Bolivia - Updating economic memorandum : Bolivia - Updating Economic Memorandum

Report No. 7278-BO Bolivia Updating Economic Memorandum June 2,1988 Latin America and the Caribbean Region FOR OFFICIAL USE ONLY Document of the World Bank 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.  Fiscal Year January 1 to December 31 Currency Equivalents Curren_y Unit: Boliviano (Bs) Exchange Rate Effective May 1, 1988 US$1.00 = Bs 2.30 Bs 1.00 = USS 0.435 Abbreviations BAB - Banco Agricola de Bolivia (Bolivian Agriculture Bank) BAMIN - Banco de Mineria BANEST - Banco del Estado CAF - Cc-poracion Andina de Fomento (Andean Corporation of Development) CBF - Corporacion Boliviana de Fomento (Bolivian Development Corporation) COB - Central Obrera Boliviana (Bolivian Workers' Confederati'on) COBEE - Bolivian Power Company COMIBOL - Corporacion Minera de Bolivia (Bolivian Mining Corporation) CRA - Certificados de Rein egro Arancelario CRD - Corporacion Regional de Desarrollo (Regional Development Corporation) ENFE - Empresa Nacional de Ferrocarriles (National Railways Corporation) FERE - Fondo Extraordinario de Reactivacion Economica (Special Fund for Economic Reactivation) FONPLATA - Fondo Financiero para el Desarrollo de la Cuenca del Plata (Financial Fund for the Development of the River Plate Basin) FONVI - National Housing Fund FSE - Emergency Social Fund GEOBOL - Servicio Geologico de Bolivia (Bolivian Geological Services) GTZ - Deutsche Gesellschaft fur Technische Zusammenarbeit (German Technical Cooperation Agency) IDA - International Development Association IDB - Inter-American Development Bank IBRD - International Bank for Reconstruction and Development ICOR - Incremental Capital Output Ratio IMF - Internaticnal Monetary Fund INE - Instituto Nacional de Estadisticas (National Institute of Statistics) ITC - International Tin Council LIBOR - London Inter Bank Offer Rate MBTU - Million British Thermal Units NCSP - National Council for Social Policy NEP - New Economic Policy NGO - Non-governmental Organization PRODEM - Non-governmental Organization working on micro enterprise development  FOR OMFFCL USE ONLY RDC - Regional Development Corporation SD 21060 - Supreme Decree which inaugurated New Economic Policy SGS - Societe General de Surveillance (Swiss Customs Administration Company) TGN - The Treasury UDAPE - Unit for Analysis of Economic Policies in Ministry of Planning UNDP - United Nations Development Program UNICEF - United Nations International Children's Emergency Fund USAID - United States Agency for International Development YPFB - 'Y cimientos Petroliferos Fiscales Bolivianos (Bolivian Petroleum Corporation) This document has a restricted distribution and may be used by recipients only in the performance of their ofh-ial duties. Its contents may not otherwise be disclosed without World Bank authorization.  This report is the result of the work done over the past eight months, beginning with a mission in September 1987 and including several brief opportunities to update the materials during the course of missions primarily focussed on other areas. The initial mission consisted of Peter Miovic (Mission Leader), Steen Jorgensen, John Newman, Joseph Pelzman and Kori Udovicki. Subsequently, contributions were also made by Troy Alexander, Katherine Baer, Mary Barton, William Shaw and Laura Tuck.  BOLIVIA Updating Economic Memorandum Table of Contents Page No. SUMMARY AND CONCLUSION i-v CHAPTER 1: BACKGROUND. .................................. . 1 I. Historical Background .1 II. The Legacy of the 19709 and Early 19809. 2 CHAPTER 2: NEW ECONOMIC POLICY. 6 I. The Government's Adjustment Package of 1985 .6 II. Reactivation Decree of 1987. 8 III. Effects of the New Economic Policy .11 CHAPTER 3: FROM STABILIZATION TO SUSTAINABLE GROWTH .15 I. Introduction ............................................ 15 II. Government Expenditures ................................. 15 III. Fiscal Reforms and Public Sector Administration ......... 16 IV. External Sector ......................................... 17 V. Debt Management ......................................... 19 VI. Financial System ........................................ 23 VII. Labor Market ............................................ 24 VIII. Physical Infrastructure .25 IX. The Social Sectors .26 X. Natural Resource Management .27 XI. Conclusions .27 CHAPTER 4: MEDIUM TERM PROSPECTS .29 I. The Base Set of Projections ........................... 29 II. An Alternative Scenario ....................... . 32 ANNEX 1: The Sectors ANNEX 2: Poverty in Bolivia ANNEX 3: Projections of the Bolivian External Accounts: 1987-95 ANNEX 4: Statistical Appendix MAP: IBRD 16591  Page No. Tables 4.1 Bolivia: National Accounts Summary Indicators ............. 31 4.2 Bolivia: Balance of Payments, 1986-95 ..................... 33 4.3 Alternative Scenario No. 1: Current Account Deficit and Financing ..................................... 35 4.4 Alternative Scenario No. 2: Current Account Balance and Financing ..................................... 36 4.5 Debt Ratios for Alternative Scenarios (1986-95) ........... 37 A3.1 Other Assumptions for the Base Run ........................ 60 A3.2 Export Assumptions ........................................ 61 List of Figures 2.1 Monthly Inflation Rate in Bolivia ......................... 12 3.1A Debt Service Due .......................................... 20 3.1B Debt Service Paid ......................................... 20 3.2 Composition of External Debt .............................. 21 Al.1 Real GDP by Sector of Origin .............................. 