Colombia - Structural Fiscal Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P 7483- CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL FISCAL ADJUSTMENT LOAN IN THE AMOUNT OF US$400 MILLION FOR THE REPUBLIC OF COLOMBIA November 16, 2001 Colombia-Mexico-Venezuela Country Management Unit Latin America and the Caribbean Region 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.  REPUBLIC OF COLOMBIA-FISCAL YEAR January 1-December 31 CURRENCY EOUIVALENTS (as of 25 October 2001) Currency Unit = Peso 2340.00 Pesos = US$1 1.12 Euros = US$1 WEIGHTS AND MEASURES Metric System SELECTED ABBREVIATIONS AND ACRONYMS AFORE Administradoras de Fondos para el IMF International Monetary Fund Retiro IPS Instituciones Prestadoras de Salud ARS Administradora del Regimen ISA Interconexi6n Electrica SA Subsidiado ISAGEN Interconexi6n Electrica SA CAS Country Assistance Strategy (Generadora) CAS-PR Country Assistance Strategy ISS Instituto del Seguro Social Progress Report LDP Letter of Development Policy CMU Country Management Unit NFPS Non-Financial Public Sector DANE Departamento Administrativo PAYG Pay-As-You-Go Nacional de Estadistica PBG Policy Based Guarantee DB Defined Benefit PFMP Public Financial Management Project DC Defined Compensation POS Plan Obligatorio de Salud DECPG Development Prospects Group PPP Purchasing Power Parity DNP Departamento Nacional de QAG Quality Assurance Group Planeaci6n SDR Special Drawing Right EPS Empresa Promotora de Salud SFAL Structural Fiscal Adjustment Loan EUR Euros SGP Sistema General de Participaciones FINDETER Financiera de Desarrollo SISBEN Sistema de Identificaci6n de Territorial Beneficiarios FOGAFfN Fondo de Garantias Financieras SNSSS Sistema Nacional de Seguridad Social FONPET Fondo de Pensiones Territorials en Salud FOPEP Fondo de Pensiones Publicas SOAT Seguro Obligatorio de Accidentes de FOSYGA Fondo de Solidaridady Garantia Trdnsito FSAL Financial Sector Adjustment Loan SSAL Social Sector Adjustment Loan GDP Gross Domestic Product TES Colombia Treasury bonds IBRD International Bank for UPC Unidad per Capita de Capitacion Reconstruction and Development URC Unified Registry of Contributors IDB Inter-American Development Bank WBG World Bank Group IFI International Financial Institutions WEO World Economic Outlook IBRD Vice President David de Ferranti Chief Economist: Guillermo Perry Director, LCSPR Ernesto May Country Director: Olivier Lafourcade Lead Economist/Manager: Marcelo Giugale Task Managers: Vicente Fretes-Cibils Marcelo Giugale Team Production Support: Michael Geller This operation was prepared by a World Bank team composed of Messrs/Mmes. Rojas (LCSPS); Webb (LCSPE); Giugale, Chal]a, Fretes-Cibils, Velez Bustillo, Cuevas, Partow, Geller (LCC] C); Escobar, Uribe (LCHH); von Gersdorff (LSCFR); Carvalhc, (LEGLA); del Valle, Zhang (FSD); de Henao, Lezaca (LCCCO); Fernandez, Gottret, and Panopoulou (consultants). The tean was led by Messrs. Fretes-Cibils and Giugale (LCC 1C), and worked under the general guidance of Mr. Olivier Lafourcade (Director, LCCIC).  FOR OFFICIAL USE ONLY REPUBLIC OF COLOMBIA FISCAL STRENGTHENING PROGRAM-STRUCTURAL ADJUSTMENT LOAN TABLE OF CONTENTS LOAN AND PROGRAM SUMMARY .............................................................i I. BACKGROUND AND RATIONALE ............................................................1 II. THE STRUCTURAL CHALLENGES OF FISCAL STRENGTHENING ........................................ 5 Intergovernmental Fiscal Relations ..........................................................5 Education ............................................................6 Health .............................................................7 Pensions ............................................................9 Public Sector Reform ............................................................ 10 Public Sector Debt .............................................................11 III. THE ECONOMIC REFORM PROGRAM OF THE COLOMBIAN GOVERNMENT .. 11 A. Government Program Policies ............................................................ 12 B. The Program's Outcomes ........................................................... 17 IV. THE PROPOSED STRUCTURAL FISCAL ADJUSTMENT LOAN (SFAL) .. 20 A. Objectives ........................................................... 20 B. Content ........................................................... 21 C. Risks ............................................................ 23 D. Poverty Impact ........................................................... 25 E. Loan Amount, Conditions, Financial Safeguards, and Disbursements and Audits ........................................................... 25 V. THE MACROECONOMIC FRAMEWORK FOR THE PROPOSED SFAL .. 28 VI. BANK STRATEGY ............................................................ 28 A. The CAS and The Proposed SFAL ............................................................ 28 B. Complementarity with Other World Bank Operations and Activities ................... 30 C. Complementarity with Other Institutions' Operations .......................................... 31 VII. RECOMMENDATION .. 31 TEXT TABLES Table 1. Colombia-Public Sector Fiscal Balances Scenario with Reforms (2000-05) ...... 18 Table 2. Colombia-Matrix of Policy Actions for Tranche Releases of SFAL ...... 21, 22, 23 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. l  FOR OFFICIAL USE ONLY TEXT FIGURES Figure 1. Colombia: Public Sector Balance, Real GDP Growth, and Poverty Rates (1978-99) ..........................................................3 Figure 2. Colombia: Public Sector Balances Under Alternative Reforms Scenarios (1999-2005) ......................................................... 19 Figure 3 Colombia: Net Public Debt Under Alternative Reforms Scenarios (1999-2005) ..................... .................................... l 9 TEXT BoxEs Box 1. Key Social Impacts of the Policies Supported by the SFAL ................................. 20 Box 2. The Colombian Constitutional Court ......................................................... 24 ANNEXES A. COUNTRY ASSISTANCE UPDATE NOTE ......................................................... 33 INDICATORS Al. Colombia at a Glance ......................................................... 41,42 A2. Key Economic and Program Indicators-Change from Last CAS ............................. 43 A3. Selected Indicators of Bank Portfolio Performance and Management ........................ 45 A4. IBRD/IDA Program Summary ......................................................... 47 A5. IFC and MIGA Program Summary ......................................................... 49 A6. Summary of Nonlending Services ......................................................... 51 A7. Colombia Social Indicators ......................................................... 53 A8. Key Economic Indicators ......................................................... 55-57 A9. Key Exposure Indicators ......................................................... 59 Al 0. Operations Portfolio (IBRD/IDA and Grants) ......................................................... 61 All. Statement of IFC's Held and Disbursed Portfolio ....................................................... 63 B. THE MACROECONOMIC FRAMEWORK .65 C. FISCAL SUSTAINABILITY, ECONOMIC GROWTH, AND POVERTY .73 D. PUBLIC SECTOR DEBT-STRUCTURE AND SUSTAINABILITY. . X..............91 E. LETTER OF DEVELOPMENT POLICY .97 F. LETTER OF PRESIDENT PASTRANA ............................................................. 109, 110 G. SPECIFICATIONS, DEFINITIONS, AND EVIDENCE FOR TRANCHE RELEASE CONDITIONS .11 H. MANAGEMENT OF PUBLIC FINANCES ........................................ 123 I. MAP 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.  FOR OFFICIAL USE ONLY REPUBLIC OF COLOMBIA FISCAL STRENGTHENING PROGRAM-STRUCTURAL FISCAL ADJUSTMENT LOAN (SFAL) LOAN AND PROGRAM SUMMARY Borrower: Republic of Colombia Amount and Terms: US$400 million fixed-spread loan, with automatic interest rate fixing whenever disbursements reach an aggregate amount of US$20 million; final repayment maturity of 13.5 years with level repayments of principal, each equivalent to 10 percent of the loan amount. Commitment charge: 0.85 percent p.a. for the first four years, and 0.75 percent p.a. thereafter. Front-end fee: 1 percent of the Loan amount, to be paid by the Government out of its own finances. Implementing Agency: Ministry of Finance and Public Credit Description: The SFAL is the Bank's response to the government's demonstrated commitment to reaching an inflection point in Colombia's fiscal accounts path, an essential first step toward achieving full fiscal sustainability, economic growth, and poverty reduction. The program to be supported by the SFAL focuses on a core set of policies that can strengthen the country's fiscal outlook. This policy package involves (a) rationalizing the system of transfers to local governments, and imposing more market- driven and more binding budget constraints on their finances; (b) establishing mechanisms to arrest the exploding cost of inefficiency in the provision of public health services; (c) halting the accumulation of pension- related contingent liabilities; (d) advancing the reorganization of public agencies and their current expenditures; and (e) setting up a better system for managing public debt. The combination of measures to improve governmental fiscal relations, rationalize public sector expenditures, and improve financial management of the public sector's assets and liabilities will lead to a more sustainable fiscal path and to greater efficiency in allocation of public resources, including those allocated to the social sectors. Both are necessary to sustain economic growth and poverty- reduction efforts, and to improve the provision of key public services. 