labor market efficiency by addressing labor tenure regulations and establishing more flexible terms for probationary periods and fixed-term contracts; * securing property rights facilitating private ownership of land; * developing a vast privatization program; * eliminating the state monopoly in social security and establishing a framework for a private pension fund system; * eliminating public development banks and state intervention in the allocation of credit; * strengthening the capacity of the state as a regulator of some economic activities; and * establishing the independence of the Central Bank.  3 Bank's Support of the Reform Program 9. Peru's reform program has been supported by five IBRD adjustment operations since 1992. A first set of three adjustment loans (Trade Reform Adjustment loan (TRAL), Structural Adjustment Loan (SAL) and Financial Sector Adjustment Loan (FSAL)) was approved by the Board between February and May 1992 as part of a program designed to clear Peru's arrears with the Bank. The TRAL was approved by the Board in February 1992 and the SAL in March 1992, each of one tranche in the amount of US$300 million. The FSAL in the amount of US$400 million was approved in May 1992. Each of these loans underwrote the same macroeconomic stabilization program and external financing plan, while supporting separate adjustment programs. Overall implementation was excellent, consistent with borrower willingness and capacity to further the adjustment process. A second set of structural adjustment loans supported privatization. A three tranche Privatization Adjustment Loan (PAL) in the amount of US$250 million was approved by the Board in March 1993 and a three tranche Electricity Privatization Adjustment Loan (EPAL) for US$150 million was approved in October 1994. 10. The TRAL supported the opening of the economy to competition with the rest of the world. The reforms, which included reduction of tariff levels and dispersion, elimination of non-tariff barriers, elimination of export subsidies, a scheme of drawbacks to exporters and reform of customs, were implemented speedily and concurrent to the stabilization program. 11. The SAL supported reforms strengthening government effectiveness to increase provision of key public goods, while, at the same time, reducing the scope of government intervention in the economy to increase efficiency in the allocation of resources. The reform program, which included reform of the tax system and tax administration, of labor legislation and social security, elimination of domestic trade barriers and public monopolies, liberalization of agriculture policies, and establishment of a social program targeted to the poor, was implemented expeditiously during 1992 before the loan was signed and became effective. 12. The FSAL supported reforms strengthening the government's capacity to provide a stable currency, redefining the role of the state in the financial sector from lender to regulator and strengthening the role of the private sector in the allocation of credit. It included closing of the development banks, strengthening banking regulation and supervision, development of capital markets, and establishing an independent central bank. Implementation of reform was speedy with the exception of the restructuring of Banco de la Nacion. 13. Two adjustment operations have supported Peru's privatization program. The Privatization Adjustment Loan (PAL) has supported reforms promoting competition and a privatization program focusing on mining, hydrocarbons, and telecommunications and selected holdings in fisheries, industry, air/urban transport and the water sector. Implementation has proceeded smoothly with the exception of the fishery sector, where key regulatory decisions are still pending, and of hydrocarbons, where the privatization of  4 Petroperu did not begin in earnest until early 1996. Thus, while privatization continues to move forward, the third tranche of this loan is still pending. The Electricity Privatization Adjustment Loan (EPAL) has supported regulatory reforms to promote competition and privatization in the electricity sector. Implementation has proceeded smoothly to date and the second tranche of this loan is still pending. 14. The Bank adjustment support strategy has been highly successful: it has contributed to the direction of the reforms and has supported a well defined strategy to reintegrate Peru into the international financial community. A key element in this success has been the sense of clear government 'ownership' of the program--which is best exemplified by the implementation of the vast majority of the conditions in the first three adjustment loans even before the approval of these loans. The Results of the Reform Program: 1990-1995 1S. Fiscal and monetary discipline together with structural reform, public order, and targeted programs to alleviate the condition of the poor had remarkable results from 1990 to 1995: the economy greatly improved (see Table I for some indicators), terrorism was defeated and the percentage of families below the poverty line decreased by 10 percent. There was steady decline in inflation and unbroken fiscal discipline, and Peru moved from virtual international isolation to become one of the most attractive emerging markets in the region. Higher confidence resulted in a large inflow of capital which boosted aggregate demand and economic growth. Productivity increased steadily and so did per capita income and consumption levels, especially in isolated regions and for the poor who had suffered the most from ten years of terrorism and devastation. Table 1: Results of the Reform Program Average Average 1986-90 1991-95 Indicators GDP (real growth) -1.2 5.5 Poverty Head Count" 55.3 49.6 Inflation Rate (eop CPl) 2/ 972.0 46.1 Tax Collection (% GDP) " 9.1 10.3 NFPS Overall Balance (% GDP) -7.8 -2.5 1/ National measure for 1991 and 1994. respetively. 21 Inflation decreaed from 7,650% in 1990 to 10.2% in 1994 and 9.2% in 1995. 3/ Tax collection evolved from 9% in 1991 to 11.1% in 1994 and 11.6% in 1995. 16. Fiscal and Monetary Discipline and Price Stabilization The rate of inflation fell steadily since 1990 as a result of stringent fiscal and monetary measures. The elimination of credit from the Central Bank to the system of development banks drastically reduced the rate of monetary expansion and inflation plummeted from 7,649 percent in  5 1990 to 139 percent in 1991 and declined steadily to 15 percent in 1994 and 10 percent in 1995. It is expected to hold at about 11.5 percent in 1996. 17. Monetary policy pursued price stability and encouraged a remonetization of the economy. Monetary expansion has been the result of purchases of foreign exchange. Open market operations, conducted through the purchase and sale of Central Bank (BCRP) short-term debt, have been used to smooth the impact of purchases of foreign exchange on the money supply. These policies have resulted in a rapid monetization of the economy--both in soles and dollars--and a steady increase in Central Bank (BCRP) and Banco de la Nacion's (BN) international reserves. 18. Peru's foreign reserve position has strengthened considerably, which is good given the high level of dollarization of the economy and complete openness to international capital flows. International reserves rose by US$2,307 million between 1990 and 1993, US$3,564 million in 1994 (boosted by US$2,217 from privatization) and US$1,116 million in 1995. The stock of foreign BCRP-BN reserves (US$9,805 million as of August 1996) includes US$3,219 million of commercial bank reserve requirement deposits and about US$3,435 million of Treasury privatization receipts. At US$6.6 billion the foreign exchange reserves net of commercial bank reserve requirements were enough to back 55 percent of the monetary liabilities of the banking system in August 1996 and, net of commercial bank reserve requirement deposits and Treasury privatization deposits, represented about 5 months of imports. 19. Fiscal policy has been tight with public sector spending in line with tax collection and the fiscal deficit entirely financed through external credit. Public sector spending was drastically reduced at the beginning of the stabilization program, but most of the savings were brought about through the elimination of credit subsidies and cuts in the deficit of state owned enterprises and therefore did not result in a drop in production of public goods. The combined public sector deficit (before privatization proceeds) fell from 7.6 percent of GDP in 1990 to about 2.7 percent of GDP in 1991-94--it was 2.6 percent in 1995 and has been fully financed since 1991 by external funds. Privatization receipts have been large since 1993--they were 0.3 percent of GDP in 1993, 4.5 percent in 1994 and 1.5 percent in 1995. Most of these proceeds have been kept as foreign exchange reserves at the Central Bank. During 1992-95 Peru fully complied with the performance criteria agreed with the IMF under a three-year EFF program. In July 1996 the IMF Board approved a new extended arrangement in the amount of SDR 248.3 million for 1996-98. 20. The government has taken decisive steps towards reintegrating Peru in the international financial market. Peru cleared its arrears with the IDB in 1991 and with the EMF and the World Bank in 1993, rescheduled its obligations with the Paris Club in 1991, 1993 and 1996, and is expected to close by December 1996 a debt and debt service reduction (DDSR) operation with its commercial bank creditors. The 1996 Paris Club agreement provides debt relief for 1996-98 and reprofiled maturities falling due from January 1999 on, corresponding to debts previously rescheduled under the Paris Club of 1991. The agreement was conceived as an exit from the rescheduling process for Peru, and it broke new ground in Paris Club treatment of country payment difficulties in a  6 medium term context as a result of previous reschedulings. The DDSR operation with the commercial banks (described in detail in the accompanying documentation for the DDSR loan) encompasses about US$7.9 billion of medium-term commercial debt. 21. Capital Inflows and Economic Growth. While Peru's formal reintegration into the international capital market has taken several years, firm steps to reform the economy had an immediate impact on international capital flows and Peru moved from net exporter of capital to net recipient of significant capital inflows both long and short term. Short- term capital inflows (including errors and omissions) during 1991-95 were over US$5.7 billion, or about US$1.2 billion a year. Long-term capital inflows were about US$6.7 billion, with a big increase in 1994, mainly due to exceptional proceeds from privatization. Taken together, the long and short term (net) capital inflows average US$2.5 billion a year-- about 5 percent of the GDP. 22. While domestic savings have increased significantly since 1990, capital inflows have become a critical source of financing the rapid increase in investment. Domestic savings increased from 12.3 percent of GDP in 1990 to 16.5 percent in 1995 but the investment to GDP ratio increased by 8.5 percentage points--reaching 24.2 percent of GDP in 1995, up from the 15.7 percent of 1990. Further efforts at increasing domestic savings are required to finance a sustained increase in investment over the next decade. 23. High capital inflows boosted aggregate demand and a sustained economic recovery started in the second half of 1992. In 1993 GDP went up 6.4 percent while aggregate demand increased by 6 percent (investment up 13.4 percent and consumption up 3.7 percent), and exports increased by 3.3 percent. In 1994 recovery took a faster pace (GDP up 13.1 percent) boosted by a 14.9 percent increase in aggregate demand (investment up 30 percent, consumption up 9.6 percent) and a 17.5 percent increase in exports. As a result by the end of 1994 the economy was operating close to full capacity. 24. In 1995 aggregate demand continued increasing, boosted by rapid credit expansion to the private sector and an increase in public spending during the election campaign and war with Ecuador. As the economy reached full capacity (in the first months of 1995), economic growth slowed down considerably (year average of 7 percent) and the deficit in the current account of the balance of payments widened from 5.1 percent of GDP in 1994 to 7.2 percent in 1995--with 40 percent of the imbalance financed by short term capital inflows. The rapid fall in public spending in the second-half of 1995 and strict fiscal discipline in the first-half of 1996 (primary surplus up one percent of GDP compared to the same period of 1995) has conveyed a message of restraint to the private sector. As a result, in the first quarter of 1996, aggregate demand fell 3.9 percent (compared to the same period of 1995), the current account deficit narrowed to about 6 percent of GDP, and the rate of growth of GDP fell to 1.9 percent in the first nine months of 1996 (compared to the same period of 1995). 