Colombia - Public Sector Reform Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY 2 37-G Report No. P-5313-CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PUBLIC SECTOR REFORM LOAN IN AN AMOUNT EQUIVALENT TO US$304 MILLION TO THE REPUBLIC OF COLOMBIA November 26, 1990 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (As at April 1, 1990) Currency Unit = Colombian Peso (Col$) USS 1 - 468.00 ColS Col$ 1 = .00213 GLOSSARY OF ABBREVIATIONS ALCALIS - Alcalis de Colombia, S.A. BCH - Banco Central Hipotecario BR - Banco de la Republica BVC - Bonos de Valor Constante COLPUERTOS - Puertos de Colombia CONFIS - Consejo Superior de Politica Fiscal CORELCA - Corporacion Electrica del Atlantico cVC - Corporacion Regional del Valle del Chuca DNP - Departamento Nacional de Planeacion ECOPETROL - Empresa Colombiana de Petroleos EMP - Economic Modernization Program FEN - Financiera Electrica Nacional FERROVIAS - Empresa Colombiana de Vias Ferreas FMG - Flota Mercante Grancolombiana HIMAT - Instituto Colombiano de Hidrologia, metereologia, y Adecuacion de Tierras ICA - International Coffee Agreement ICBF - Instituto Colombiano de Bienestar Familiar ICEL - Instituto Colombiano de Electrificacion ICT - Instituto de Credito Territorial IDB - Interamerican Development Bank IDEMA - Instituto de Mercadeo Agricola IFC - International Finance Corporation IFI - Instituto de Fomento Industrial IMF - International Monetary Fund ISA - Interconexion Electrica, S.A. ISS - Instituto de Seguridad Social NFPE - Non-financial Public Enterprise Sector NGOs - Non-Governmental Organizations PAPELCOL - Papeles de Colombia, S.A. PPES - Performance Planning and Evaluation System PROEXPO - Fondo de Promocion de Exportaciones SENA - Servicio Nacional de Aprendizaje SOFASA - Sociadad Fabricante de Autoneviles, S.A. STF - Sociedad Colombiana de Transporte Ferroviario TAP - Trade and Agricultural Policy Loan TELECOM - Empresa Colombiana de Telecomunicaciones TPED - Trade Policy and Export Diversification Loan  CoOwMIA FOR OFFICIAL USE ONLY PUBLIC SECTOR REFORM LOAN TABLE OF CONTENT1 Paae No.- LOAN AND PROJECT SUMMARY ............................*.....** (i) FART Is TIHE ECONOMY 1.............. A: Background ........... 1 B. Recent Developments. . . .. 3 C. Medium-term Economic Modernization Program. 3 D. Bank Support for the Economic Modernization Program 9 PART II: PUBLIC SECTOR IN COLOMBIA: STRUCTURE PERFORMANCE AND 11 RECENT DEVELOPNENTS A. The Public Sector in Colombia. 11 - Size and Composition . .11 B. Performance of the Decentralized Public Sector 12 - Size, Composition and Financial Performance. 12 - Economic Performance . .14 * Inadequate Public Sector Management Policies and Structures .14 * Public Sector Monopolies .14 * Inefficiencies in the Budgeting and Programming of Public Resources. 16 C. Recent Developments in Public Sector Reform . . is PART III: TIE PUBLIC SECTOR REFORM LOAN ........................ 19 A. Objectives of the Proposed operation . .19 P. Main Components of the Proposed Operation ... 20 - Public Sector Management Modernization ... 20 * Performance Planning and Evaluation System 20 * Improvement of Policy and Institutional Environment for the Management of DPS Operations ...23 * Extension of PPES to Municipally-Owned Entities Benefitting from External Credit . .24 - Privatization. . . 25 - Private Sector Development ...27 * Railways ...27 * Ports.. 29 * Shipping ...31 * Low-income Housir; . ..32 * Agricultural Marketing ...33 C. Loan History .. ....................* 33 D. Loan Amount and Tranchir . 34 E. Loan Conditions . . .34 F. Disbursement, Procurement and Auditing . .36 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.  G. Monitoring and Reporting ......... .................. 38 H. Benefits and Risks . ..... ....................... 38 PART IV. BAINK GROUP OPERATIONS AND STRATEGY IN COLOMBIA ....... 4t - Lending Operations and Economic Sector Work ........ 40 - Bank Assistance Strategy ...... . *................. 41 - Risk Analysis ................*. .. .................* 43 PART V. COLLABORATION WITH THE IMF ...... ..... ....... ........ . 43 PART VI. RECOMNENDATION ..*................* .............. 