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. i  FOR OFFICIAL USE ONLY Risks and Benefits: The proceeds of the loan will help to implement fiscal reforms, provide a confidence-building signal to international markets, reduce the cost of borrowing, and lengthen debt maturity. These will, in turn, grant the government the fiscal space for protecting social sector expenditures and implementing difficult structural measures. In addition to their fiscal implications, the measures supported by the SFAL have social impacts that have been identified and evaluated, and which will provide the basis for additional policies to protect the most vulnerable. The SFAL carries both internal and external risks. The main internal risks include (a) the fragility of the overall political context. Prolonged social disruption and resistance from interest groups could derail the reform agenda, and the internal conflict could further escalate. The government is committed to continuing its dialogue with the guerrillas, and is working to mitigate political and social risks through building a consensus with a variety of interest groups. (b) Blocking or substantial alteration by the opposition-led Congress of the policy initiatives in the program. This risk is mitigated because the bulk of the reforms have already been discussed with Congress. The SFAL has also sought to include reforms that require Congressional approval up front in the program or in the floating tranche, and has stressed measures to be carried out by the Executive. (c) A reversion to fiscal mismanagement. The government's commitment to reform militates against this, as do hard budget constraints faced by subnational governments. The loan also requires a set of nonreversible actions prior to tranche disbursement. The most important external risk is that of a deeper downturn in the world economy. This could be transmitted to the Colombian economy through a further deterioration in terms of trade and the closure of access to international financial markets. In this regard, the government intends to continue its flexible exchange rate policy and retains access to IFI financing, particularly the IMF through continued fulfillment of conditions and the right to draw upon resources under its Extended Arrangement. Schedule of Disbursements: The loan is expected to be disbursed in three tranches, of US$160 million in December 2001, US$180 million expected in March 2002, and a US$60 million floating tranche to be disbursed upon fulfillment of its specific conditions. Project ID Number: CO-PE-P073572-LEN-BB 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. ii  REPUBLIC OF COLOMBIA FISCAL STRENGTHENING PROGRAM STRUCTURAL FISCAL ADJUSTMENT LOAN (SFAL) President's Report I. BACKGROUND AND RATIONALE 1. Starting in the mid-1990s, Colombia entered an unsustainable path of overall fiscal imbalance-by the end of the decade, central government expenditures had grown by about 8 percentage points of GDP, while revenues, despite no fewer than eight tax reforms, increased by only about 2.5 points. As a result, the total gross stock of public sector debt as a percentage of GDP almost doubled (to about 50 percent by 2000). Such a fragile fiscal position made Colombia particularly vulnerable and ill prepared to respond to the economic recession that would unfold in 1998. This was triggered by a combination of a sharp deterioration in the country's terms of trade, the effect of the East Asia and Russia crises, and a weakening of investor confidence due to stepped-up guerrilla and illegal drug activities. The downturn, the first in 70 years, revealed critical structural weaknesses in the government accounts-notably, the encroachment of entitlements in favor of politically powerful sectors, unbridled subnational spending, the deterioration in quantity and quality of social services, and the substitution of current for capital expenditures and weaknesses in the banking sector (its mortgage industry all but collapsed, adding to the fiscal malaise). In the end, Colombia, a country previously reputed for its sound macroeconomic management, lost its sovereign investment grade and saw its access to international financing tightly restricted. 2. To deal with the immediate effects of the recession, the then incoming Pastrana Administration formulated a three-year stabilization program for the period through 2002 based on exchange rate flexibility (the peso was floated in September 1999), fiscal stabilization, and the implementation of structural reforms, including financial sector restructuring and privatization. The international financial community mobilized to support that program, and the IMF Board of Directors approved in December 1999 a three-year, SDR 1.96 billion Extended Arrangement Facility-the first of its kind for Colombia. This arrangement was entered into with a clear understanding on the part of the Colombian authorities that (a) it was precautionary in nature, (b) it was meant to send a confidence-building signal to international markets, and (c) it would not be drawn upon unless there was a pressing balance-of-payments need. The authorities have proceeded along the precautionary path in not drawing upon the arrangement, and despite the deteriorating external environment, to date this has proven to be the right policy decision (the spread of the country's sovereign borrowing rate continues to decline and is gradually converging to the level of investment-grade borrowers such as Mexico).' 3. The World Bank joined the stabilization efforts. Its Board approved in November 1999 an EUR 482 million Financial Sector Adjustment Loan, the second tranche of which would be 1. However, should an international crisis occur and the financial markets further tighten access for all emerging country borrowers-particularly following the tragic attacks of September 11, 2001 and subsequent events- Colombia's drawing upon the IMF arrangement would not be perceived as a negative signal about the country's economic management. I  converted, in February 2001, to a Policy Based Guarantee (PBG) operation of up to about EUR 238 million, fiurther reinforcing credibility in intemational markets. Moreover, the government requested last year that the World Bank take the lead in identifying and supporting the implementation of key structural reforms to (a) complement the stabilization effort under the IMF program; and (b) help bring Colombia's fiscal accounts onto a sustainable path in the medium- and long-term. The operation proposed in this document is the Bank's response to suoh request, and reflects our extensive dialogue with the authorities regarding fiscal structural weaknesses. 4. The implementation of the stabilization program produced some positive results-key indicators, such as growth, inflation, and the fiscal balance have improved; the extemal position and financial system have been strengthened (see Annexes A and B); and compliance under the above-mentioned IMF and World Bank operations has been satisfactory. The 1998--99 recession had a devastating social impact and provided a crucial policy lesson in this regard. In Colombia, there has been a close positive correlation between growth and poverty reduction (see Figure 1 and Annex C). During periods of positive growth (and fiscal balance), Colombia enjoyed substantial declines in poverty (even though inequality increased). Specifically, fr2,m 1988 to 1995, as average GDP grew at about 3.5 percent per year, poverty rates declined frcm about 65 to 60 percent of the population. This reduction, and the government's efforts that helped achieved it, were completely wiped out by the 1998-99 recession. Poverty levels today are not substantially different from what they were in the late 1980s (and inequality has increased). More immediately, unemployment climbed to and has since remained at, almost 20 percent of the labor force. Put differently, the evidence suggests that sustainable growth has been Colombia's best social safety net.3'4 5. That link between growth and poverty in effect dictates Colombia's economic policy agenda over the next two years-the priority is to sustain first, and then consolidate, the observed, albeit timid, recovery of growth, especially in light of the impacts of the events of September 11. For several reasons, the key to sustaining and then consolidating econoiriic recovery is the strengthening of the fiscal accounts. First, in spite of important progress, the initial round of stabilization-related reforms did not attend to the structural, sector-specific 2. Since the approval of the IMF Extended Arrangement, two reviews were successfully completed in September 2000 and March 2001, and the third review is expected to be completed by January 2002. The borrowing facilitated by the World Bank's PBG has been used to meet the country's financing needs for 2001. While it provided market access at a critical time and contributed to the decline in Colombia's sovereign bond spread over the U.S.'s sovereign bond, that borrowing has been relatively expensive (probably a reflection of investors' concern over delayed structural reforms and potential contagion effects from other emerging markets in che region). 3. As part of the authorities' efforts to deal with the immediate, recession-driven unemployment problem, the World Bank approved a US$100 million Community Works Project (January 2000), and a US$150 million Huiran Capital Protection Project (March 2001). While these interventions mostly deal with recession-drixen unemployment, it is recognized that there are structural rigidities in the formal labor market including high payroll taxes, binding minimum wages, and inflexible contractual arrangements, causing structLiral unemployment. The government will tackle these rigidities to make the labor market more flexible through labor reforms supported by the forthcoming SSAL. 4. A recently completed draft World Bank report on the evaluation and causes of Colombia's poverty reconfirns the formidable, dominant role that economic growth plays among the determinants of the country's poverty levels. 