25. External Trade and the Real Exchange Rate. The exchange rate has been floating with limited intervention by the central bank. The exchange rate had a rapid appreciation in the second-half of 1990 following the beginning of the stabilization  7 program. From that period it remained (with fluctuations) at a stable level until 1995 when there was a further 5 percent real appreciation. The real appreciation, particularly since 1993, must have been of some significance for both export and import performance during the period. 26. From 1990 to 1995, aggregate exports increased by 67.9 percent in current dollar terms while imports increased 163.1 percent. Exports as a percentage of GDP fell from 10.4 percent to 9.5 percent in 1995 while imports increased from 9.2 percent to 13.1 percent in 1995. Among exports, non-traditional exports increased during the period 45.4 percent and traditional exports increased 76.2 percent. Within the non-traditional sector, exports of agro-processing products increased 130 percent from 1990 to 1995 whereas exports of manufacturing sector (half of which are textiles) increased 23.3 percent. It is possible that for manufactures (in which the domestic and foreign markets are closer substitutes) exports are more affected by the exchange rate and by anti-export bias. The lack of a significant emergence of manufactured product exports is likely an important element today which makes manufacturers in Peru the strongest protagonist for the re- introduction of substantial protection. Insofar as sustainability of the low tariff dispersion trade policy is not entirely secure, the threat to it comes primarily from this source. 27. Income and Consumption Increases and Poverty Reduction. In 1990-95, per capita income grew 3.6 percent a year and the percentage of the population below the poverty line fell from 55 to 50 percent (see Table 2). Thus, the poverty situation in Peru, Table 2: Poverty Measurements by Region Lima Urban Coast Urban Sierra Rural Sierra National 1991 1994 1991 1994 1991 1994 1991 1994 1991 1994 Expenditure percapita (annual)' 2197 2739 1621 2301 1563 2297 900.2 1207 1699 2190 Gini coefficient 0.373 0.374 0.353 0.379 0.358 0.357 0.371 0.367 0.398 0.399 Head count2 47.6 37.6 54.9 48.9 53.2 41.6 72.7 68.3 55.3 49.6 Poverty gap3 14.6 10.6 20 17.1 20.8 14.9 34 27.2 20.9 17.5 Household size 5.0 4.9 5.3 5.2 5.0 5.2 4.7 5.2 5.0 5.1 Peru Living Standard Study, 1991 and 1994. 1 In constant soles. 2 Percentage of families below the poverty line. 3 The aggregate income shortfall of the poor as a percentage of aggregate consumption. The income shortfall is the transfer that would bring the income of every poor person exactly up to the poverty line.  8 although still serious, has improved greatly. Higher productivity and the creation of more jobs and higher earnings, greatly increased per capita consumption spending, especially for people in areas devastated by a decade of terrorism and isolation. Less developed areas have fared better than Lima, and the lowest income ranges, better than the average. The 32 percent consumption increase of the lowest quintile surpassed the average of 29 percent. And the biggest increase in expenditure per capita from 1991 to 1994 were in the urban areas of the Coast and the Sierra. Peru's Economic Outlook 28. Short-Term Macroeconomic Outlook. Economic growth is estimated at about 2-3 percent in 1996 and 4-5 percent in 1997--lower than in 1994-1995 as a result of capacity constraints and a slowdown in the rate of growth of aggregate demand. In spite of rapidly growing investment, economic growth in mining and tourism will be affected by the low levels of investment in the past decade, in fisheries because of natural resource constraints. In the manufacturing industry increasing competition from imports will make economically obsolete part of the import substitution industry and lower growth of aggregate demand will further squeeze its market share. At the same time, growth of export oriented activities will be adversely affected by the ambiguities of trade policy and high implicit taxation faced by these activities. The rate of growth of spending in consumer durables and residential construction are projected to fall as more realistic projections about the pace of future economic growth substitute the bullish views of 1994-1995 and previous pent-up demand has been satisfied. 29. Peru's deficit in current account of the balance of payments is expected to fall to about 5-6 percent of GDP in 1996-1998 as a result of a slowdown in absorption. The three year EFF program approved by the IMF Board in July 1996 is an important step towards renewed fiscal effort and a reduction of the deficit in the current account of the balance of payments. It aims to reduce inflation from 10 percent in 1995 to industrialized country levels in 1998 and to reduce the combined public sector deficit from 2.5 percent in 1995 to about equilibrium in 1998, the result of a decline in interest spending following the closing of the DDSR and a strong increase in the Central Government primary surplus. 30. Medium-Term Debt and Financing Outlook. In the absence of corrective measures public debt service would have increased significantly at the beginning of the next decade as a result of payments due on the external debt and of growing social security spending. To meet these financing demands Peru has to design and implement policy measures reducing the burden of this service and encouraging higher domestic savings. On the external debt front the recent rescheduling of Paris Club obligations and the planned closing of a DDSR agreement with the commercial banks are important steps to reduce the debt overhang and smooth the flow of debt service in the next decade. A similar approach has been followed on the domestic debt front by way of repackaging contingent pension liabilities into new pension debt and establishing a Pension Trust Fund  9 (FCRP) which will be used in due time to redeem the pension obligations. Allocating the bulk of the privatization proceeds to finance the FCRP would be critical to strengthen the medium-term fiscal outlook. 31. External public debt and debt service due will drop in 1997-2000 as a result of the DDSR agreement between the GOP and the commercial banks. While Peru will remain not only a highly indebted country but also one with a more inflexible external debt structure, the Government's ability to service its remaining debt would strengthen as reforms take hold and the economy improves, thereby lowering the scheduled debt service ratio from 37 percent of total exports in 1995 to a projected ratio of about 21 percent in 2000 and lowering the debt/GDP ratio from about 54 percent in 1995 to about 38 percent in 2000. 32. Should Peru stay the course, complete the reform of its pension system and continue opening the economy to the rest of the world, its external financing outlook is strong. The current account deficit is estimated to fall from 7.2 percent in 1995 to about 5 percent in 1998 and to about 3 percent in 2000 (see Annex 4). Staying the course would gradually reduce Peru's perceived country risk, attract new investment and broaden access to long-term external financing. Implementing the reform of the pension system would result in domestic debt and debt service reduction, while, at the same time, it would encourage higher domestic savings. Further opening the economy to trade with the rest of the world would ensure that the build up of Peru's capital stock would take place in a low- distortion environment and hence the capacity to repay currently incurred obligations would increase. HI. THE GOVERNMENT'S ONGOING ADJUSTMENT PROGRAM Objectives 33. The Government's structural reform program for 1996-98, described in detail in the Letter of Development Policy (see Annex 1), aims to consolidate a dynamic market economy, one that creates new jobs and supports sustained increases in productivity. The program intends to lower inflation to about 4 percent by 1998, sustain 5-6 percent annual economic growth, reduce extreme poverty by 50 percent by the year 2000 and consolidate external viability (as stated in the Letter of Intent to the IMF requesting an extended arrangement). 34. The program addresses the main issues pending in Peru's reform agenda. First, it includes a macroeconomic program to maintain price stability and complete Peru's integration into the international financial market. Secondly, it includes reforms directed to consolidate a dynamic market economy with measures: (i) establishing a labor market regime that contributes to create new jobs in the formal sector, (ii) reducing tariff levels and tariff dispersion, (iii) completing the privatization program, (iv) creating an inviting environment for investment in areas where the reform process has proceeded at a slower pace (agriculture and infrastructure), and (v) improving the efficiency of programs  10 targeted to the poor and providing secure property rights to the poor. Thirdly, it includes a program to increase domestic savings and strengthen the medium-term fiscal outlook by way of deepening the reform of the pension system and allocating part of the large receipts from privatization to back pension obligations. Fourthly, it includes complementary capital market reforms. The Macroeconomic Program 35. Objectives. The Government's macroeconomic program aims to lower inflation, continue Peru's reintegration into the international financial community and maintain a viable external financing program. The Government is committed to: (i) increase the primary surplus from 0.3 percent of GDP in 1995 to one percent in 1996 and 2 percent in 1998; (ii) maintain a monetary policy so as to reduce inflation to industrialized country levels in 1998; and (iii) pursue a flexible exchange rate policy with central bank interventions aimed only at smoothing out temporary fluctuations of the exchange rate. The targets are consistent with those of the EFF program. 36. The program aims to reduce the current account deficit and reliance on short-term capital inflow financing. It projects an increase in the ratio of investment to GDP from 24.2 percent in 1995 to 25.5 percent in 1998, which is more than offset by the projected increase in domestic savings from 16.5 percent of GDP in 1995 to 20.5 percent in 1998-- thus, a reduction of the deficit in the current account to 5 percent by 1998. To that end the Government will not only continue to encourage higher domestic savings (through deepening the pension reform and increasing capital market efficiency) but also will increase the nonfinancial public sector balance (before privatization receipts) from a 2.6 percent deficit in 1995 to about equilibrium by 1998. By completing its DDSR agreement with the commercial banks and continuing negotiations with other creditors, the Government projects larger access to long-term financing. The Reforms to Consolidate a Dynamic Market Economy 37. Objectives. Peru is entering a second stage of reform. The challenge at this new stage is to consolidate a dynamic market economy, one that creates new jobs in the formal sector and supports sustained increases in productivity and poverty reduction. This requires improving the efficiency of the economy, creating an inviting environment for new private investment, and pursuing efficient poverty alleviation programs. 38. To improve the efficiency of the economy. The Government has modernized labor legislation and will (i) continue opening the economy to competition with the rest of the world, and (ii) complete the privatization program. Law 26513 of July 1995 and Legislative Decree (DL) 855 of September 1996, continued the process launched in 1991 with DL 728 making the labor market more flexible and thus facilitating the creation of jobs in the formal sector. These measures will contribute to strengthening an inviting environment for investment in the manufacturing industry and services. To increase competition with the rest of the world the Government will further reduce average tariffs and tariff dispersion which will contribute to create new jobs and attract investment to  11 areas where Peru has comparative advantages. 