44 ANNEXES:5 Table 1 Colombia: Medium-Term Balance of Payments - Base Case Table 2 Colombia: Medium-Term Balance of Payments - High Case Annex 1 Public Sector Contribution to Gross Domestic Product 19981-19986 Annex 2 Publi', Sector Contribution to Final Demand, 1981-1986 Annex 3 Share of Public Sector Wages in Total Salary Earnings and Participation in Total Public Sector Wages Annex 4 Public Sector Contribution to Gross Fixed Capital Formation, 1981-1986 Annex 5 Public Sector Production by Ecnomic Activity, 1981-1986 Annex 6 Composition of Public Sector in Colombia by Type of Entities and Number Annex 7-A Consolidated Decentralized Sector Expenditure and Revenue, By Subsector, 1988 Annex 7-B Consolidated Total of Local Enterprises Annex 7-C Public Sectgor Deficit Annex 8 Letter of Development Policy Annex 9 Import and Export Cargo Annex 10 Import and Export Cargo by COLPUERTOS and Private Docks Annex 11 Share of Colombian Shipping Lines in Total Maritime for Transport by Type of Cargo and Average Percentage 1980-1985 Period Annex 12 IFI's 1989-1990 Privatization Program Annex 13 Technical Assistance Component Annex 14 Policy Matrix Annex 15 Status of Bank Operations  PUBLIC SECTOR REFORM LOAN Loan and Proiect Summary Boarrowers Republic of Colombia Amount: US$304.0 million equivalent. Torwsz: 17 years, including 5 years of grace, at the standard variable interest rate. Loan and Proaram The proposed loan would support a program of reform in the Descrigtion: sector aimed at achieving two basic objectives: (i) improving productivity in the use of public sector assets through the establishment of a performance planning and evaluation system to modernize public sector management and the privatization of public assets whose continued holding ry the public sector is no longer in line with the Government's priorities; and (ii) increasing efficiency in resource allocation and use by eliminating public or quasi-public monopolies in critical economic sectors and their replacement Dy an incentive structure promoting freedom of entry and a competitive sector environment. In addition, the loan will finance a technical assistance program to prepare and implement the proposed reforms. Benefits and The proposed reforms are expected to result in significant Risk: increases in the productivity in resource use by the public sector leading ultimately to improvements in the public sector's fiscal performance, a basic condition for the successful implemen :ion of the Government's Economic Modernization Program. The proposed elimination of entry and competition constraints in sectors which up to now, have been dominated by the public sector will increase efficiency in the allocation and use of resources and improve the economy's ability to adjust to an open and competitive environment. The main risks are related to short-term social effects derived from the need to lay-off personnel from public entities that present gross overstaffing and the possibility that the Government would not be able to put together the support required--at the political level and from the relevant interest groups--to complete the reforms proposed in a timely and successful manner.  (ii) Istimated Disbursements The policy-based component of the loan will be disbursed in three equal tranches of US$100 million each. Disbursement of the first tranche will be made at the time of loan effectiveness. The second and third tranche will be made available upon meeting the respective conditions of tranche release. It is estimated that the second and third tranche release will take place by December 31, 1991 and December 31, 1992 respectively. A US$4 million tschnical assistance component will be available upon loan effectiveness. The loan is expected to be fully disbursed by December 31, 1992. Retroactive Retroactive financing in an amount not excaeding US$60 million Financina: equivalent will be allowed on the basis of eligible import expenditures incurred after September 1, 1990. Rate of Return: Not applcable. Appraisal Report: Not applicable. Schedule of Disbursements: Bank Fiscal Years 1991 1992 1993 ----- US$ Million Annual 101 102 101 Cumulative 101 203 304  COLOMBIA PART I . TEE ECONOMY A. Background 1. The economy of Colombia has come a long way over the past four decades. Economic growth has averaged about 4.5% per year and Colombia has been one of the most stable economies in the developing world. This solid growth, combined with a reduction in the population growth rate to 1.9% per year, have facilitated substantial improvement in social conditions. Life expectancy at birth now stands at 64 years compared with 50 years in 1970; primary school enrollment was over 80% in 1985 and the literacy rate about 80%. Nonetheless, poverty remains a critical problem. Some 25% of the population has substandard nutrient intake levels, more than a third lacks access to safe water, and child mortality remains high. Disparities in the quality of life among regions are also significant and contribute to strong regional pressures in many spheres of activity. 