2  imbalances that have weakened, and continue to weaken, the country's fiscal position. In the timid economic recovery path, these weaknesses will further push down economic growth. Second, the recovery has been smaller than previously anticipated and it will now take longer to achieve significant positive economic growth; thus, tax revenues have not met expectations, and will be lower than previously anticipated. Third, the period leading to next year's Congressional and presidential elections will exacerbate political pressures toward spending. Fourth, an intensification of the internal conflict, and the violence associated with illegal drug activities, could dilute investor confidence in Colombia, from an already low point. Finally, further deterioration in the external environment, contagion from financial crises in major markets and/or a major emerging economy, terms of trade shock caused by a global recession (especially the U.S. economic downturn, and the impact of oil and coffee price declines), or a combination of the above, could restrict Colombia's access to international capital markets even more (as explained later, the financing scenario for the rest of 2001 and for 2002 calls for significant foreign funding). In brief, in the absence of further structural fiscal strengthening, the probability of a sharp, recession-driven rise in poverty is high-a probability that has been heightened by the events since September 11. Figure 1. Colombia: Public Sector Balance, Real GDP Growth, and Poverty Rates (1978-99) 85- 6 ; 75- ; > ~~~~1990-1995 5 e 0 - 19852002< _5 4 3 ~ 5 1978 1988 ~~~~ ~ ~~1995 1999 .70 ,~65 - > ~~~~~~~~~~~~~~~~~~~~~~~~-2 o60 -3 55 ~~~~~~~~~~~~~~~~~~~~~~~-4 1978 1988 1995 1999 _ Average Real GDP Criowth Rate - Average NFPS Balne (Percentage of GDP) - Poverty Rate Source: National Accounts, IMF, and World Bank. 6. The Colombian authorities understand the urgent need for policy action, and, as indicated above, have requested the World Bank's technical and financial assistance in the design and implementation of a wide-reaching fiscal strengthening program, to be supported by the proposed US$400 million Structural Fiscal Adjustment Loan (SFAL). This President's Report (a) summarizes the diagnosis of the main sectoral imbalances that lie behind Colombia's fiscal weaknesses; (b) describes the policy package that the SFAL will support; and (c) explains the strategic fit, risks, and modalities of the operation. 3  7. At the outset, it is crucial to notice that, on the one hand, the sociopolitical situation in the country severely limits the government's space for reform (notably, through the dynamics of the ongoing civil conflict and of the upcoming elections) and, on the other, many of the required reforms are long-term undertakings that will take time to be fully implemented and show results. There is, however, strong government commitment for reform, and ownership of the refonn program is widespread-this is a coalition government and the program has been discussed with, and has the support of, the main political parties, ensuring both viability and continuity. The government should be able to fully implement its fiscal reform package within this administration's term, and leave the fiscal accounts on a more sustainable path for the next administration, smoothing both the political and, more important, the economic and social transitions. The program to be supported by the SFAL is, nevertheless, not intended to deal exhaustively and conclusively with all areas where action could improve Colombia's fiscal outlook. Rather, it is conceived as a first-step package that focuses on a core set of critical policies that can sufficiently strengthen and consolidate that outlook. In particular, the SFAL- supported policy package involves (a) rationalizing the system of transfers to local governments (especially education-related transfers), and imposing more market-driven and more binding budget constraints on their finances; (b) establishing mechanisms to arrest the exploding cost of inefficiency in the provision of public health services (particularly the cost of public hospitals and the health arn of the Social Security Institute); (c) halting the accumulation of pension- related contingent liabilities; (d) advancing the reorganization of public agencies and their current expenditures; and (e) setting up a better system for managing public debt. 8. The Country Assistance Strategy Progress Report (CAS-PR), discussed by the Banlk's Board in November 1999, recognized that the performance of the Colombian economy-most notably, economic growth and fiscal stability-had deteriorated sharply during the two years since the presentation of the last full CAS. As a result, restoring the fiscal balance Was determined as being crucial for the success of Colombia's efforts to recover growth and reduce poverty. The CAS-PR also recognized that the government had made reducing the fiscal deficit one of its key macroeconomic objectives, and that the worsening economic situation, including fiscal imbalances and financial instability, could lead to financing gaps and problems in accessing external financial markets on reasonable terms that, in turn, would prevent the achievement of the CAS objectives. In light of the deteriorating external environment, strengthening the fiscal account remains as crucial as before, if not more so, for sustaining and consolidating economic recovery, and preventing the deterioration of social conditions. The CAS-PR moved the assistance strategy to a high-case lending scenario, including adjustment operations, and justified this movement due to (a) the need to cushion the adverse social impact of the economic recession, financial instability and internal conflict on the poor and vulnerable groups, and (b) the government's commitment to undertake fiscal adjustments and implement structural reforms to be supported by an IMF program. As explained in the Country Assistance Update Note (Annex A), the reasons and triggers to operate in a high-case scenario not only remain current but have also been enhanced by recent developments-a deteriorating external macroeconomic environment that threatens growth sustainability, the continuing govermnent commitment to fiscal discipline, and the strength of the reform agenda. 9. The SFAL is the Bank's response to the government's demonstrated commitment to reaching an inflection point in the country's fiscal accounts path-an essential first step toward achieving full fiscal sustainability. The ambitious policy agenda that the operation will 4  support-as elaborated in the government's Letter of Development Policy (LDP), see Annex E-has been discussed and designed over a series of technical missions starting in early 2001.5 Moreover, given the likelihood of social impacts from these policies (see paragraph 54), the agenda envisions that the SFAL would be followed up and complemented by a Social Sector Adjustment Loan (SSAL) that would enhance the social sustainability of the reforms. II. THE STRUCTURAL CHALLENGES OF FISCAL STRENGTHENING 10. The Colombian government has maintained its commitment to a program of fiscal adjustment, despite the difficult economic, political, and security conditions. The authorities have made advances in implementing a number of key reforms, including strengthening the financial system and passage of legislation to (a) allocate funds for financing local government pensions; (b) strengthen the fiscal position of local governments; and (c) increase core taxes, including the presumptive income tax, the value added tax (from 15 percent to 16 percent), and the financial transactions tax (from 0.2 percent to 0.3 percent). However, along with these advances, there have been some setbacks, most notably (a) a court order in October 2000 requiring backward indexation of public sector wages; and (b) the failure to privatize two large enterprises in the electricity sector (ISA and ISAGEN). To ensure sustainability in the medium term, the government must urgently deepen the fiscal reforms by addressing some additional fundamental structural weaknesses that are discussed below. 11. INTERGOVERNMENTAL FISCAL RELATIONS. Colombia has been recognized as one of the leaders in decentralization in Latin America, and has led the region in explicitly acknowledging that subnational governments have different management capabilities. The constitutional reform of 1991 and ensuing legislation transferred sizeable revenues and responsibilities to subnational govermments.5 The transfers were established through formulas and include (a) general-purpose transfers for municipalities; and (b) earmarked transfers for education and health, primarily to the departments. In 1993, the central government began a gradual process to transfer education and health resources and responsibilities to those subnational governments that demonstrated sufficient capacity and received certification. In addition to promoting results orientation, the decentralization included a market-like set of rules and monitoring mechanisms to regulate subnational borrowing. The Ley de Semaforos (1996) introduced measures and market signals of subnational indebtedness capacity, with the intention of transferring the cost of risky lending to commercial credit institutions. 