4 To consolidate the subsidiary role of the state in the economy the Government will also continue with the privatization of Petroperu, Centromin and remaining state-owned electricitv companies. 39. To invite new private investment in agriculture and infrastructure. New investments in agriculture and basic infrastructure are critical to reach Peru's medium-term economic growth and poverty reduction objectives; even so, private sector investment in these activities has proceeded at a slow pace. Because of security problems and weak property rights, modernization of agriculture has lagged behind that in other sectors of the economy. To encourage private investment in agriculture Law 26505 of July 1995 raises limits on private land ownership in the agricultural sector and DL 807 of April 1996 allows the transformation of sugar cooperatives into corporate businesses. In the future the Government intends to (i) accelerate the registration of titles on agricultural land, and to (ii) promote a more efficient use of water resources through a new water law. To promote private investment in infrastructure DL 839 of August 1996, a new concessions law, allows private participation through long-term concessions in the provision of most public infrastructure services. 40. To alleviate poverty. While the Government's poverty reduction strategy has been based on reestablishing public order, price stability and free market policies, it has also successfully used targeted programs to alleviate the condition of the poor and extreme poor, has launched a program to secure the property rights of the poor, and continues to improve education and health services. Targeted social programs, as the Fondo Nacional de Compensacion y Desarrollo Social (National Fund for Social Compensation and Development (FONCODES)), which implemented more than 20,160 projects for US$766 million in social infrastructure between 1992 and 1996, will continue playing an important role, using a revised poverty map which improves the capacity to reach the extreme poor. Also, the Government has launched an ambitious plan to provide registered titles to urban property which will facilitate the use of these titles as collateral and will broaden access to the formal financial market to the poor. The Pension Reform Program Background 41. There are two publicly sponsored pension systems: the Sistema Nacional de Pensiones--National Pension System (SNP)-- and the Cedula Viva System--Pension System for State Employees (CV). The SNP, a 'pay as you go', defined benefit system, was created by Law 19990 in 1973 through the consolidation of a number of separate retirement programs. While intending to cover all Peruvian workers (except for those under the CV system or the armed forces pension system), the SNP never reached more 4 There are two tariff rates: 15 percent--which applies to about 97 percent of the value of imports-- and 25 percent.  12 than 50 percent of the labor force and, as of 1990, it only collected contributions from 50 percent of its affiliates and ran a high deficit. 42. The CV system, a defined benefit regime, had its origin in the civil servant pension system of the 19th century. Law 20530 of 1974 intended to close the CV system, establishing a self-phasing out mechanism by limiting eligibility to benefits to workers who entered the civil service before 1962. However, the coverage of the system was extended considerably during the 1980s; thus, instead of being gradually phased out, the system grew explosively. This was the result of (i) laws which extended coverage to new groups of public employees, and (ii) legally questionable incorporations made possible, in part, by administrative disorder and corruption. 43. From 1985 to 1990 four laws modified Law 20530 and extended the closing date for the CV regime from 1962 to 1980. Law 24366 of 1985 extended eligibility to benefits to workers who had been in the civil service for more than 7 years as of 1974, thus moving the closing date for the CV from 1962 to 1967. Law 25066 of 1989 extended eligibility to benefits to workers who had joined the civil service before 1974, even if they were as of 1989 working under private sector law. This moved the closing date for the CV from 1967 to 1974. DL 556 of 1989 extended eligibility to benefits to workers in all agencies included in the public sector budget, thus establishing grounds for claims to benefits from groups of workers in state owned enterprises. And Law 25212 of 1990 extended eligibility to benefits to workers in the education sector who had joined the civil service before 1980. 44. During the late 1980s, the chaotic state of the public administration facilitated the passage of many legally questionable claims to CV benefits. It is presumed that benefits were granted, in many cases, based on fraudulent documentation. *And many workers in state owned enterprises became eligible to CV benefits in a manner presumably inconsistent with Law 20530--which prohibits the accumulation of years of service in the private and public sectors.5 45. Because benefits are very generous and contribution rates are low the CV system is very costly. Female (male) workers are entitled to CV benefits after 12 (15) years of service. And time spent while working for a university degree can be counted as years of service (Law 24156 of 1985). Benefits for male (female) workers are set at 1/30 (1/24) of the average salary during the last year of service. Thus the replacement rate varies between 50 percent, when the worker has been in service for 15 years, and 100 percent when the worker has been in service for 30 years. Survivor's benefits set by Law 25048 of 1988 at 100 percent of CV pensions are also extremely generous. Contribution rates vary from 8 percent to 15 percent. Under Peruvian law workers in state owned enterprises have always been under private labor law.  13 The first stage of the reform of the pension system 46. Law 25897 of 1992, authorized a system of private pension funds (AFPs) as an alternative to the 'pay as you go' national pension system (SNP). The new regime (SPP) permitted Peruvians to open individual retirement accounts in AFPs, receiving partial credit for previous contributions to the SNP through a bond--'Bono de Reconocimiento' (BR) 6 While Law 25897 was an essential first step in that it launched a frilly financed pension system, it (i) maintained both different contribution rates and ditferent retirement ages for the SNP and the SPP, (ii) did not allow the transfer to the SPP of public employees covered by Peru's oldest and most expensive, defined benefit system, 'Cedula Viva' (CV), and (iii) did not close entry to the SNP regime to new entrants to the formal labor force. The second stage of the reform of the pension system 47. The first step. Law 26504 of July 1995 eliminated differences in contribution rates and retirement ages between the SNP and the SPP (Table 3 presents contribution rates before and after the reform). These measures brought about a significant increase in TABLE 3: CONTRIBUTION RATES TO THE SPP AND SNP7 Contribution rate j SPP SNP Before Law After Law Before After Law 26504 26504 Law 26504 26504 Total Contribution: 21 11 9 11 Contribution to the SPp8 10 8 | | Contribution to the SNP9 | - 3 1 Fees and Insurance Premium 4 3 Health Insurance 3 -- 3 Solidarity Contribution 1 -- -- Housing tax (FONAVI) 3 -- 3 [ ______________________________ ' _____,___ _.____________ _________ _____-_l__ 6 See Annex 3 for details on the methodology to calcu]late the value of a BR. 7 Source: ONP. 8 The contribution rate will be increased to 10 percent in December 1996 (Law 26504). 9 Starting January 1, 1997 the contribution rate will be belowr 13 percent (Law 26504).  14 transfers from the SNP to the SPP after July 1995 and reduced, through the increase in retirement age, the contingent pension obligations of the SNP. 48. The elimination of differences in contribution rates has been critical to continue shrinking the SNP. The difference in contribution rates is the most important factor in determining the decision of a young worker to join the SNP or the SPP and the only factor that may incline a new entrant to the labor force to prefer the SNP--and the phase out of the SNP depends on few or no new affiliations of young workers. Thus, maintaining a contribution rate to the SNP higher than or equal to that to the SPP is likely to result in a gradual phase out of the 'pay as you go'. 49. The second step. DL 817 of July 1996 (i) unambiguously established the right of public employees to transfer from the CV to the SPP; (ii) gave authority to the National Pension Office (ONP) to audit all claims for benefits to the CV regime to determine their legitimacy; (iii) required the ONP to periodically estimate the actuarial cost of the pension obligations under the SNP and CV regimes and from the issue of BRs; (iv) instituted the pension trust fund--Fondo Consolidado de Reservas Previsionales (FCRP)--to back pension obligations; (v) established that adjustments of pensions of employees of formerly owned state enterprises will be subject to the same limitations as SNP pensions; (vi) instituted incentives for migration from the CV regime to the SPP; (vii) established a ceiling for CV pensions--at the level of remuneration of a member of Congress. Thus DL 817 significantly reduced the future impact of the CV regime on the Treasury's coffers, established grounds for an accounting system that quantifies and recognizes contingent pension obligations, and created the legal basis for a pension trust fund to back these obligations. 50. The public pension systems as of September 1996. Peru's pension system is in a transition stage where a fully funded regime covering about 1,400,000 employees coexists with (i) a 'pay-as-you-go' regime covering about 980,000 active and about 320,000 retired employees and (ii) a privileged defined benefit regime which covers about 50,000 active and 250,000 retired civil servants and employees of former state owned enterprises. At about one million, the number of workers affiliated to the unfunded publicly sponsored pension regimes is still high and so are the state contingent pension liabilities. At the same time, operating costs of the private pension system's AFP's are high, and their investment opportunities in Peru's capital markets are still limited. 51. During 1996, the annual expenses of the SNP (about US$394 million equivalent) are largely covered by revenue from contributions and other assets (about US$288 million equivalent). The deficit, estimated by the ONP at about US$106 million equivalent, is expected to widen to about US$207 million equivalent in 1997, and to increase steadily in the next 10 years as a result of a drop in revenue contributions. The annual expenditure of the Treasury in CV pensions is about US$400 million. The current cost of CV pensions financed directly by state owned enterprises, local governments, and/or agencies outside the Central Government is not known yet.  15 52. The net present value of pension obligations exceeds US$15 billion. There are explicit pension obligations--BRs issued to those who transferred from the SNP to the SPP-- and contingent pension obligations--those who result from the ONP obligation to pay future pensions to those under the SNP and the CV systems. The present value of BRs already issued is about US$137 million. The present value of pension liabilities under the SNP (net of contributions) was, as of September 1996, about US$10-14 billion--this is the cost the Government would have to finance in the absence of any new reform. The present value of pension liabilities under the CV system was, as of December 1995, about US$5-7 billion. 53. Thus, Peru's public pension systems (SNP and CV) are bankrupt on an actuarial basis. They demand payments from the State that cannot be met now and which are projected to increase exponentially during the next 20 years. The 'Cedula Viva' system is particularly costly because it requires increases in pensions to meet salary increases, because it has been carelessly administered to permit unauthorized expansion of the system, and because many pensions are excessively large. 