38 A1.2 Composition of Nominal GDP 1980 ........................... 40 A1.3 Composition of Nominal GDP 1986 ........................... 40  - i - SUMKARY AND CONCLUSIONS 1. By September 1985, Bolivia's past had caught up with it. Inflation was running at 24,000Z a year, per capita GDP had fallen by more than a third since 1979 and the deficit of the public sector approached a quarter of GDP. The economic mismanagement leading to this disaster had many aspects. 2. After the revolution in 1S52, the tin mines, Bollvia's major source of revenue, were nationalized. The nationalized mining company (COMIBOL) grew into a huge bureaucracy with twice as many administrators as workers. Revenues were not plowed back "nto the sector as investment; in fact, no new mine had been opened since 1952. Governments have come and gone, but all followed a policy of public sector expansion; the more radical governments steadily increased the public sector's role in the economy, while the more conservative governments tried to strengthen public sector management. For many years, foreign exchange earnings from tin, accompanied by substantial foreign aid, hid the growing underlying imbalances in the economy. In addition, in the seventies, hydrocarbon discoveries combined with easy access to commercial bank credit led to a large inflow of foreign funds. By 1980, however, the funds began to dry up, the economic mismianagement became increasingly apparent and private investors withdrew. The situation, now worsened by a substantial debt burden, deteriorated during the eighties under a series of governments which were unable to put the economy back on track. 3. Within three weeks of taking office, the government of Dr. Paz Estenssoro introduced a drastic stabilization package which started a 180 degree turn in the official economic philosophy. This package, named the New Economy Policy (NEP), was introduced on August 29, 1985. The public sector was not allowed to run a deficit. The Ministry of Finance essentially stopped writing checks and revenues were raised through increases in the price of petroleum products. The peso was allowed to float based on an auction system, most price controls were removed, interest rates were freed and many government regulations dropped. In 1986, a uniform import tariff of 202 was introduced. The adjustment policy has proven to be very effective. Inflation has been low and relatively stable, official and parallel market rates for the Boliviano (worth a million of the old pesos) are effectively equal, and the public sector deficit has been significantly reduced. Besides these achievements in stabilization policy, the government has passed a comprehensive tax reform, is pushing for reforms in the public sector, is changing the mining code to open the possibility of private joint-ventures in mining, and has transferred most public production companies to the regional development corporations. 4. The external economic situation worsened considerably in late 1985 as first tin and later natural gas prices fell dramatically. Together these two products represented more than 802 of Bolivia's exports in 1985. Until 1987 the gas price for sales to Argentina had been set at a relatively high level, in a contract that runs out in 1992. The high price  - ii - in part reflected the fact that 602 of the payment was to be made using Argentine goods and services, rather than foreign exchange. Fren so, to force renegotiations of the price, Argentina stopped paying its gas bills in late 1986. The arrears were allowed to mount to over US$400 million before an agreement was reached in late September 1987. Due to Argentina's own difficulties, however, there have been serious delays on its payments for current exports of Bolivia's gas in the past few months and there has been no progress on the roughly $120 million of arrears owed by Argentina for gas exported prior to the September 1987 agreement. r. With the worsened external situation, real interest rates of 22 per month (in US$) and only slight signs of growth, the government introduced X :Lew set of measures in July 1987 to reactivate the economy. The measures included the establishment of a fund (Special Fund for Economic Reactivation [FERE]) to provide low interest rate loans for working capital to the private sector and for low-income housing, adjustment measures in the financial sector, establishment of a method for buying back the commercial debt, strengthening of public investment Eplanning and implementation, and various export incentives including a tax rebte for exports. As pointed out in Chapter II, it is probably still too early to judge the success of the measures introduced by the Reactivation Decree. They should, in any case, be viewed as extensions to the measures of the package that introduced the NEP. 6. The economy finally began to turn around in 1987 and posted a real increase (2.4Z) in GDP for the first time since 1981. Non-traditional exports have grown by more than 80% from 1985 to 1987 even though total exports fell. Fiscal performance deteriorated in 1987 with an overall deficit of about 10 of GDP, in large measure due to nonpayment by Argentina (2.5% of GDP) and payment of the remaining separation payments to the 23,000 disr.issed COMIBOL miners (22 of GDP). The public investment program has improved considerably, and measures are being taken to further strengthen coordination and implementation of investmernt projects. Tax collection showed some signs of levelling off after a good performance in the first 10 months of 1987. Due to irregularities in disbursements arnd lack of capital, the FERE established under the Reactivation Decree has disbursed only a modest amount of money, further hampering recovery. 