12. By the end of the 1990s, however, transfers to subnational governments had become a major source of the fiscal imbalances for the central government, primarily because the transfer of resources preceded the transfer of full responsibility. The resulting lack of accountability led to a decline in the quality of public services, notably education and health. In reality, the transfer of responsibilities has been limited because many expenditure decisions, such as the teacher payroll (including compensation and benefit levels) are still controlled by the central government. Since the central government intervenes and is too weak politically to resist demands of special interest groups (for example, teachers unions), local expenditures have 5. A collection of detailed policy notes underpinning the agenda was produced and is available on request. 6. The major revenue sources of the transfers are (a) the so-called Situado Fiscal, (b) the Participaciones Municipales, and (c) part of oil and mining royalties. 5  continually increased. The problem has been compounded because the central government carried out the certification process for decentralization of services under political pressure, meaning that the standards for certification were largely ignored and the central government approved the transfer of education resources and responsibilities to most departments, even to those without adequate capacity. With the fiscal problems of the subnational governmenl.s caused, to a large extent, by the interference of the central government, the latter has consequently been forced to provide an implicit guarantee of subnational debt. This has created perverse incentives and moral hazard behavior when commercial banks provide financing to the subnational entities. 13. The two major transfers (the Situado Fiscal and the Participaciones Municipales, which absorb over 40 percent of central government current revenues) have not sufficed to cover increases in the subnationals' current expenditures, particularly the growth of the teacher payroll. The central government has come to the rescue with additional temporary transfers, which then become permanent. However, these additional transfers have frequently been insufficient to pay for expenditure increases, and most subnationals have inadequate tax bases to make significant local revenue contributions. These elements have resulted in a soft budget constraint for the subnationals and, as a consequence, several departments and municipalities have overspent and are heavily indebted. Moreover, the national government has carried out significant "bailouts" of subnational governments and their creditors, despite its limited capacity to effectively monitor subnational fiscal efforts and the provision of services. 14. In summary, when the central government kept control of human resource policy and collective bargaining, it blurred the division of responsibilities (especially in education) and created perverse incentives, leading to fiscal deficits, demands for additional transfers, increased moral hazard, and bailouts. When resources were insufficient to guarantee coverage and national quality standards, or national policies restricted mobility of input factors (particularly labor), subnational governments had little choice but to spend funds beyond the allocations provided by the central government (as they did for teacher salaries, for example) and to run deficits that were financed by increased borrowing. This put pressure on the central government to bail out the subnational governrments. Bailouts took many different forms, both hidden (as in the case of Treasury credits in 1997-98 for a selected list of departments) and explicit (as in the case of Law 617 of 2000). At other times, the central government paid for subnational responsibilitics directly with resources from the Treasury, resorted to the creation of special funds (the compensation fund, and/or emergency funds), or transferred higher royalties. 15. EDUCATION. Public expenditure in education has expanded rapidly during the last decade-from about 3 percent of GDP in the early 1990s to about 6 percent by the end of the decade. This expansion has been determined primarily by the supply of inputs, particularly teachers, generating inefficiencies in the education system and neglecting significant parts of the demand for education. 16. Over the last decade, education expenditures increased at both the national, and more important, subnational, levels. The expansion has mainly resulted from the implementation of the 1991 Constitution and subsequent decentralization laws that mandated the decentralization of education services. The decentralization was to be financed mainly through two sources (a) the Situado Fiscal-transferring resources to departments, and (b) the Participaciones-transferring 6  resources to municipalities. Beginning in 1995, however, to help the transition toward a full decentralization of education services, a compensation fund increased transfers from the central to the subnational governments. This compensation fund has become permanent and has partly financed the emerging fiscal imbalances at the subnational levels. 17. As a result of the large allocation of resources to education and slow expansion of the school population, the unit cost of providing public education has increased over the long term, particularly in the last decade-the unit cost of public education doubled in real terms during the 1990s. Moreover, teacher salaries and wages represent about 80 percent of the total cost of public education, and the share has increased continuously since the early 1990s. The total supply of teachers-distributed unevenly geographically-and not the student educational needs, has driven the growth in education expenditure, resulting in a suboptimal allocation of resources per student.7 18. Despite expenditure increases, educational coverage is not universal, and inequality, in terms of access by the poor, remains an important issue. Improvements in educational achievements have also been slow-Colombia took about 35 years to significantly raise the average number of years of formal education for people over 18 years of age, from about 3 years in the mid-1960s to about 7 years in late 1990s-and, the urban-rural formal education gap has not changed over this period. The average level of education for adults is still below comparable countries in the region-for example, average formal schooling for adults is 8 years in Mexico, and 13 years in Argentina and Uruguay. Moreover, the public education system remains internally inefficient-there are high repetition and dropout rates at all grade levels, particularly in primary school-despite the improvements over the last decade. 19. HEALTH. The Social Security Institute (ISS) and the public system of hospitals are absorbing a ballooning amount of public resources and, unless tackled and reversed, that trend threatens fiscal stability. As a result of the law reforming the provision of health services (Law 100 of 1993), together with the decentralization law (Law 60 of 1993), public resources allocated to health have increased from about 1 percent of GDP in 1991 to about 4 percent in the late 1 990s. Health insurance coverage has increased from about 20 percent of the total population in 1992 to about 57 percent in 1997, while the quality of health services has improved. Despite these improvements, emerging financing imbalances in the ISS health services, the high cost of public hospitals, increasing evasion of contributions and supply subsidies-delaying the transformation of fiscal transfers to demand subsidies-are threatening the stability of public health services. They are, indeed, undermining both overall fiscal sustainability and the objectives of the health system reforms-namely, universal coverage of health services through a solidarity system, with managed competition of insurers and providers, and resulting improvements in equity and efficiency. 20. Health Reform. The health reform of 1993 (through Law 100) created a mandatory universal health insurance system. Individuals could choose and affiliate to any insurer (Empresa Promotora de Salud, EPS) that receives the individual's contribution (4 percent of 7. To overcome these problems, the special district of Bogota, with legal attributes of both a department and a municipality, has started to implement education reform using its own resources. This may become an example for other fiscally strong municipalities to take over and reform basic and secondary education. 7  salary from employees and 8 percent from employers) as an insurance premium. Independent workers would contribute 12 percent (over two minimum salaries), and the State would subsidize the contribution of poor individuals. In turn, individuals and their families would have acce<;s to a defined health benefits package (Plan Obligatorio de Salud, POS). A solidarity and guaraitee fund (Fondo de Solidaridad y Garantia. FOSYGA) would monitor and administer the contributions, paying each insurer the risk-adjusted premium for the affiliated individual (called Unidad Per Capita de Capitacion, UPC); the fund would also function as a redistribution mechanism, allocating one percentage point of the collected salary-based contributions to subsidizing insurance premium for the poor. The insurers would contract, on a competitive basis, with health care providers (Instituciones Prestadoras de Salud, IPS) to offer health care services to beneficiaries. 