54. The private pension system as of September 1996. The private pension fund (AFPs) portfolio has grown fast to about US$1 billion equivalent, but there is little product diversity and intermediation costs are high. The pension fund regulatory regime does not encourage an efficient intermediation of funds. The situation of the AFP industry shows remarkable similarity in aggregate portfolio composition (shares invested in stocks, bonds, bank CDs etc.) as well as individual stock holdings. In addition, at two percent of salaries, the commissions charged for managing the accounts are high compared to similar systems in other countries. 55. Lack of product diversity is due to a regulatory regime which penalizes deviations from the current market average. Thus, it encourages each AFP to invest in the same portfolio or a portfolio highly correlated with the AFP current average. At the same time, it does not discourage taking high risk (which is associated with high return) and actually contributes to systemic risk by inducing an overconcentration in a limited set of assets. The result of these perverse incentives was that the AFPs were encouraged to invest in sol-denominated CDs and Central Bank paper (which have a higher short term yield but a lower-compound long-term yield and also high risk) rather than in long-term and foreign currency denominated instruments. 56. The third step. The reforms of November 1996 aim to: (i) continue shrinking the SNP, (ii) strengthen the medium-term fiscal outlook by making substantial deposits into the pension trust fund to finance the state contingent and explicit pension liabilities, and (iii) strengthen the private system. 57. To continue shrinking the SNP. DL 874 of November 1996 extends until December 1997 the current structure of contribution rates to the SNP and SPP. In addition DL 874 eases the eligibility criteria to apply for a BR. Under the new law, all new applicants who have contributed to the SNP for 48 months within the 10 years before  16 December, 1996, will be able to receive a BR.lo Other things equal, the higher the credit a worker receives for its past contributions, the more likely it is she (he) will transfer to the SPP. Thus, this will help to attract young workers still affiliated to the SNP in the 25-31 age cohort --there are still about 134,000 affiliates in this age cohort. Most of these workers did not qualify to receive the BR set by Law 25897 but will be eligible to receive a BR under DL 874 of November 1996. 58. To strengthen the medium-term fiscal outlook. The Government will enact in November, 1996 the regulatory regime for the pension trust fund (FCRP), and will by December 10, 1996 deposit into the FCRP account US$1 billion from the proceeds from privatization to back pension obligations. The DS establishing the regulatory regime for the FCRP will allow the FCRP: (i) to invest funds in the domestic market or abroad, and (ii) to subcontract one or more administrators to manage the FCRP investment portfolio. It also establishes (iii) that no more than 5 percent of the funds can be invested in public sector debt, and (iv) the obligation to report periodically the FCRP investment portfolio performance. 59. To strengthen the private sector pension system. DL 874 of November 1996 takes some significant initial steps to discourage high fees and increase competition of AFPs. It eliminates the use of a benchmark rate of return for the industry and of 'bands' around this rate of return, thus increasing the benefits achievable by AFPs for relative overperformance, and reducing the penalties for relative underperformance. It also requires that investment results be reported on a regular basis net of fees, and expands the categories of securities in which AFPs can invest. 60. T'hese reforms will encourage: (i) competition among the AFPs to offer a broader range of portfolio options--inducing an allocation of savings as close as possible to the true preferences and interests of savers; (ii) longer term investment, particularly in securitized mortgage obligations; (iii) reduced investment in short term bank obligations; and (iv) more investment in foreign markets. The changes in the regulatory regime will make the AFPs better able to provide long term financing for the Peruvian economy while removing disincentives to prudent and diversified investment. 61. The costs and benefits of the reform. The costs to the Treasury as a result of the issue of the BR set by DL 874 arise from the possible loss of contributions and from the issue of the BRs. The benefits are the savings resulting from not paying at retirement the SNP pensions to those who transfer, If as a result of the reform about 133,000 SNP young affiliates in the 25-31 years old cohort move to the SPP, the Treasury would have to issue BRs for a nominal value of US$247 million equivalent (net present value of about US$13 million equivalent). In addition, the Treasury would lose annually contributions for about US$31 million equivalent. The net present value of the costs resulting from losses in contributions and issue new BRs is US$844 million. The net present value of the 10 Aninex 3 presents tise methodology to estimate the value of the BRs.  17 benefits is US$2,117.11 The centralization of all claims to CV benefits at the ONP would be the first step to gauge the cost reducing impact of DL 817. Future steps 62. The next stage in the reform of the pension system will include measures (i) to strengthen the quality of the regulatory regime for pension funds, (ii) to establish a unified framework for pension asset and liability management including the use of government extraordinary revenues and (iii) to continue reducing the debt and debt service resulting from publicly sponsored pension programs--see Matrix of Policy Actions (Annex 2). 63. To improve the efficiency of financial intermediation of the AFPs, the Government will enact during the first-half of 1997 a new regulatory framework to encourage the offer of a diversified range of financial products and a more transparent disclosure of risk and will review the present regulatory structure to explore possible reductions in complexity and cost. 64. To introduce more transparency as to the financial situation of the publicly sponsored pension regimes as well as to the fiscal outlook, the Government will issue, in the first-half of 1997, budgetary rules consistent with the accounting of the accrued costs of the contingent pension obligations. These rules will determine mechanisms to reduce the difference between the pension obligations and the value of assets of the FCRP through the transfer of ordinary and extraordinary revenue from the Treasury to the FCRP. 65. To encourage migration of workers with legitimate claims to CV benefits to the SPP, the Government will issue the necessary regulation so as to implement the incentive schemes introduced in DL 817 and will complete the audit of claims to benefits during 1997. 66. To define future steps in pension reform the Govermment will prepare during the first half of 1997 a study analyzing the state of the SNP. This study will address the costs of the SNP. In particular, it will compare the alternative of a gradual phase out of the SNP with that of transforming the SNP into a fully financed pension regime. Following the recommendations of the study the Government will design and implement the necessary changes in the pension regulatory framework during the second-half of 1997. Complementary Capital Market Reforms 67. Background. The improvements in the economy after 1990 and the modernization of the capital market regulatory regime after 1992 have resulted in a significant increase in the capacity of Peru's capital market to intermediate funds. As a result, stock market capitalization increased from US$1,124 million in 1992 to US$15,221 million in 1996, the The discount rate is 6 percent.  18 value of bond and short-term commercial paper financing went up from US$125 million in 1992 to US$435 million in 1995, and foreign portfolio investment increased from US$27 million in 1992 to US$1,875 million in 1995. The expansion of the private pension funds--with assets valued at US$1 billion as of October 1996--contributed significantly to these results. 68. The reforms of 1992 enacted in DL 755, the capital markets law, helped start or increased use of new financial institutions and instruments (such as mutual funds, ADRs, and corporate bonds) and improved regulatory oversight and trading and information systems. 69. Notwithstanding these improvements Peru's capital market is small and there is need to expand the range of financial instruments available (especially for institutional investors). First, the stock market is almost entirely devoted to trading in shares issued prior to 1990, most of them, by the Velazco Government fiat shares issued to labor. Few companies have sold shares in the market to increase their capital (mostly in connection with mergers and reorganizations) and none has made an initial public stock offering over the past five years. Secondly, there have been increasing public issuances of corporate bonds but most of the financing of business start-ups, expansions, and operations (not including privatizations and foreign direct investment) has been provided by bank short term loans. Thirdly, the development of an individual account pension system has not had a significant impact in the supply of medium-and long-term financial instruments. In fact, the bulk of the AFPs investment portfolio has been concentrated in short term sol- denominated deposits in banks or short term paper of the BCRP. 70. To address these issues it has been necessary to modify the regulatory regime (i) to incorporate the use of new financial instruments into Peru's capital market, (ii) to improve the regulatory environment and (iii) to expand the range of instruments available for investment of institutional investors such as the AFPs. 71. The reforms of October 1996. Legislative Decrees 861 and 862 of October 1996 introduce these improvements in capital market regulation. They (i) establish a framework for the operation of investment funds; (ii) provide a solid base for securitization of otherwise illiquid financial assets such as mortgage loans and consumer credit receivables; (iii) simplify the regulation of mutual funds; (iv) improve regulation pertaining to short term paper and convertible bonds; (v) increase capital requirements for financial intermediates; (vi) introduce the concept of self-regulation of the stock market; (vii) establish the independence of the agent in charge of the clearing and liquidation of financial transactions in the stock market; and (viii) improve market transparency. It is expected that experience with the mechanisms introduced by DL 861 and DL 862 will require further adjustments and refinements in order to more fully implement the concept of an essentially self-regulating market and limited government involvement (see Annexes I and 2).  19 HI. BANK ASSISTANCE STRATEGY Overall Assistance Strategy 72. Since August 1990, the Bank has assisted the Government in preparing and implementing its reform program. The Bank has extended US$1.4 billion in five adjustment operations since 1992, as well as US$947.2 million in complementary investment and technical assistance projects. The objectives set by the 1994 Country Assistance Strategy (CAS) discussed by the Board on November 22, 1994, were to help: (i) sustain and accelerate the stabilization and adjustment processes; (ii) foster private sector development and public sector reform; (iii) rehabilitate key infrastructure; and (iv) alleviate poverty and promote human resource development. Bank lending was forecast at about US$500 million p.a. for FY94-96. While the 1994 CAS acknowledged the declining importance of structural adjustment operations in following years and the increasing importance of investment projects, it also contemplated preparation of a possible structural adjustment and/or a DDSR operation to support the consolidation of the reform program and a possible DDSR agreement with the commercial banks. The proposed loan would assist directly in the achievement of the first two objectives set by the CAS and complement the Bank's poverty-focused lending program which includes targeted investment programs for health, nutrition and primary education, a social investment fund and investment in basic infrastructure for the poor such as rural roads, water and sanitation. 