7. In the medium-term, a substantial reform of public administration is necessary to return to acceptable rates of GDP growth. A more efficient allocation of current expenditures (between wages on the one hand and raterials and maintenance on the other) must be established. Some increases in public investment will be necessary to ensure continued recovery, and will have to be financed by higher revenues. Such revenues can only be achieved through continuation of tax reform efforts and improvements in the structure and performance of public institutions involved in mobilizing domestic resources. Substantial work remains to be done in other areas of public management. Besides the difficult problem of appropriate wage levels, a more secure working environment and increased training are essential to raise the productivity of the civil service.  - iii - 8. Sucial indicators show a dismal situation for Bolivia with infant mortality rates estimated as high as 30% and widespread illiteracy. Funds need to be redirected in the social fields to basic health care and basic education away from advanced hospitals and expensive universities. In the short run the Government's Emergency Social Fund will partially address the immediate need for employment and assistance, but this successful short- term effort should not lead to complacency in implementation of the needed structural reforms. Bolivia needs also to raise literacy rates to achieve a more productive labor force. This will require a reallocation of funds from higher education (which produces many graduates ill-suited to Bolivia's immediate needs) to primary and secondary education. 9. Achieving external equilibrium w'il also be a difficult task. Bolivia faces one of the largest debt burdens in Latin America. Despite allowing a substantial accumulation of arrears and despite the recent buyback of about a half of the commercial bank debt (with the other half expected to be settled via zero-coupon exit bonds during 1988), the pressure to service a portion of the debt has placed a great strain on domestic resources. Moreover, Bolivia can expect to confront a large financing gap by 1990 as official debts rescheduled under the 1986 Paris Club agreement begin to be repaid. 10. Projections of a possible evolution of Bolivia's external accounts have been developed. The projections are based on the assumption that GDP must grow enough to keep consumption per capita from falling further. This requires a GDP growth rate of around 4 percent. With good policies and a relatively favorable external environment, the current account as a percent of GDP will gradually decline over ti.e. The decline will be more rapid if Bolivia is able to maintain the level of gas exports after the contract with Argentina runs out. Nevertheless, the level of the current account will remain large because of the import content of the necessary investment required to achieve the target GDP growth. How to finance that current account becomes - key challenge. 11. Even assuming that Bolivia is able to reduce significantly the servicing of the remaining commercial debt (by replacing it by new obligations at a discount), the country will require large increases in disbursements from official sources. These required flows are significantly higher than those envisaged under present plans. Thus a financing gap will emerge unless multilateral and bilateral agencies increase disbursements on concessional terms and Bolivia's bilateral debt continues to be rescheduled. 12. Bolivia continues to face problems inherited from past economic mismanagement. The change, through decrees, of the basic incentive system is rLot enough to change ingrained attitudes and institutions. The experience of two years under market-oriented economic policies is not sufficient to establish a strong competitive economy. In the past, heavy public involvement in economic activity meant that the successful firms were those good at eliciting political support, not necessarily those good at producing efficiently. The tradition of political and social instability could ruin even the best laid plans. An investor needs to know that policies will remain the same at least through the life of the  - iv - investment being contemplated. Following a high-level strategy meeting ir Chulumani in April 1988 tnere are grounds to believe that a strong consensus on future long-term development is finally emerging. Efforts to achieve a stable macroeconomic environment, an open trading system, an appropriate and stable structure of incentives facing producers and consumers, and improvements in social conditions are necessary to encourage participation by both domestic producers and potential foreign investors, and facilitate longer-term social, political and hence economic development. Prospects for growth will also depend importantly on support from the international donor community. Bolivia's policy performance over the past few years has been impressive. Still, despite the control of inflation and extensive liberalization of the economy, the country faces an uncertain future. Continued slow growth may well undermine the progress made t3 date. Financial assistance from officiai tionors can play a critical role in supporting the Bolivian economic program and facilitating a continuation of responsible economic policies.  