21. Users of the new system were divided into two groups (a) those with income capacity to pay the contribution ("contributory regime"); and (b) those without income capacity to pay ihe contribution (the poor), and who thus needed to be subsidized ("subsidized regime"). Under this system, municipalities have to identify the poor for affiliation to the subsidized regime, using a beneficiary identification system. Moreover, selected individuals can choose the insurer of the subsidized regime (Administradora del Regimen Subsidiado, ARS), which receives from municipalities a UPC per beneficiary with the corresponding cost for a basic health benefit package plus an administration fee. The ARS could enter into contracts with public and priv ate health care providers. 22. The ISS-Health Problems. In the context of overall health system reform, Law 100 also gave the ISS the legal form of a public industrial and commercial company. As such, it could manage retirement pensions, workers' compensation, health insurance (ISS-EPS), and health service delivery (ISS-IPS). In health, ISS-EPS and ISS-IPS business are in practice a simple financing operation, which remains inefficient and unable to compete with the private seclor. These problems arise primarily from (a) mixing the financing (EPS) and the delivery (IPS) of services, with large hidden cross-subsidies; (b) difficult labor issues, including large pension liabilities and labor rigidities; (c) high fixed costs relative to service provided, making both ISS- EPS and ISS-IPS not profitable and noncompetitive in the market; and (d) poor management, including inadequate planning and control, causing abrupt and costly decisions. In addition, poor quality of services and noncompliance with minimum health and financial indicators led the Superintendency of Health to prohibit registration of new affiliates by the ISS-Health (until, in the Superintendency's assessment, those minimum standards were fulfilled), compounding its financial and economic problems. 23. ISS health is both illiquid and insolvent. The consolidated ISS-EPS and ISS-IPS incoirme statement has registered losses over the last five years; cumulative losses over this period totaled about US$440 million, and losses for fiscal year 2000 amounted to about US$70 million. lTo cover these losses, in the past, the Treasury provided transfers or credits. Moreover, the consolidated ISS-EPS and ISS-IPS balance sheet shows negative equity starting in 1994, reaching a negative US$270 million as of 31 December 2000, and the accumulated overdue debt with private and public hospitals surpassed US$250 million as of the end of 2000. 24. The Public Hospital System's Problems. In the context of health reform, the public network of hospitals, health centers, and other health facilities was supposed to (a) compete with 8  and complement the private network of health providers, and (b) sell services to the affiliated population through the EPSs and ARSs. Simultaneously, since the National System of Social Security in Health (Sistema Nacional de Seguridad Social en Salud, SNSSS) did not cover the entire population, the public hospitals provided services to those not affiliated with an insurer. The implementation of health system reform is an ongoing process, and during the transition several problems have emerged. These include (a) public hospitals have not fully adjusted their cost structures, thus becoming less competitive than private health providers and less attractive for the EPSs and ARSs; (b) real labor costs have increased 40 percent since 1995 due to centralized salary negotiations, distorting cost structures even more and requiring large transfers from the Treasury; and (c) the transformation from supply subsidies to demand subsidies mandated by the reform has moved slowly (to about 50 percent by mid-2001 for the main sources of transfers), if not stalled, because of the pressure to continue financing public hospitals through supply subsidies based on historic budgets independently of output.8 25. Health Financing Problems. One of the key problems in the sources of health system financing, affecting both the contributory and the subsidized regimes, is evasion in the contributory regime-in 2000, total evasion was estimated to be about 36 percent of total potential contributions, representing about US$900 million. Evasion results from two main sources (a) under-declaration of income by individuals who already contribute in the system, and (b) lack of contribution payments by individuals. In addition, the cumbersome transfer system results in delays that translate into accumulation of cross debt at different levels-that is, from subnational governments to insurers and from insurers to both public and private providers. Moreover, subnational governments use most of their resources for payments to public hospitals, neglecting the possibility of increasing affiliation in the subsidized regime. As a result, the transformation from supply to demand subsidies (and hence to insurance affiliation) has also been slow. Finally, the new health care and insurance system was intended to cover a limited health benefit package. However, the Constitutional Court ruling of "right to life" expanded health care benefits, creating additional pressure to finance unexpected benefits, including the provision of health services abroad. 26. PENSIONS. The current condition of Colombia's pension system constitutes a major risk to fiscal sustainability over the medium and long term. The pension system is technically insolvent and the annual imbalances in the public sector worker regimes are increasing. The estimated net present value of the pension system liabilities amounted to about 200 percent of GDP in 2000-up from an estimate of about 150 percent of GDP in 1997. Moreover, the Treasury's transfers to finance the deficits for public sector worker regimes increased from about 0.8 percent of GDP in 1991 to 1.3 percent of GDP in 1995, and to 2.3 percent of GDP in 2000. The causes of the current pension system insolvency and liquidity problems include generous benefits, benefit guarantees, perverse incentives for reserve management, and recent Constitutional Court rulings expanding pension benefits. These causes are rooted in the slow reform transition (see below) and the large number of workers exempted from the reform. This has resulted in pension expenditures still growing at a fast rate, particularly the pension expenditures for public sector workers. 8. If public hospitals do not change their cost structures and continue to be financed through supply subsidies at the same pace as in the last six years, the total accumulated operating cost of public hospitals over the next 10 years could amount to about US$30 billion (about 35 percent of GDP in year 2000). 9  27. To confront the problems of a financially bankrupt and fragmented defined benefit 1 lDB) pension regime, Colombia undertook a first-generation of reforms of the Social Security System (enacted by Law 100 of 1993). The main elements of the reform included (a) introduction of a mixed DB and defined contribution (DC) pension system-workers could choose between the DB regime run by ISS or the DC regime run by private pension fund managers (AFPs); (b) increases in contribution rates paid by all active workers (that is, all public sector workers would now contribute) and reduction of pension benefits for younger workers; (c) insolvent persion funds for public sector workers at the national and regional level would be closed and pension payments would be taken over by the Public Pensions Fund (FOPEP) and specialized regional entities; (d) introduction of explicit redistribution through additional contributions to support pension benefit programs for the poor; and (e) government recognition of pension rights accrued until 1994 through "pension recognition bonds"-that is, the government would assume the repayment of the corresponding implicit pension debt (IPD). The law, however, exempted the pension funds for Ecopetrol (6,000 members), teachers (300,000 members), the armed and police forces (200,000 members but only half with pension rights), and representatives of Congress. Furthermore, the law allowed for an extended transition to the new system, scheduled to be completed by 2014. 28. PUBLIC SECTOR REFORM. Colombia's current public sector structure and fiscal imbalances still reflect practices of a welfare state and state interventionism, which are not consistent with the market-oriented policies and decentralized framework adopted during the last two decades. To correct these inconsistencies and tackle the growing central government fiscal imbalances during the 1 990s, Colombia attempted to revamp the public sector structure through three important reform initiatives. First, during 1992-94, the government adopted a public sector modernization strategy that covered most central government agencies (and a few decentralized ones). The main purpose of the reform was to set up an organizational structure more consistent with the provision of decentralized public services. The reform, however, led only to a modest expenditure rationalization at the central level. Second, in 1998-99, a proposed reform was priniarily targeted to public sector rationalization through streamlining and downsizing of the central government administration, including civil servants. The scope and impact of the reform was significantly limited when the Constitutional Court ruled that some of the decrees enacting the reform violated the Constitution. And finally, in 2000, the government introduced a refo-rm package focusing mainly on fiscal rationalization. 