73. Under the proposed lending program, which assumes sustained stabilization and structural reform, Bank exposure during 1996-2000 is projected to increase from US$1.7 billion to US$2.8 billion. Exposure ratios are expected to remain within Bank norms during this period. Debt service to preferred creditors is expected to rise gradually to 33.6 percent of total public debt service by 2000, due largely to substantial disbursements from preferred creditors. IBRD's share is projected to increase from 8.1 percent of total public debt service in 1995 to 16.3 percent by 2000, and debt service to IBRD as a share of export of goods and non-factor services earnings is expected to increase from 3 to 4 percent over the same period. These projections are conditioned on sustained progress by the Government in implementing its reform program. Inadequate macroeconomic progress or major policy reversals could trigger a substantial reduction in the lending program, with correspondingly less exposure but higher risk for the Bank. IFC 74. Since 1992, IFC has committed US$46.2 million in loans, US$24.7 million in equity and US$6.2 million in quasi-equity in companies mainly in the financial services and non-ferrous mining sectors. With the recent investments in the banking sector, financial services have replaced mining as the principal area of IFC investment. IFC has been an active partner in Peru's privatization process through its commitment of US$20 million to the Peru Privatization Fund which helps swap sovereign Peruvian debt for equity in newly privatized companies. The Fund made, for example, investments in  20 Edelsur, the recently privatized electricity distribution company for southern Lima. IFC has also played a significant role in promoting Peru's private pension system by taking a US$1.1 million equity stake in AFP Horizonte, one of Peru's largest pension funds. Coordination with the IMF and the IDB 75. The Bank has worked closely with the IMF and the IDB in the design and supervision of adjustment operations in Peru, in formulating country strategy, and in economic and sector work. The three-year extended arrangement between Peru and the IMF expired in March, 1996 during which all performance criteria were observed. A new three-year extended arrangement was approved by the IME Board in July 1996 for an amount of SDR 248.3 million. The Bank has also maintained a close relationship with the IDB in the design of supporting adjustment operations loans and investment loans. For instance, the Bank's Trade Reform Adjustment Loan (TRAL) was paralleled by a complementary Trade Institutional Strengthening operation by IDB, and IDB's Financial Sector Adjustment loan was complemented by the Bank's FSAL. A similar strategy has been followed as to investment project loans with close coordination between the two banks in support of the social emergency program (FONCODES), transport infrastructure rehabilitation, and health sector reform. The IDB is currently preparing an investment sector loan supporting those elements of the Government program designed to: (i) modernize the state, (ii) improve regulation in a variety of areas (including public utilities), and (iii) strengthen banking supervision. IV. THE PROPOSED LOAN Origin 76. The Bank's involvement in the area of pension reform in Peru began with the FSAL and continued with economic and sector work--Peru: Public Expenditure Review of October, 1994 (Report No 131 90-PE) and Peru: Policy Notes of July, 1995 (Report.No 14824-PE) and policy advise. A number of these reports' recommendations were taken up in Law 26504 and DL 817. The proposed loan is the outcome of a close dialogue between the Bank and the Government on the need to deepen pension reform, strengthen Peru's capital market and increase domestic savings. Objectives 77. As a result of the establishment of public order and successful implementation of the reform program, Peru's economy has greatly improved since 1990. However, a significant part of the economic growth and poverty reduction experienced in recent years has been of a one-time nature and, without a sustained flow of new investment, they will be difficult to replicate. Financing this investment would require higher domestic savings and broader access to long-term external funds.  21 78. The reforms supported by this loan would contribute to increase domestic savings, strengthen the medium-term fiscal outlook, broaden access to long-term external financing, and provide a clear signal of the Government's deterrmination to stay the course. They would help increase savings and strengthen the fiscal outlook by way of (i) deepening pension reform, (ii) improving the efficiency of capital markets, and (iii) earmarking part of the privatization proceeds to back pension obligations. This use of privatization receipts underscores the need for external financing for the DDSR operation with the commercial banks. The DDSR agreement would contribute to broaden access to long-term external financing. 79. Performance indicators of the impact of the reforms recognized by this loan will be: (i) the changes in the rate of affiliation to the SPP before and after the initiation of the second stage of pension reform; (ii) an increase in the percentage of workers in the 20-31 age cohort affiliated to the SPP; (iii) the earmarking of part of the future privatization proceeds to the FCRP; (iv) the offer of a broader range of options available to the affiliates of the SPP; and (v) the reduction of the total cost of tne CV system. Rationale for Bank Involvement 80. The balance of payments support provided by the PRAL is necessary in spite of Peru's strong foreign exchange reserve position. First, because the economy is highly dollarized and the capital account is completely open, high foreign exchange reserves reduce exposure to short term capital outflows and are a critical ingredient for the stability of the financial system. Secondly, about 44 percent of the direct financial requirements for the DDSR agreement will be met with Peru's foreign reserves. Financing a higher percentage of the up-front cost of the DDSR agreement, while, at the same time, allocating US$1 billion of the international reserves to the pension trust fund, would jeopardize the stability of the external financing program. 81. The amount of this PRAL is determined by the Government short-term financing needs (fifty percent of the amount would be set aside to finance part of the cost of the DDSR agreement), the quality of the program and the clear Government commitment to allocate a significant part of the receipts from privatization to the FCRP to back the issue of new securities resulting from the pension reform. The policy actions supported under this proposed PRAL, particularly the use of privatization proceeds to back pension obligations, underscore the need for external financing for the DDSR.agreement. The proposed PRAL would be presented to the Board together with a free-standing DDSR loan of US$183 million. Description and Co-Financing 82. Loan Size. A single tranche loan of US$100 million is proposed to be made available upon loan effectiveness, anticipated for December 1996. The Republic of Peru would be the borrower and implementation would be shared by the Ministry of Economy and Finance, and agencies responsible for social security--ONP and the Private Pension Fund Superintendency (SAFP)--and capital markets--Capital Market Superintendency  22 (CONASEV). Fifty percent of the funds provided by this would be set aside to finance part of the cost of the DDSR agreement. The provisions regulating the set-asides are included in an implementation agreement to be signed between the Republic of Peru and the Bank. The loan closing date would be March 31, 1997. 12 83. Proposed Tranche Conditionality. The conditions below (para. 84) have been selected based on their importance in the setting up of the new pension system. In addition to the specific actions listed below, tranche release would also be contingent upon maintenance of a macroeconomic framework consistent with the objectives set forth in the Letter of Sector Policy. 84. The following actions were taken prior to Board Presentation: * Reform of the 'Cedula Viva" System: DL 817 of April 1996 (i) established the right of and instituted incentives for public employees to transfer from the CV to the SPP; (ii) authorized the National Pension Office (ONP) to audit all claims for benefits to the CV regime to determine their legitimacy; (iii) established that adjustments of pensions of employees of formerly owned state enterprises will be subject to the same limitations as SNP pensions and (iv) established a ceiling for CV pensions. * Reform of the National Pension System: Law 26504 of July 1995 (i) eliminated differences in contribution rates and retirement ages between the SNP and the SPP; and (ii) increased the minimum retirement age to claim benefits from the SNP. DL 874 of November 1996 broadened the eligibility criteria to apply for a 'Bono de Reconocimiento'. * Reform of the Private Pension System: DL 874 of November 1996: (i) eliminated the use of a benchmark rate of return for the industry and of 'bands' around this rate of return; (ii) required that investments results be reported on a regular basis net of fees; and (iii) expanded the categories of securities in which AFPs can invest. * Reforms Developing a Framework for Asset and Liability Management: Law 26504 (i) required the ONP to periodically estimate the actuarial cost of pension obligations under the SNP and CV regimes and from the issue of BRs and (ii) instituted the FCRP--to back pension obligations. A DS (to be passed in November 1996) will establish the regulatory regime of the FCRP. A DS will authorize the deposit of US$1 billion from Treasury resources in the FCRP, and communication by December 10, 1996 will confirm such a deposit was made in the FCRP Deposit Account. * Complementary Capital Market Reforms: DL 861 and DL 862 of October 1996: (i) established a framework for the operation of investment funds; (ii) provided a solid base for securitization of otherwise illiquid financial assets such as mortgage loans and 12 At 20 percent of the three-year adjustment lending program the US$50 million set-aside from the proposed PRAL is below the Bank guideline (25 percent).  23 consumer credit- receivables; (iii) simplified the regulation of mutual funds; (iv) improved regulation pertaining to short term paper and convertible bonds (vi) introduced the concept of self-regulation of the stock market. 85. Effectiveness and disbursement conditions for the Implementation Agreement are the same as provided for the DDSR Loan (para. 40 of the MOP). The Bank will provide up to 100 percent retroactive financing on the set-aside part of this loan, if needed, on the basis of eligible expenditures incurred after September 1, 1996.13 86. Co-Financing. The JEXIM Bank will provide US$100 million in cofinancing to the PRAL and the IMF's EFF. The amounts of cofinancing with each instrument will be determined shortly. The JEXIM Bank loans will be part of the package of official support for the DDSR Agreement. Technical Assistance 87. The technical assistance requirements to identify and design future steps in pension reform will be financed through part of an existing Japanese Policy and Human Resources Development (PHRD) Grant in the amount of US$550,000 equivalent (61.5 million yen) obtained to support the preparation and implementation of the proposed loan. In addition the Bank is working on a technical assistance project to improve public sector management and additional technical assistance for future adjustment operations, if needed, could be included in this TA project. Disbursements, Accounts, and Audit 88. The Ministry of Economy and Finance, the Borrower of the loan, would be responsible for submitting withdrawal applications. Upon loan effectiveness, one half of loan proceeds (US$50 million) will be disbursed directly to the settlement agent for the DDSR operation to purchase collateral and finance buyback operations. The remaining half will be deposited by the Bank in a Deposit Account opened and maintained by the Borrower in US dollars. If after deposit in this Deposit Account, the proceeds of the loan are used for ineligible purposes (e.g., to finance items imported from non-member countries, or goods or services in the standard negative list), the Bank will require the Borrower to either: (i) return that amount to the account for use for eligible purposes; or (b) refund the amount directly to the Bank, in which case the Bank will cancel an equivalent undisbursed amount of the loan. Such remaining half will not be utilized for financing the costs of the DDSR agreement 89. The Ministry of Economy and Finance will maintain separate records and accounts for all transactions under the loan. Upon the Bank's request, the Borrower shall have the Deposit account audited by independent auditors acceptable to the Bank in accordance 13 After the confirmation of Bank's responses in August 31, 1996 the Govermnent started purchasing the necessary collateral.  