2. Natural resources are plentiful. These include agricultural land, water for irrigation, energy resources (oil, natural gas, and coal), and mineral resources such as ickel, gold, and emeralds. Colombia has a significant locational advantp because it is close to North America with coasts on both the Pacific and . ntic Oceans. Mountainous terrain, however, makes internal transportation c. ly and slows down physical and social integration. Rich physical resources, a literate and dependable workforce, a robust private sector, competent macroec -omic management, and political stability are major factors explaining Colombia's good record of economic development and social improvements over the last 30 years. 3. World coffee price cycles and attendant shifts in economic policies demarcate the development episodes of the last two decades. Four such episodes can be distinguished: 1967-75, 1975-80, 1980-83, and after 1983. The 1967-75 period witnessed the pursuit of prudent economic policies. GDP growth averaged 6.3% p.a. During 1975-80, a coffee boom took place. Because the Government was not successful in sterilizing coffee export earnings, inflation rose and the real exchange rate appreciated. As a result, growth of non-traditional exports slowed considerably, and economic growth slowed to 5% p.a. After the coffee boom subsided in the early 1980s, public sector deficits rose sharply. Since the deficit was monetized, it brought high inflation. Exports declined as a result of continued appreciation in the real exchange rate and the fall in international demand. The current account turned from a slight surplus in 1980 to a deficit of 10.8% of GDP in 1983. In spite of the progressive tightening of import restrictions, international reserves fell sharply by the end of 1984. During 1980-83, GDP growth averaged only 1.6% p.a. 4. In late 1984 the Government introduced an economic adjustment program designed to achieve stabilization with growth. Devaluation of the nominal exchange rate was sharply accelerated. The Government deficit was reduced through both tax increases and expenditure reductions. Import restrictions, imposed during the previous period, were rolled back. Public sector investment was streamlined. Colombia was able, because of this convincing policy effort, to secure renewed support from the international financial community. The World  Bank supported the program with two policy-based loans in 1985 and 1986. A "Jumbo" US$1 billion loan package was negotiated with the commercial banks in 1986. 5. The economic adjustment program was quite successful. By 1986, the current account, helped by higher coffee prices and a rapid expansion of petroleum and coal exports, turned into surplus for the first time in several years. Fiscal performance also improved substantially: the fiscal deficit was reduced from 3.5% of GDP in 1985 to 0.3% of GDP. Non-traditional exports and private investment grew rapidly. As a result, the rate of GDP growth recovered to 5.8% in 1986. The Government repaid some short-term external debt and built up reserves. The Government also launched a major tax reform program with a view to improving tax collections and thus keep reducing the bud-t deficit. 6. The economic adjustment program was maintained by the Barco administration which took office in August 1986. For 1987, the rate of GDP growth was 5.3%, despite a sharp decline in coffee prices. The effect of the drop in world coffee prices on the balance of iayments was significantly offset by a large increase in private transfers and by an increase in non-coffee exports, particularly petroleum and coal. The current account had a small deficit of 0.1% of GDP. However, the fiscal balance deteriorated to register a deficit of 1.8% of GDP, despite the strengthening of Central Administration revenues as a result of the tax reform. Unemployment declined to 10.1% in December (from 14-15% in 1985). After difficult negotiations the Government succeeded in obtaining a quasi- voluntary US$1 billion "Concorde" loan from the commercial banks. 7. While the 1984 economic adjustment program restored macroeconomic stability, external balance, and economic growth by 1987, inflation started to accelerate from the end of 1985. By the summer of 1988, the rate of inflation (based on the consumer price index) rose to 30.3% from the 18.9% recorded in 1986. The step-up in the rate of inflation resulted from a combination of several factors: notably the drought and reduced agricultural protection that raised food prices, the emergence of capacity bottlenecks associated with strong economic growth, and high credit expansion in 1986-87. The authorities responded by reducing credit expansion and by increasing permitted agricultural imports. As inflation rose, interest rates followed. Under strong pressure from the private sector, the authorities put controls on interest rates and adopted measures to inject more liquidity into the economy at the end of August, 1988. Interest rate controls were removed in January 1989. Subsequently, interest rates rose slightly above the previously controlled levels. 