29. The inertia of the public sector structure and its functioning, combined with the numerous attempts to adjust the provision of public services to new trends and country needs, seems to account for the eclectic nature of Colombian's public sector today. For example, agencies and civil servants provide services typically assumed by the private sector (including ancillary services, data processing, accounting, and external auditing), and they coexist with modern regulatory agencies, privatization processes, market-oriented organizations, and demand-drivmn public services. The culture of state enlargement and political patronage competes with the culture of streamlining and efficiency seeking in allocation and production of public services. This bureaucratic dualism has been compounded by political fragmentation, internal conflict, corrupt practices, and high crime indexes that seriously constrain good governance. In addition, legitimate concerns for the protection of human and property rights have often led to misguided state intervention, which has further restricted and complicated the design and implementation of economic policy. Unfortunately, this has distorted market signals and incentives, creating I 0  opportunities for moral hazard behavior, misallocation of public resources, and costly bailouts, hampering the efforts to correct fiscal imbalances. 30. PUBLIC SECTOR DEBT. The current level and structure of Colombia's public sector debt is risky and makes the overall fiscal position vulnerable. Should current trends continue in the absence of comprehensive fiscal reform, public sector debt is likely to become unsustainable. Moreover, Colombia's debt portfolio is characterized by high interest rate and foreign exchange exposures, and high refinancing risks significantly increase the vulnerability of government finances. Management of these exposures is difficult due to the absence of comprehensive debt portfolio and funding strategies. 31. Over the last six years, to finance fiscal imbalances at different levels of government, the authorities have issued large amounts of public debt. As a result, total gross public debt has been rising steadily in absolute terms and as a proportion of GDP (see Annex D). The total gross stock ofpublic debt increased from about 27 percent of GDP in 1994 to about 50 percent of GDP in 2000. A sizeable portion of the change in the level of total debt occurred through an increase in external debt, which reached about 26 percent of GDP in 2000.10 Most of the increase in external debt has been driven by central government borrowing; other levels of government currently face statutory and procedural restrictions on borrowing abroad. Public sector internal debt also rose from the mid-1990s, reaching (in gross terms) 27 percent of GDP by 2000, because both the central government and subnational entities sought financing domestically. As a consequence of the increase in the stock of public sector debt, total public debt interest service increased from about 2.2 percent of GDP in 1994 to about 4.4 percent of GDP in 2000. Interest payments on internal debt increased more than proportionately-almost threefold-from 1 percent of GDP in 1994 to about 2.7 percent of GDP in 2000. III. THE ECONOMIC REFORM PROGRAM OF THE COLOMBIAN GOVERNMENT 32. The Colombian government is well aware of the weaknesses in its fiscal accounts; the shortcomings in its intergovernmental fiscal relations; the inefficiencies in the provision of key public services, including education and health; the increasing fiscal pressure from the pension system and public sector debt; and their negative effects on long-term real economic growth and poverty reduction. The authorities therefore sought to design and implement, with support from the World Bank, a fiscal strengthening agenda that would put the non-financial public sector accounts on a more sustainable path while contributing to enhancing and improving the provision of social services. This section summarizes the rationale behind the various policies in that agenda and compares the projected evolution of Colombia's fiscal accounts under the reform and no-reform scenarios. 9. In net terms, the total stock of public debt represented about 42 percent of GDP in 2000. Net debt is total gross debt minus the stock of Treasury bonds (TES) held by all public sector entities. The evolution of debt aggregates in the last decade is discussed with reference only to gross aggregates because estimates of net debt are available only from 1999 onward. 10. The sources of external credit also changed considerably throughout the decade. Whereas in 1990 official debt amounted to 66 percent of the total stock of public external debt, this had fallen to only 39 percent by 1999. The share of commercial bank debt fell relative to the total stock of public external debt, from 32 percent in 1990 to 23 percent in 1999. In contrast, bonds gained considerable ground over this period, increasing from about 2 percent in 1990 to over 36 percent of the total external debt of the public sector by 1998. 11  (A) Government Program Policies 33. The policies that make up Colombia's economic reform program, including its overall strategic vision and the fiscal strengthening initiative, are described in the government's letter of development policy (LDP, see Annex E). The authorities' ownership of the program is strong and widespread, and so is their commitment to continue implementing reforms until the very end of the current administration (see letter of President Pastrana, Annex F).1' The program has also been discussed with, and has the support of, the main political parties, ensuring its viability and continuity beyond this administration. Moreover, at the government's suggestion, through a series of seminars the Bank has started a technical dialogue with the economic teams of the main political candidates contending for the Presidency, something that is intended to smooth the economic transition between administrations and facilitate the continuity of these reforms. While supporting the full reform program of the government, the Bank will explicitly requiire certain key commitments for the disbursement of tranches under the proposed SFAL operalion, as elaborated later on. 34. The specific targets of Colombia's fiscal strengthening effort are to (a) increase the primary fiscal surplus of the Non-Financial Public Sector (NFPS)-from 0.8 percent of GDP in 2000 to at least 1.3 percent of GDP in 2002, and to at least 2.5 percent of GDP in 2005; and simultaneously, (b) reduce the NFPS fiscal deficit-from about 3.6 percent of GDP in 2000 to 3.1 percent of GDP in 2002, and to 1.5 percent of GDP in 2005. This will prevent and reverse an otherwise unsustainable debt and debt-service accumulation and will be achieved in a marmer that protects social sector expenditures and vulnerable groups. To deliver those targets, a combination of policies-described below-will enhance revenues and rationalize spending.' 2 35. INTERGOVERNMENTAL FISCAL RELATIONS AND EDUCATION. The government program in intergovernmental fiscal relations includes reforms to (a) make subnational governments filly responsible for expenditures, (b) increase subnational tax revenues, (c) simplify and make more transparent the transfer system, and (d) reduce moral hazard from subnational borrowing ard reinstate hard budget constraints. Key components of the reforms are presented below-for expenditures, the presentation covers both general expenditure policy and the education sector. Given the magnitude of the problem and the characteristics of the health sector, while the general expenditure policy applies, the specific sectoral reforns are discussed separately (see below). 36. Expenditures. The authorities seek to control the cost of general administration of subnational levels and to allocate public resources more closely toward the original design of decentralization in the Constitution-which foresaw an allocation according to service needs by population, with adjustments for poverty, among other factors. To control general administration costs, subnational governments are getting structural adjustment loans to finance downsizing of 11. A strong demonstration of this commitment was evidenced by the fact that in early October 2001, three key Ministers of the Colombian government (Finance, Labor, and Planning) and their technical staffs had two fUll days of meetings in Washington at Bank headquarters just to discuss technical issues on pensions (including reform models and lessons in other parts of the world) in order to absorb and exchange information for finalizing the design of the country's pension reform. 12. These policies also preserve the autonomy and accountability of the local authorities to implement environmental policies, including the management and allocation of public resources resulting from the transfers of oil and mining royalties from the national to subnational governments, particularly municipalities. 12  personnel (severance pay, etc.) under the terms of Law 617 of 2000. In addition, the central government has recognized the need to amend Law 60 of 1993-which governs the sectoral allocation of territorial transfers under the decentralization framework-to ensure consistency with the Constitutional reform (Acto Legislativo). To achieve this, the government has recently submitted to Congress an amendment to Law 60, which includes, inter alia, (a) the automatic certification of municipalities (that are capitals of departments and/or have more than 100,000 inhabitants) to autonomously manage the provision of education services; and (b) specific education performnance goals included in a performance matrix (matriz de desempeno). Moreover, in the event that passage of the amendment to Law 60 is delayed, the government intends to proceed with certification (via performance agreements) of key municipalities for autonomous management of resources, particularly education-related resources. These new, more efficient practices embedded in performance agreements are consistent with the ones that are institutionalized in the proposed amendment to Law 60 of 1993. 