24 with the loan agreement. The records and accounts for the set-asides will be audited by independent auditors acceptable to the Bank in accordance with the implementation agreement. Monitoring and Reporting 90. Monitoring and reporting will be facilitated through the close coordination of activities and implementation agencies and direct technical assistance from the Bank. Under the Japanese PHRD Grant, technical assistance is being provided to assist the Government in the implementation of the overall program through ONP, SAFP and CONASEV. Benefits and Risks 91. Benefits. This loan supports reforms that will (i) reduce the domestic debt overhang and strengthen the medium-term fiscal outlook, and (ii) provide a judicious use for part of the privatization proceeds. These are key to finance the large scale capital accumulation the country needs to create new jobs and support sustained increases in productivity. 92. The approach adopted to reduce domestic debt is similar to the one used to reduce external debt. The reform of the pension system results in debt and debt service reduction by way of repackaging contingent pension liabilities into new pension obligations backed by a pension trust fund. This will increase domestic savings by (i) allowing a larger set of individuals to have access to individual accounts, (ii) making more transparent the state of the public pension systems, and (iii) strengthening the medium-term fiscal outlook. 93. The establishment of a pension trust fund and the use of privatization proceeds to feed this trust fund breaks new grounds in linking asset management during a privatization program with liability management during a domestic debt repackaging program (pension reform). The trust fund is an enhancement to the new debt created by the pension reform and its establishment makes more attractive to individuals to participate in such voluntary program of debt restructuring. 94. Risks. The main risk to this operation is in maintaining sustained Government commitment to complete the several steps that will result in the completion of the pension reform. The measures adopted between July 1995 and October 1996 supported by this loan have popular support. While the amendments to the 'Cedula Viva' regime affect a privileged group of pensioners they have popular support because the CV regime is perceived as highly corrupted. Similarly, the reforms introduced by DL 874 have popular support because they promote competition among the AFPs and reduce the Government's discretionality to manage the large privatization proceeds. But the completion of the reform of the SNP will require a great deal of consensus building and may be a sensitive political issue (see paragraphs 62 to 66). Also, the continued build up of the Trust Fund  25 with the receipts from privatization may face strong opposition from politicians which prefer discretionality rather than rules. 95. Overall, these risks are mitigated by a combination of factors. First, the reform of the pension system is not opposed by the vast majority of the people who work in the informal sector and have never reaped benefits from any of the publicly sponsored regimes. Second, the reform will release in the medium term resources from the public budget which can and should be used to improve the quality of education, health and nutrition programs which directly benefit the poor. Third, because it is a self-imposed disciplining measure, the Government decision to establish a trust fund with the receipts from privatization, cannot be seriously attacked by the opposition. 96. Progress over the past five years, the relative irreversibility of some key actions and growing public appreciation of the benefits of the reforms accomplished present a favorable environment for further measures. The private sector has now seen the successful sustaining of Peru's fiscal position and turn from hyperinflation. The policy reform supported by this proposed loan will help guard against erosion of public confidence and reversal of the policy framework. Environmental Impact 97. There are no negative environmental impacts associated with this loan, which therefore, has an environment rating of "C". V. RECOMMENDATION 98. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank, and recommend that the Executive Directors approve it. James D. Wolfensohn President By Caio Koch-Weser Washington, D.C. November 25, 1996 Attachments  26 Annex I LETTER OF SECTOR POLICY PENSION REFORM ADJUSTMENT LOAN November25, 1996 Mr. James Wolfensohn President The World Bank Dear Mr. Wolfensohn: 1. The Government of Peru has taken significant steps over the past 18 months to deepen the reform of its pension system and to improve the efficiency of its capital market. The Government is now requesting from the International Bank for Reconstruction and Development a Pension Reform Adjustment Loan (PRAL) of US$ 100 million to support the implementation of these measures. 2. In support of this request this Letter of Sector Policy and accompanying Policy Matrix describe: (i) the Government medium-term macroeconomic stabilization program and progress in Peru's reintegration into the international financial community; (ii) its medium-term adjustment program; (iii) the medium-term objectives and guidelines of the pension reform program, identifying specific measures that will be undertaken before the presentation of this loan to tlhe Board and further measures the Government intends to undertake following Board approval; and (iv) the reforms directed at improving the efficiency of the Peruvian capital markets to intermediate funds. Background 3. The defeat of terrorism and the free market policies implemented by Peru since 1990 have resulted in a remarkable economic recovery. Over the past six years inflation has gone down (from 7600 percent in 1990 to 10 percent in 1995), there has been vigorous economic growth (GDP up 30 percent since 1990) and poverty has been reduced (the percentage of families below the poverty line went down from 55 percent in 1991 to 50 percent in 1994). Even so, the Government is aware that a significant part of this economic growth and poverty reduction has been of a one-time nature, difficult to replicate without sustained investment in physical and human capital. Financing this investment will require higher domestic savings and broader access to long-term external funds. Deepening the reform of the pension system (described in paragraphs 15 to 26) will increase domestic savings, while, reintegrating Peru into the international financial community (through the Paris Club agreement of July 1996 and the Brady agreement with the commercial banks to be closed in December 1996) will increase access to long-term external financing.  27 Annex 1 The Macroeconomic Program 4. The Government's macroeconomic program for 1996-98, supported by the Intemational Monetary Fund through an Extended Fund Facility approved on July 1, 1996, aims to sustain economic growth, lower inflation and maintain a strong international reserve position. The GDP is projected to grow at 6 percent by 1998 (up from an estimated 2.5 percent in 1996) and inflation is projected to fall to industrialized country levels by the end of the period (down from 10-11 percent in 1996). 5. The program aims to reduce the current account deficit. Thus the projected increase in the ratio of investment to GDP from 24 percent in 1995 to 25.5 percent in 1998 is more than offset by the projected increase in domestic savings from 16.5 percent of GDP in 1995 to 20.5 percent in 1998. To that end the Government will not only continue to encourage higher private domestic saving but also will increase the primary surplus from 0.3 percent of GDP in 1995 to one percent in 1996, and 2 percent in 1998. Also, the nonfinancial public sector balance (before privatization receipts) is projected to move from a 2.6 percent deficit in 1995 to about equilibrium by 1998. The projected improvement in the fiscal accounts is based on continuous strengthening of the tax administration and a reduction in spending as a percentage of GDP--the result of higher efficiency in the provision of public goods and services. 6. During 1996 the Government has taken decisive steps towards (i) reintegrating Peru into the international financial market and (ii) reducing the domestic debt overhang. The 1996 Paris Club agreement provides debt relief for 1996-98 and reprofiles maturities falling due after January 1999, corresponding to debts previously rescheduled under the Paris Club of 1991. The debt and debt service reduction (DDSR) operation with the commercial banks encompasses about US$10.8 billion of commercial debt. The agreement includes a Brady-type menu of options and has an upfront cost of about US$1.4 billion. The reform of the pension system results in domestic debt and debt service reduction by way of repackaging contingent pension liabilities into new pension obligations backed by a pension trust fund. 7. About forty percent of the direct financial requirements for the DDSR agreement will be met with Peru's own foreign reserves. Financing a higher percentage of the upfront cost of the DDSR agreement, while, at the same time, allocating US$ 1 billion of the international reserves to the pension trust fund account (see paragraphs 14 to 24 below) would jeopardize the stability of the extemal financing program. Thus the Government has requested additional financing from the international financial institutions and the Export-Import Bank of Japan to complete the financing of the DDSR agreement. The Medium-Term Adjustment Program 8. Peru has transformed its economic policy since 1990. It has opened its economy to competition with the rest of the world and allowed unrestricted inflows and outflows of capital. It has eliminated domestic public monopolies and liberalized prices of goods and  28 Annex 1 services. It has deregulated the labor market and liberalized the financial system while, at the same time, strengthening prudential regulation. It has launched a vast privatization program. It has reformed its tax administration and rebuilt the tax base. 9. Now Peru is entering a second stage of reform. The challenge at this new stage is to consolidate a dynamic market economy, one that creates jobs and supports sustained increases in productivity. This will require: (i) strengthening the efficiency of the domestic market by reducing distortions and completing the privatization program; (ii) creating an inviting environment for private investment in areas where the reform process has proceeded at a slower pace (agriculture and infrastructure); (iii) increasing the quality of provision of health and education services; and (iv) improving the efficiency of government provision of public goods and services. 10. To improve the efficiency of the economy the Government has substantially deregulated the labor market and will (i) continue opening the economy to trade and competition with the rest of the world; (ii) establish an efficient regulatory regime in fisheries and (iii) complete the privatization program. Law 26513 of July 1995 and DL 855 of September 1996, continue the process launched in 1991 with DL 728, to make the labor market more flexible, thus facilitating job creation in the formal sector. To increase competition with the rest of the world the Government will continue to reduce average tariffs and tariff dispersion. To support the efficient exploitation of the fisheries resource the Government will enact a new regulatory regime during the first-half of 1997. To advance with the privatization program the Government will finalize the privatization of Petroperu during the first half of 1997, and remaining state-owned electricity and mining companies during 1997-1998. 