CHAPTER Is BACKGROUND 1. This Chapter reviews briefly the economic history of Bolivia ending with the economic crisis in the mid-1980s and the present government's adjustment program. Section I deals with the pre-1970 history while Section 1. describes the legacy of the 1970s and early i)80s. I. Historical Background1 2. Until the middle of the 20th century, Bolivia's monetary economy was confined to mining and mining-reiated activities, with little spill- over into the rest of the economy. The vast majority of the population was excluded from both political and economic life. Until 1952, fewer than 32 of Bolivians were entitled to vote and over 702 lived in a quasi-feudal rural economy. No significant linkages developed between mining and the rest of the economy, because both Bolivian and foreign mining entrepreneurs chose to reinvest most of the profits generated ty their operations abroad. Successive governments found themselves unable to tax mining activities in any meaningful way, which meant that investments in infrastructure and education needed for Bolivia's long-term development, were not undertaken. Bolivia's political instability in the first half of the twentieth century was due in part to conflicts between various governments' attempts to tax mining activities and mining entrepreneurs' resistance to these efforts; until 1952, the latter were generally able to ensure that governments enacted policies favorable to their interests. 3. Bolivia's highly unequal distribution of weelth in those yeers led to a similarly unequal distribution of income. This led the leaders of the 1952 Revolution (among whom was Bolivi'.'s current president, Dr. Paz Estenssoro) to give priority to agrarian reform and to nationalization of major mines. Both these policies were carried out, but with mixed results. Inadequate investments and lack of support services, in both quantitative and qualitative terms, prevented the 1952 agrarian reform from producing sustained and vigorous agricultural growth. In the case of mining, both the government and the miners saw nationalization as a means to achieving their own, conflicting, objectives. The government saw nationalization as a way to finance investment in other sectors of the economy while the miners saw it as way of raising their living standards. As a result of this conflict, an adversarial relationship has developed between the government and the miners since 1952, with both groups trying to seize the surpluses generated in the mining sector. Successive governments have extracted resources from mining through exchange rate overvaluation, export taxes and allocation of minimal funds for invest,nent and mining. The miners have extracted resources through higher-than-average real wages and fringe benefits, which have made the workers a relatively privileged class in Bolivia. Depending on the political orientation of the government and the strength of the labor unions, different administrations and the miners have taken turns at being the beneficiaries of these efforts. Meanwhile, 1/ For further details see the Economic Memorandum on Bolivia, August 2, 1985 (World Bank Report No. 5680-BO).  - 2 - the main consequence for the economy as a whole has been chronic under- investment in the mining sector: neither the government nor the miners have had any incentive to invest in its development, partly because it has been unclear which of the two parties would be able to appropriate the future benefits generated by new investments. Not surprisingly, no new large mine has been put into production since 1952, and the development of Bolivia's mining sector is still lagging well behind its potential (see Annex 1). II. The Legacy of the 1970s and Early 1980s 4. The discovery of hydrocarbons in Bolivia indicating the possibility of sizable petroleum and gas deposits during the world oil, gas, and commodities boom of the early 1970s, made the country attractive to foreign financial entities. Capital inflows grew, reaching US$300 million a year at their peak in the period of 1975-78--an amount that was equivalent to about 502 of total exports during those years. Foreign exchange which was obtainable with relative ease during the second half of the 1970s was often spent on consumption or public investments of dubious quality, increasing further the role of the state in the economy, and accelerating private capital flight when it bcc-me clear that this situation was unsustainable. 5. In spite of an unprecedented degree of political stability in the 1970s private entrepreneurs did not find investing in Bolivia an attractive longer-term proposition. Although the government issued policy statements encouraging foreign and domestic private sector entrepreneurs to invest in Bolivia, new private foreign direct investment averaged only US$25 million a year during the five-year period 1974-78, while errors and revisions in the balance of p:iyments (suggesting capital flight) which had been on the order of US$60 niillion during 1970-73 averaged US$150 million during 1974-78. Private fixed capital formation did rise to above 102 of GDP for three years (1973-75), reflecting the oil, gas and commodities boom of the period, but then bDZLiea back to its pre-boom range of 6-7Z of GDP during 1976-78 and then declined further following the ouster of Banzer from power by a coup in 1978. The political stability cf the Banzer years was recent from a h'istorical point of view, and memories of the post-1952 nationalizations were still fresh; invebtors consequently perceived the risks of long-term investments in Bolivia to be out of proportion to the expected returns--which were subject to the vagaries of government policies and restrictions of a highly regulated economy. 