37. More specifically, the automatic certification or perfornance agreements will imply that (a) the transfer of resources to municipalities will be calculated on the basis of the number of students who attend class (not the number of teachers on the payroll); (b) minimum coverage goals will be established with the objectives of increasing enrollment and reducing drop-out ratios; (c) certified municipalities will be authorized to reallocate resources from teacher vacancies-both existing and new-within the education sector and to eliminate teacher positions; (d) the certified municipalities will be able to reallocate teachers within the local jurisdiction; and (e) the Ministry of Education will provide technical assistance to certified municipalities, if requested. The central government will publish and otherwise disseminate quarterly performance monitoring and evaluation reports of the certified municipalities. 38. Revenues-Taxes. The government intends to strengthen the subnational tax system- which is in contrast to previous reforms focusing on the national tax system. In particular, it will revise the tax system of territorial entities (Estatuto de Ingresos Territoriales) to rationalize subnational tax power and strengthen enforcement. Specifically, the revision will include measures to regulate (a) the basic principles and rules for all departmental, district, and municipal revenues, including taxes, fees, and special contributions; (b) the distribution of tax revenues by level of government; (c) the tax base and tax rates (or delegation to subnational entities) for liquor, beer, and tobacco excises, vehicle taxation, property tax, and industry and commerce tax, valorization contribution, and participation in surplus value of real estate; (d) penalties for noncompliance by taxpayers or beneficiaries; and (e) tax procedures. In addition to benefiting subnationals, the proposed reforms will also benefit the central government because increases in subnational revenues would decrease pressure for more transfers and bailouts. 39. Revenues-Transfers. The Constitutional reforn (Acto Legislativo) recently approved by Congress, intends to de-link transfers from current revenues, and put the growth of transfers from the central government to the territorial entities on a more sustainable path, thus limiting the growth of central administration's operational expenditures (gastos generales).13 The reform combines the current three major sources of transfers financing-Situado Fiscal, 13. The limits on the growth of the central administration's operational expenditures will be equal to (a) 1.5 percent in real termns per year for 2002-08; and (b) thereafter, a rate of growth equal to the average growth of the central administration's current revenues during the previous four years. 13  Participaciones, and FEC-into the Sistema General de Participaciones (SGP), and includes an eight-year transition period (2002-08). Specifically, the reforms include that total transfers will (a) grow by 2 percent in real terms during 2002-05, and 2.5 percent during 2006-08; and (b) from 2009 increase at the average growth rate of the central administration's current revciiues during the four preceding years. In addition, if real GDP growth exceeds 4 percent in any year of the transition period, SGP resources would be increased proportionally, but only after adjusting for the transfers made during years where real GDP growth was less than 2 percent (2002-05;) or 2.5 percent (2006-08). It is expected that after the Acto Legislativo is implemented, the annual transfers would decline from about 5 percent of GDP in 2001 to about 4.0 percent of GDP in 2010, and would generate fiscal savings equivalent to a total accumulated amount of about 5 percent of GDP over the next 1 0-years. 40. As indicated above, the Constitutional reform of transfers is complemented by the amendment of Law 60 of 1993, which specifies the mechanism for distribution of resources among entities. Within this reform framework, the government seeks to (a) prohibit the distribution of any cash transfers to subnational governments except where the distribution is specified by formula or by law; (b) require that any national decision affecting subnational government spending be accompanied by a transfer that is sufficient to cover the cost; and (c) require the annual publishing of the subnational distribution of budgeted expenditures, along with the regulations and matching grant ratios of each cofinancing program. These reforms, over the long term, will help to (a) reduce earmarking of transfers so that they specify only the sector allocation (for example, education and health), not the economic category (for example, wages and investment); and (b) distribute all transfers either on a capitation basis to pay for social services (as equalization grants to entities with lower than average per capita tax bases) or on a matching fund basis (for functions with national externalities). 41. Subnational Borrowing. The government's reform strategy stresses a series of actions to correct perverse incentives to subnational governments and their lenders, and to begin to eliminate discretion on the part of the national government. In accordance with Law 617 of 2000, since July 1, 2001, the central government has stopped providing territorial entities with bailouts or guarantees on their debt.' It has also revised its regulations concerning debt and borrowing of territorial entities in order to start halting unsustainable borrowing, limiting bailouts with national budget resources, and eliminating discretionality in the treatment of debt. To this end, the authorities have issued a decree whereby the debt of territorial entities contracted after December 31, 2001 and held by commercial and development banks would be subject to a differential capital-risk-weighting grid based on a current published credit ratings performed by an internationally reputable credit-rating agency. 42. In addition to making the capital-risk-weighting for the debt of territorial entities helc by banks dependent on international credit ratings, new banking and securities regulations altow pension funds, insurance companies, and other regulated investment firms to hold territorial entity bonds only if they have been given investment-grade credit ratings by at least two international agencies. Further, the government has revised the regulations of the Ley de Sem6foros to (a) link the "color" of the Semtiforos (that is, the central government's 14. This law allowed for bailouts and national government guarantees of territorial debt up to June 30, 2001 under strict conditions to enter, implement, and perform under fiscal adjustment programs at the local level. 14  authorization to borrow) more clearly to the ratings of the international credit agencies; and (b) restrict commercial borrowing for all entities having loans subsidized under Law 617 of 2000, until they have complied with their respective adjustment program for at least four years. In addition, the government will continue with the practice that each request for subnational government foreign borrowing has to be approved by the National Congress. 43. HEALTH-The ISS-Health Service. The government's main objectives with respect to ISS-Health are to (a) improve the quality of services to affiliates; (b) eliminate inefficient supply subsidies to its ISS-IPS; and (c) limit fiscal costs to the national government. To achieve these objectives, both ISS-Health "stock" and "flow" financial problems need to be addressed-that is, the existing accumulated deficit and its underlying causes both need to be eliminated. To tackle the "stock" problems, the program includes (a) transferring resources to the ISS only after the renegotiation of the collective bargaining agreement with its labor unions has been successfully completed; (b) lifting the sanction applied by the Health Superintendency prohibiting new affiliations to the ISS after the underlying causes of the sanction have been resolved; and (c) withholding compensation transfers from FOSYGA to the ISS until more accurate information on the number of its affiliates has been provided. 44. To resolve the "flow" problem, the government has defined, approved, and initiated the implementation of a restructuring plan for ISS-Health (that is, ISS-EPS and ISS-IPS). This plan focuses on both reducing costs and increasing revenues. Measures for reducing costs include (a) restructuring of accumulated debt; (b) renegotiating the collective bargaining agreement in what refers to primas extralegales (related to vacations, seniority, and services), seniority-based severance, and pension benefits; (c) rationalizing clinics and ambulatory health services; (d) improving contracting mechanisms with own and external health care providers; and (e) effectively verifying beneficiary rights to services, based on improvements in the enrollee database. Measures for increasing revenues include (a) better collection of contributions from affiliates through reforms to the current system of self-estimated contributions (autoliquidaci6n); (b) increased collection of arrears from, among others, FOSYGA, SOAT, and the ISS-ARP; and (c) enrolling more affiliates after the sanction imposed by the Superintendency of Health is lifted. 45. Public Hospitals. As part of its public hospital network reform, the government is committed to (a) reducing the network's cost structure; (b) rationalizing the supply of health services and adapting to actual demand; and (c) making the public network effectively complementary of the private network, thus creating a consistent health system of both public and private facilities. To achieve these objectives, the government is tackling both sides of the equation-namely, supply and demand-simultaneously. On the supply side, last year the government started a pilot program to restructure 27 public hospitals (out of a total of about 170 medium- and high-complexity public facilities). As a result of this program, hospital costs have already been reduced by 5 percent in real terms in just one year. On the demand side, total public resource for health allocation has been partially reformed from supply to demand subsidies, and by mid-2001 about 50 percent of resources allocated to public hospitals were demand-driven. 