11. New private investment in agriculture and basic infrastructure are critical for Peru's medium-term economic growth and poverty reduction. Because of security problems modernization of agriculture has lagged behind developments in other sectors of the economy. To encourage private investment in agriculture the Government enacted in July 1995 Law 26505 eliminating limits on private land ownership in the agricultural sector. It also enacted in April 1996 DL 807 allowing the transformation of sugar cooperatives into corporate businesses. In the future the Government intends to (i) accelerate the registration of titles on agricultural land, and to (ii) promote a more efficient use of water resources through a new water law. To promote private investment in infrastructure the Government enacted a new concessions law (DL 839) in August 1996 allowing private participation through long-term concessions in t:-e provision of most public infrastructure services. 12. The Government is aware that significant poverty reduction requires sustained improvements in health and education. Government will continue improving access and quality of basic health services to the poor. DL 887 of November 1996, encourages broader private participation in these areas through greater competition in the provision and financing of health services. To improve the quality of education the Government will continue to rehabilitate infrastructure, modernize the curricula, upgrade the training of  29 Annex 1 teachers and decentralize greater authority over school administration to the school directors. DL 882 of November 1996 encourages broader private sector participation in all levels of education through greater competition in the provision and financing of educational services. 13. The Government's poverty reduction strategy since 1990 has been multi-faceted. It has reestablished public order, price stability and structural reform. It has also successfully used targeted programs and secured property rights as means to alleviate the condition of the poor and extreme poor. To that effect Foncodes, which implemented more than 20,160 projects for US$766 million in social infrastructure between 1992 and 1996, will continue playing an important role. And the Government has launched an ambitious program to provide registered titles to urban properties. 14. To improve the efficiency of state provision of public goods the Government will pursue a program to modernize the public administration. The Government enacted DL 834 in July 1996, placing new administrative personnel in the Judiciary under private sector labor regulation rules. It also established an internal evaluation process to help improve performance of the judiciary. The Pension Reform Program 15. The reform of Peru's pension system started in 1992. The first step was Law 25897, authorizing a system of private pension funds (AFPs) as an alternative to the 'pay as you go' National Pension System (SNP). The new regime (SPP) permits workers to open individual retirement accounts in AFPs, and receive partial credit for previous contributions to the National Pension System (SNP) through a bond--'Bono de Reconocimiento' (BR). While Law 25897 was an essential first step in that it launched a fully financed pension system, it (i) maintained both different contribution rates and different retirement ages for the SNP and the SPP, (ii) did not allow the migration to the SPP of public employees covered by Peru's oldest and most expensive, defined benefit system, 'Cedula Viva' (CV), and (iii) did not close entry to the SNP regime to new entrants of the labor force. 16. The second step in the reform of the pension system was taken by Law 26504 of July 1995, which eliminated differences in contribution rates and retirement ages between the SNP and the SPP. These measures brought about a significant increase in transfers from the SNP to the SPP after July 1995 and reduced, through the increase in retirement age, the contingent pension obligations of the SNP. 17. The third step in the reform of the pension system was the enactment of DL 817 of April, 1996. It (i) unambiguously established the right of public employees to transfer from the CV to the SPP; (ii) gave authority to the National Pension Office (ONP) to audit all claims for benefits to the CV regime to determine their legitimacy; (iii) required the ONP to periodically estimate the actuarial cost of the pension obligations (PO) under the SNP and CV regimes and from the issue of BRs, (iv) instituted the pension trust fund--  30 Annex 1 Fondo Consolidado de Reservas Previsionales (FCRP)--to back pension obligations; (v) established that adjustments of pensions of employees of formerly owned state enterprises will be subject to the same limitations as SNP pensions; (vi) instituted incentives for migration from the CV regime to the SPP; (vii) established a ceiling for CV pensions--at the level of remuneration of a member of Congress. Thus DL 817 significantly reduced the future impact of the CV regime on the Treasury's coffers, established grounds for an accounting system that quantifies and recognizes contingent pension obligations and created a pension trust fund to back these obligations. 18. Peru is currently in a transition stage where a fully funded regime (SPP) covering about 1,400,000 employees coexists with (i) a 'pay-as-you-go' regime (SNP) covering about 980,000 active and about 320,000 retired employees and (ii) a privileged defined benefit regime (CV) which covers about 50,000 active and 250,000 retired civil servants and employees of former state owned enterprises. At about 1.5 million, the number of workers affiliated to the unfunded publicly sponsored pension regimes is still high and so are the state contingent pension liabilities. At the same time, operating costs of the private pension system's AFPs are high, and their investment opportunities in Peru's capital markets are still limited. Thus, continuing the shrinkage and control of benefits in the public pension system and simultaneous strengthening of the private system is critical to improve the medium and long-term fiscal outlook. 19. To that effect the Government enacted new legislation and regulation in November 1996. To encourage higher migration of young workers from the SNP to the SPP, the Government enacted in November 1996 DL874 easing the eligibility criteria to apply for a BR. Under the new law, all new applicants who have contributed to the SNP for 48 months within the 10 years before December 1996, will be able to receive a BR. To establish a unified framework for asset and liability management the Government will enact in November 1996 a Supreme Decree establishing the regulatory regime for the FCRP and will transfer by December 10, 1996 to this fund, to back BR obligations, US$1 billion of Treasury deposits previously held at the Central Bank and/or Banco de la Nacion. The regulatory regime of the FCRP will provide transparency as to the current state of the asset and liability situation of the publicly sponsored pension systems. 20. The November 1996 DL874 also took some significant initial steps to discourage high fees and increase competition of AFPs. It eliminated the use of a benchmark rate of return for the industry and of 'bands' around this rate of return, thus increasing the benefits achievable by AFPs for relative overperformance, and reducing the penalties for relative underperformance. It also required that investment results be reported on a regular basis net of fees, and expanded the categories of securities in which AFPs can invest. 21. The next stage in the reform of the pension system will include measures (i) to strengthen the quality of the regulatory regime for pension funds and the capacity of the respective regulatory institution, (ii) to establish a unified framework for pension asset and liability management including the use of government extraordinary revenues and (iii) to  31 Annex 1 liability management including the use of government extraordinary revenues and (iii) to continue reducing the debt and debt service resulting from publicly sponsored pension programs. 22. The Government is persuaded that the current pension fund regulatory regime does not encourage an efficient intermediation of funds. The current situation of the AFP industry shows remarkable similarity in aggregate portfolio composition (shares invested in stocks, bonds, bank CDs etc.) as well as individual stock holdings which is reflected in increasing convergence of values of AFP quotas. In addition, at two percent of salaries, the commissions charged for managing the accounts are high compared to similar systems in other countries. 23. To improve the efficiency of financial intermediation of the AFPs, the Government will enact during the first-half of 1997 a new regulatory framework to encourage the offer of a diversified range of financial products and a more transparent disclosure of risk and will review the present regulatory structure to explore possible reductions in complexity and cost. 24. To introduce more transparency as to the financial situation of the publicly sponsored pension regimes as well as to the fiscal outlook, the Government will issue, in the first-half of 1997, budgetary rules consistent with the accounting of the accrued costs of the contingent pension obligations. These rules will determine mechanisms to reduce the difference between the pension obligations and the value of assets of the FCRP through the transfer of ordinary and extraordinary revenue from the Treasury to the FCRP. 25. To encourage migration of workers with legitimate claims to CV benefits to the SPP, the Government will issue the regulation required to implement the incentive schemes introduced in DL 817 and will complete the audit of claims to benefits during 1997. 26. To define future steps in pension reform the Government will prepare during the first half of 1997 a study analyzing the state of the SNP. This study will address the costs and benefits of alternative courses of action to reduce the contingent obligations of the SNP. In particular, it will compare the alternative of a gradual phase out of the SNP with that of transforming the SNP into a fully financed pension regime. Following the recommendations of the study the Government will design and implement the necessary changes in the pension regulatory framework during the second-half of 1997. The Reform of Capital Market Regulation 27. The improvements in the economy after 1990 and the modernization of the capital market regulatory regime after 1992 have resulted in a significant increase in the capacity of Peru's capital market to intermediate funds. As a result, stock market capitalization increased from US$1,124 million in 1992 to US$15,221 million in 1996, the value of  32 Annex 1 bond and short-term commercial paper financing went up from US$125 million in 1992 to US$435 million in 1995, and foreign portfolio investment increased from US$27 million in 1992 to US$1,875 million in 1995. The expansion of the private pension funds--with assets valued at US$1 billion as of October 1996--contributed significantly to these results. 28. The reforms of 1992 enacted in DL 755, the capital markets law, helped start or increased use of n 'vw financial institutions and instruments (such as mutual funds, ADRs, and corporate bonds) and improved regulatory oversight and trading and information systems. Notwithsta, ling these improvements it has been necessary to modify the regulatory regpmre to (i) incorporate the use of new financial instruments into Peru's capital marke' i): improve the regulatory environment and (iii) expand the range of instruments available for investment of institutional investors such as the AFPs. 29. Legislative Decrees 861 and 862 of October 1996 introduce improvements in capital markets regulation. They (i) establish a framework for the operation of investment funds; (ii) provide a solid base for securitization of otherwise illiquid financial assets such as mortgage loans and consumer credit receivables; (iii) simplify the regulation of mutual funds; (iv) improve regulation pertaining to short term paper and convertible bonds; (v) increase capital requirements for financial intermediaries; (vi) introduce the concept of self-regulation of the stock market; (vii) establish the independence of the agent in charge of the clearing and liquidation of financial transactions in the stock market; and (viii) improve market transparency. It is expected that experience with the mechanisms introduced by DL 861 and DL 862 will require further adjustments and refinements in the framework to implement the concept of an essentially self-regulating market and limited government involvement. 