6. Therefore, the accumulation of capital needed for Bolivia's long- term development became a government responsibility. The already strong tendency for successive administrations to participate extensively in economic activities had been legitimized by the lack of private sector investment, and by relatively easy access to international capital markets for the government. The 1970s saw the creation of relatively large, complex and inefficient, state-owned metallurgical and agroindustrial factories, and of several public sector industrial plants. Public fixed capital formation rose to over 11? of GDP during 1976-78 from an average of just over 72 in the preceding five years. Rising publicly-financed investment produced rising public sector deficits (which amounted to over  10 of GDP during the years 1976-79) and an expansion of aggregate demand. The economy grew at about 5.5Z a year between 1971 and 1978, an historically high rate for Bolivia. 7. In retrospect, together with betting on large future petroleum exports (which did not materialize), the main error of economic policy during the 1970s was the ease with which the government granted Jt5 guarantee to external financing of both public and private sector invest- ment projects of often questionable profitability. While officially guaranteed capital was flowing in, private capital was moving out: capital flight (and unrecorded imports) amounted to over 602 of the value of the debt accumulated during the years 1971-81. The government's foreign borrowing for public investment thus effectively financed the accumulation of privately owned assets abroad. 8. The accumulation of debt to finance publicly-sponsored investment was interrupted in 1978-79 by a change in the commercial banks' perception of Bolivia's export potential and debt servicing capacity. This led the banks to try to reduce their exposure, leaving Bolivia without the subs- tantial foreign inflows needed to help service its large external debts- -debts which had in turn financed mostly investments of dubious quality which could not contribute to repaying the debts. 9. As a response the government opted for a combination of a reduction in public expenditures and a devaluation in the exchange rate. The program was initiated in December 1979, supported by an IMF stand-by and a World Bank structural adjustment loan. Negotiations with creditor banks on rescheduling Bolivia's commercial debt began at the same time (resulting eventually in a rescheduling agreement). The structural adjustment program was disrupted by a coup in 1980, however, and no consistent policy for economic recovery was implemented. The 1980 coup was followed by three military governments, which could not muster the political stupport needed for an adjustment policy, and eventually turned power over to a democratically elected government in October 1982. During its nearly three years in power (1982-85), however, t"i democratic governmeht was also unable to implement a coherent economic program. The net outcome was that the problem of how to handle the repayment of debt accumulation of the 1970s remained unaddressed. 10. In addition to the program initiated in December 1979, Bolivia attempted to implement no less than six stabilization packages between 1982 and 1985; they were adopted in February 1982, November 1982, November 1983, April 1984, November 1984, and February 1985. While the 1979 program contained relatively well defined and comprehensive po.icies for stabilization, the subsequent six economic packages were ad hoc in nature. They concentrated on the short term, gave no sense of continuity, and often neglected measures needed for effective progress towards stabilization. The February 1982 package, for example, consisted of a devaluation together with adjustments in public sector tariffs and petroleum and foodstuff prices. It had no provisions dealing with wage compensation or future Government wage policy. This failure was one of the reasons for the popular discontent that forced the return to democratic rule. The November 1982 package, while providing a coherent wage oolicy, included the  - 4 - elimination of foreign exchange deposits in the banking system ("dedollarization") and freezing of interest rates in the face of increasing inflation. Each of the other packages failed in one or another crucial area of the economy. Some provided insufficient devaluations (e.g., the November 1983 package); others were unclear regarding wages and interest rate policies (e.g., the April 1984 program). Some packages were initially considered to be the first stages of a continuing stabilization effort. All of them were interrupted, however, and the follow-up steps were never taken. The November 1982 package was interrupted by the dissolution of the coalition that had brought the democratic government to power in October 1982. The April 1984 stabilization effort was interrupted by a general strike which lasted until the Minister of Finance (who had initiated the program) resigned. 11. The results of 30 years of state involvement in the economy was a public sector which had developed into a complex entity composed, by the mid-1980s, of some 520 agencies--120 in the central government, 350 in departmental (regional) and local government, and 50 public enterprises and financial institutions. The public sector was responsible for some 65Z of mineral production, 802 of hydrocarbon output, 70? of energy production, over half the assets of the banking system, and over 70Z of air passenger transportation. Lack of