46. Based on these results, the government will expand its public hospital network reform and implement further measures to reduce costs, including (a) reforming the personnel structure 15  of public hospitals; (b) resolving accumulated debts (to public hospital employees and providers); and, critically, (c) renegotiating collective bargaining agreements with hospital unions, especially relating to seniority-based severance. It will also implement actions to increase public hospital networks' productivity, such as (a) reaching agreements among na-ional, departmental, and municipal governments, and hospital directors to advance the long-lasting restructuring of public hospitals and to develop functional health service networks; and (b) identifying and analyzing existing information regarding supply and demand of health services in different regions in order to better define plans for managerial and technology improvements. In addition, the transformation of resources from supply to demand will continue. 47. Health Financing. To tackle health financing problems, and particularly evasion in the contributory regime, the government's program includes (a) registration and periodic updates of all affiliates of the system in the Health Superintendency's Internet database; and (b) creation of a unified reporting system, with authorizations for entities different from EPSs to collect contributions. In addition, the authorities intend to fully implement Decree 40 of 2000, which allows for payments of subnational debt, including that for the health system, directly from resources to be transferred from the Treasury to subnational governments (that is, departments and municipalities). A study to redefine the content of the health benefit package and the corresponding risk-adjusted premium (UPC) will be launched. Based on the study, the National Council of Social Security in Health (Consejo Nacional de Seguridad Social en Salud, CNSSS) would establish the cost-benefit relationship in the health package, and the level of the risk- adjusted premium. Coverage for health care services outside Colombia will be severely lirnited, and at a later stage, the health benefits package will be redefined by law. 48. PENSIONS. The major objective of the second-generation pension reform is to rmake Colombia's pension system more equitable and sustainable. Thus, members of new cc horts entering the pension system will all have the same rights and obligations and will not increase the current implicit pension debt (IPD). While the proposed reform maintains the culTent situation of concurrent defined benefit (DB) and defined contribution (DC) regimes, it deepens the reform envisioned in Law 100 of 1993 and strengthens the pension system by reforming the overall pension system and/or at least one of the exempted pension regimes. It also seeks to harmonize or introduce a single set of unified pension rights and obligations for all new entrants, while increasing coverage and improving services to all participants. 49. The proposed reform-which includes the reform of the overall pension system thrz ugh new legislation-also envisions, among other things, (a) a deadline for a final switch of current members of the system between the DB and DC regimes; (b) increased eligibility requirenlonts in terms of age and number of weeks of contribution for a pension; (c) centralizing the administration and control of transfers of public pension regimes into a single agency; (d) improving the data-bases required for the recognition and recertification of pensions, (e) pre- funding new accrual of rights to extraordinary benefits; and (f) creating a unified registry of contributors (URC). Moreover, the new legislation reforming the pension system would (a) continue to transform the DB scheme through better individual work records, which wo'uld constitute the basis for pensions at retirement in the ISS-managed scheme; (b) fund the minimum pension guarantees through an insurance scheme; and (c) close entry into any pension fand except for ISS and AFPs. Finally, the reform of the exempted regimes, if advanced---for example, the teacher's pension fund-would contain features such as (a) individual pension 16  saving accounts; (b) a close link between contributions and benefits; and (c) the application of the new regime to all new entrants. 50. PUBLIC SECTOR REFORM. The government's public sector reform effort is framed within the overall fiscal strengthening program described above. The authorities intend to (a) issue a decree for the rationalization of central government current expenditures, notably personnel, and procurement of goods and services, including temporary workers and ancillary services; (b) close redundant national government agencies, and redundant and nonessential decentralized agencies; and (c) build consensus with the Judiciary branch for reduction of the budget allocation to the Superior Judicial Council (Consejo Superior de la Judicatura). The government is also committed to additional public sector reforms with a view to strengthening governance, including deepening the dialogue with the Constitutional Court to enhance the effectiveness of economic policies. 51. PUBLIC SECTOR DEBT. To improve debt management and debt portfolio structure, the government is developing new portfolio and funding strategies, and corresponding benchmarks. These strategies-that integrate fiscal projections with analysis of portfolio risk exposure-will reflect the government' s assessment of an acceptable level of fiscal risk (that is, "budget-at-risk") relative to the expected reduction in the cost of funding, and thus, include the maximum amortization that the government can manage in any given year. The funding strategy will also allow for the use of active debt management tools (for example, debt exchanges, swaps, and buybacks) to enhance the structure of the portfolio. However, significant institutional strengthening will be required to carry out and implement these strategies. 52. To reduce central government debt exposure, a debt portfolio restructuring strategy has recently been defined. As part of this strategy and to tackle the bunching of domestic debt amortizations, in June 2001, the authorities swapped domestic debt due in 2001-05 with debt issues of longer maturities, extending the average maturity of domestic debt from 3.5 to 4.5 years and minimizing the need for rollovers in the next few years. With regard to foreign exchange exposure, the government continues to use the currency composition of international reserves to hedge against net liability positions. In addition, to facilitate the management of the explicit contingent liabilities of the public sector, the government's program includes the development and implementation of a plan to improve the registration and quantification of these types of liabilities. (B) The Program's Outcomes 53. The fiscal strengthening program described above puts the NFPS accounts on a more sustainable path. Each of the proposed measures carries fiscal implications, and they are singled out in the projections through 2005, shown in Table 1 and Figure 2. The combination of measures to improve governmental fiscal relations, rationalize and reallocate public sector expenditures, and improve financial management of assets and liabilities of the public sector brings about both a more sustainable fiscal path-a necessary condition for sustaining economic growth and poverty reduction-and greater efficiency in allocation of public resources in the social sectors-a necessary condition for improving the provision of key public services, particu- 17  Table 1. Colombia: Public Sector Fiscal Balances Scenario with Reforms (2000-05) Percent of GDP 2000 2001p 2002p 2003p 2004p 2005p Total Revenues 28.8 28.7 27.N 27.9 28.0 28.: Tax Revenues 179 10.8 19.3 19.5 197 1999 of which Revenues from Territorial Tax Reform' 00 0.0 0 2 0 2 0.2 0.: of which: Savings due to Evasion Reduction2 0.0 0.0 0 1 0 1 0.2 0o: Non-tax Revenues 10.9 9.9 8.5 8.4 8.3 h.' Property Income 1 7 1.5 1.3 1.1 1.1 I Operational Surplus of public enterprises s5o 4.2 3.9 3 8 3.7 3.7 Other 63 42 33 35 36 31 Total Expenditure and Net Lending 32.4 32.0 30.9 30.4 29.9 29., Current Expenditures 24 7 24.1 23.6 23.0 22A4 22 Wages and Salaries 7.5 7 3 70 6.8 6 7 f of which: Effect of Acto Legislativo3 0.0 0.0 -0.2 -0.3 -0.3 -0 of which: Closure of Agencies4 oo 0.0 -0.1 -01 -0.1 -0.8 Goods and Services and Other 3.5 3.1 3.0 2.9 2 8 2.8 of which : Savings from Public Hospital Restructuring5 00 0.0 -0.2 -.3 -0A4 -0 5 *(includes: Lower Transfers due to ISS health restructuring) Interest 4.4 4.4 4.4 4.2 4.0 4.0 of which: Debt Management' 00 0.0 -07 -0 2 -0.2 -0 3 External 17 20 I'S 1.6 7.S 1.5 Internal 2 7 24 2.6 2.6 2.5 25 Transfers to Private Sector 9.3 9.3 9.2 9.1 S.9 8 0 of which : Savings due to Pension Reform 0.0 0.0 0.0 -0.2 -0 3 -0 4 Capital Expenditure 7.9 7.9 7 3 7.4 7.5 7.5 of which: ISS Health Restructuring' 00 0 3 0.5 0.0 0.0 0.0 Fixed Capital Formation, cash basis 8.5 81 7 4 7.4 7.5 7.5 from floating debt -0.7 -0 3 -02 -0.7 -0.e -0. Transfers 0.1 0.1 0.l 0 X 0.1 0.7 Net Lending -03 0.0 0.0 0o0 0 0 0.0 Nonfinancial Public Sector Balance -3.6 -3.3 -3.1 -25 -2.e -tL Quasi-fiscal balance 0.5 0.5 0.3 0.5 03 03 Fogafin balance 0 0