30. The Government of Peru is committed to consolidate the program of reforms started in 1990. The implementation of the policies described in this Letter of Development Policy ?.re in accordance with the Extended Fund Facility agreement with the IMF and will contribute to sustained economic growth and poverty reduction with macroeconomic stability. As we implement the measures discussed in paragraphs 21 to 29 we intend to approach the Bank for further support through policy advice, technical assistance, and/or adjustment lending. Jorge Camet Dickmann Minister of Economy and Finance Lima, Peru November 25, 1996  PERU - PRAL: MATRIX OF POLICY ACTIONS (Actions in italics are inicluded in Letter of Sector Policy onil'y to be mionitored as part of the overall program implemenitation and not as loan or guarantee agreement conditions) I.MACROEC0NOMIC POLICY: RAMEWOMRK:~ ..E.E.T.TI.. ....N .I4T0 . J~PR A * A 4-5 percent rate of economic growth A macroeconomic framework- consistent with the A macroeconomic framework conisistenti in 1996-1998. objectives set forth in the Letter- of Developmnent with the objectives set forth ini the Letter Policy, of Development Polic.y. * A drop in the intlation rate from 1 0-1 1 percent in 1996 to 6 percent by 1998. * Public Sector Overall Balance ~E uilbr-ium by 1998.- . _ _ _ -_ _ _ _ _ _ _ _ _ i., PIENSION SYSTE:M R__ __ __ ___ __ __ . A. REFORM OF THE 'CEDULA VIVA' SYSTEM _______________ * Reduce the contingent obligations of DL 817 enacted on April 23, 1996 reformed the Complete the auidit of claims to benefits to the 'Cedula Viva' pension svstem., I Cedula ViNa' svustetn DL S i 7 'k) unamhlguoLISIV the C IV regime. established the right of public enmplovees to Stthe wtate for she r-eform of thle cilvii I ransfer fromi the (CV lco the. SPP-: ci) gave JYvuL regudlaion implemnwmng the cer'.ice by -iak-ing p1-S; d, V- zluthority to th e National Per_ion Office (ONP) to ticenwiiies (esiablished in L)L, SI7) it.) (CV pension adiu-tnients~ ui atudit all diaims for benefits to ,he CV regime TO j tr.Nsfer frorn the CJl' theS.PP. ser-vants wage adjustments, determinie their 1egitimacv- (iii) established that adjustmenai; of pensions of crnployees of forrnerix owned state enterprises will 1be subjectL to the same limitations as SINP pensions:. (iv) instituted incentives for migration from the CV regime to the SPP: (v) established a ceiling for CV pensionis- -at the level of remuneration of a member of Congress. 13B. REFORM OF THE NATIONAL PENSION SYS'TEm * Encourage migration of workers and Law 26504 was enacted in July 1995, The key Issue regulation aimning to a gradual employees from the SNP to the SPP legislative changes introduced by Law 26504 are phasing out of the SNP or tranisforminig (i) the elimination of differenices in contribution the SNP in afully financed pension * Reduce the contingency obligations of rates and retirement ages between the SNP and regime. the national pension system. the SPP; (ii) the increase in the minimum _________________________________retirement age to claim benefits from the SNP Issue the 'Bono de Reconocimienito'  OBEC...ATINSTAKE.N1PRIOR UTO_J BOR7 4T0N XCEDURGTH i C -iE L EEL E DiS i 7- i t - S :E :;: : :::ff:: t? : :: .............................. fss~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~. . . . . . . . . . . . . I 'AAETA1 O..... ..EON HAEOFTEPOG M from 60 to 65--for men-- and from 55 to 65-- designed by DL 874. women. DL 874, enacted in November 1996, broadens the eligibility criteria to apply for a 'Bono de Reconocimiento' by requiring as only condition to qualify for benefits having contributed for 48 months within the 10 years before December 1996. :'.'e,l.: o ' ' -XW' '' ' ' ' :::X.] @- :.- - -t -: . .............. t.--: , C-; .-:: RI..O. OF:.. T... ...... --. iUNDS * Increase the menu of investment Regulatory changes were enacted to discourage options available for those affiliated to high fees and increase competition of AFPs. DL Enact during the first-half of 1997 a new the AFPs. 874 (i) eliminated the use of a benchmark rate of regulatoryframework to encourage (i) the return for the industry and of 'bands' around this offer of a diversified range offinancial * More transparent disclosure of risk. rate of return, (ii) required that investments results products, (ii) a more transparent be reported on a regular basis net of fees, and (iii) disclosure of risk. * Reduce complexity and associated expanded the categories of securities in which costs of current regulatory regime. AFPs can invest. Review the present regulatory structure to explore possible reductions in complexity and cost. 1. DEVLOY A RMWOR FOR_ PKENSION ASEVN IBLIYMNGMN Increase the transparency of the fiscal Law 26504 (i) required the ONP to periodically Issue budgetary rules consistent with the accounts. estimate the actuarial cost of pension obligations accounting of the accrued costs of the under the SNP and CV regimes and from the issue contingent pension obligations. Contribute to a judicious use of of BRs and (ii) instituted the pension trust fund-- Government extraordinary revenues. Fondo Consolidado de Reservas Previsionales Issue budgetary rules establishing a (FCRP)--to back pension obligations. formula to reduce the difference between the pension obligations and the value of A regulatory regime of the FCRP acceptable to assets of the FCRP through the transfer of the Bank will be enacted in November 1996. ordinary and extraordinary revenue from the Treasury to the FCRP. US$1 billion from Treasury resources will be deposited in the FCRP by December 10, 1996.  * Incorporate the use of new financial DL 861 and DL 862 were enacted in October Issue regulation requiredfor effective instruments into Peru's capital market. 1996. They: (i) establish a framework for the implementation of DL 861 and DL 862. operation of investment funds; (ii) provide a solid * Improve the regulatory environment. base for securitization of otherwise illiquid Introduction offurther adjustments and financial assets such as mortgage loans and refinements in the regulatory framework. . Expand the range of instruments consumer credit receivables; (iii) simplify the and strengthen the capacity of the available for investment of institutional regulation of mutual funds; (iv) improve supervisory agency to implement the investors such as the AFPs. regulation pertaining to short term paper and concept of an essentially self-regulating convertible bonds; (v) increase capital market and limited government requirements of financial intermediates; (vi) involvement. introduce the concept of self-regulation of the stock market; (vii) establish the independence of the agent in charge of the clearing and liquidation of financial transactions in the stock market; and (viii) improve market transparency. m:\peru\edgardo\mnx3sal2.doc:ef   ANNEX 3 PENSION REFORM TECHNICAL APPENDIX I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~   36 PENSION REFORM TECHNICAL APPENDIX Introduction This appendix provides background on the methodology to calculate the value of a BR set forth by DL25897, explains the methodology used to estimate the costs resting from the reforms enacted in DL 874 of November 1996, and the methodology to estimate the costs and benefits of the reform presented in paragraph 61 of the document. The first section describes methodological aspects of the estimation of a BR. The second section presents the methodology to calculate the value of the BRs under DL 874. The third section describes the methodology used to calculate the costs and benefits of the transfer of about 130,000 workers in the age cohort 25-31 from the SNP to the SPP. Calculation of the Value of a Bono de Reconocimiento 1992 When developing the new private pension system, Peru's government adopted most of Chile's system. Among those, they created the Bonos de Reconocimiento, an instrument that recognizes past contributions to the old system. The idea behind these bonds is simple. While the pension system worked as a pay-as-you-go system, there was no legal link between past contributions and benefits at the individual level. The benefits offered by the Peruvian Social Security System were financed with contributions of currently working affiliates and, in principle, no accumulation of funds was needed. Instead, when switching to a capitalization regime, accumulated contributions became the central parameter in determining benefits. Two options were available to circumvent this problem. First, the Government could pay monthly benefits to those who retire under the capitalization system in a level compatible with the contributions they made before switching to the new system. The total amount of benefits would result from the monthly payment from the public system, and the benefits paid from the capitalization system. This approach was chosen in Argentina's reform. The second choice is that the Government can promise that, by the time individuals retire, it will make a one-time transfer to the individuals' account at the AFP, increasing their funds, in a level compatible with the contributions these individuals made to the old system. This alternative was chosen in Chile and, similarly, in Peru. According to the decree-law 25897, the face value of the bonds should reflect the total contributions made to the old system by its affiliates. Because of the difficulties that would be created by the need to actualize old contributions, and the lack of reliable records, a relatively simple formula was defined to calculate the value of the bonds in the decree supreme 206-92. This formula indicated that the face value of the bond ("B") will be equal to the multiplication of the number of months an individual contributed before December 1992 ("M") times the average salary of the last 12 months previous to December 1992 ("S") times an adjustment factor (0.1831). Thus: B=MxSx0.1831 [1]  37 Because there were no adequate records to calculate the exact number of months with past contributions those had to be estimated. Supreme decree (DS) 602-92 defined a table that has been used to determine an assumed number of months with contributions, based on the age of the worker. This table defines the number of months as approximately half of the elapsed months between the 20th birthday of the worker and December 1992. Nevertheless, an option is left open to the workers to prove he has made contributions for longer period than results from the application of the table. The second parameter needed to determine the value of the bonds is the average salary of the last 12 months prior to December 1992. Because the ONP had no adequate records of actual contributions, initially there was no clear procedure defined to calculate this amount. Later on, a mechanism based on sworn statement presented by the workers was admited as the basis to determnine the relevant salaries. Since the only pension obligation the government will assume with the changing system is the recognition bonds, calculating the future flow of expenses is relatively simple. The annual government expenditure on recognition bonds ("Et") on any year "t" can be calculated with equation 2: N E = E M.xS.xS x0.1831 [2] a-1 When 'N' is the number of workers with rights to receive a bond retiring on year "t". Thus, knowing the age distribution of Peru's active population, we can make a first estimation of the expected annual expense. While 2 million workers qualified, in principle, to receive a BR when DL 25897 was enacted, the actual number of bonds issued as of October 1996 is 48,301. This is because a large number of workers decided to stay within the SNP, and also a significant group of workers for one reason or another have not applied for them. According to the AFP Superintendency, about fifty percent of the workers affiliated to an AFP declared they do not qualify to receive a bond. According to the law, the salary used in the calculation of the BR was the average of the last twelve months, prior to December 1992. The formula used to calculate the average salary considers the current, and not real, salaries. Thus, we must estimate the level of inflation induced erosion on this average salary. Calling the 1992 monthly salaries "Wjan" to "Wdc'" we can define the average salary "S" as: S= I x [Wjan + Wfb + Wr + + WdeC] [3] 1 2 Now, if we assume a constant monthly inflation rate "i", the value of salaries, measured in salaries of December 1992 would be:  38 Wdic Wda, Wdec Wduc Wd,. = Wdec nv .i; W ot . ( ........ . .... . .......... ; Wfeb = 1;Wjan = I.............. )1 [4] ~~~~(1+ i) (1+i)2 .W - (I+ i) ( +1) 4 Thus: s + Wd.c . ....+ + Wd.c [5] 12 L(1 +i) 11 (I + i) '