8. Because of the earlier tight liquidity, more restrictive quotas on coffee exports, and guerrilla attacks on fuel oLl pipelines, the economy slowed down considerably in 1988, growing at only 3.7% while inflation accelerated to 28.1% from 23.3% in 1987. However, non-traditional exports continued to perform well and absorbed some of the negative impact on the balance of payments of lower oil prices and guerrilla attacks on the oil pipelines. The current account deficit rose to 1.0% of GDP while the public sector deficit also rose slightly to 2.0% of GDP.  -3- S. Recent Develooments 9. The signs of weakness in the economy continued intoa 1989, with further deceleration of growth in domestic demand. Activity in industry, commerce and construction became increasingly sluggish, with agriculture constituting the main growth area in the economy, on account of good weather and stimulative policy measures. Two developments which occurred in mid-1989 further darkened Colombia's economic outlook. First, the demise of the International Coffee Agreement (ICA) in July, which reduced by half the price of coffee in the international markets, sharply reduced export earnings from Colombia's main export industry. Second, the assassination of presidential candidate Luis Carlos Galan by drug traffickers in August triggered a generalized conflict between the drug traffickers and the Government with adverse effects in terms of the investment climate, increased fiscal pressures derived from the security effort, and reduced traffic related revenue. The economic authorities reacted quickly to ameliorate the negative impact of this "coffee-drug" shock with a tighter credit policy, investment cuts and reductions in subsidies. These measures helped reduce the overall nonfinancial public sector deficit to 2.1% of GDP in 19s9 and inflation from its high of 28.1% in 1988 to about 26%. However, economic growth arther decelerated to around 3.2% of GDP. Despite continued weakness in the real sector, urban unemployment fell to below 10% in recent months as a result of a decline in the labor participation rate. 10. The effects of the "coffee-drug" shock have been expected to materialize mainly in 1990 and after. The Government, therefore, adopted additional economic measures to further adjust to the shock. The main elements of the program that has been applied during 1990 are: (i) further devaluation of about 8% in the real exchange rate by end-1990, reflecting a decision to devalue the real rate beyond the December 1986 benchmark used so far; and (ii) enhanced fiscal austerity through a variety of measures, viz. eliminating major subsidies in the coffee sector and enforcing a decline in the real domestic coffee price, holding down public sector wage increases to below expected inflation for 1990, postponing public sector investments in selected areas, and raising gasoline prices aimed at increasing their domestic level in real terms. C. Medium-Term Economic Modernization Prograri 11. The main objective of the measures undertaken in the last quarter of 1989 was to stabilize the economy in the aftermath of the coffee-drug shock. However, it was recognized that these measures alone would be insufficient to raise longer term productivity and growth in the Colombian economy. During the last two decades, the economy has experienced low and frequently negative productivity growth in most sectors, and without improvements in the efficiency of resource use, future economic growth will be constrained by the rate of growth of productive factors. To address these longer term structural problems, the Colombian authorities announced to the Bank in November 1989 their intention to define a medium-term program -- the Economic Modernization Program (EMP) -- to go beyond stabilizati-n and accelerate growth through improved efficiency of resource allocation at. use. The EMP was approved by the National Social and Economic Policy Counci. (CONPES), the highest policy-making body in Colombia (in February 1990).  12. The EMP proposed a set of structural reforms in the public, trade, and financial sectors, as well as macroeconomic policies designed to increase productivity, raise economic growth to about 5S annually, slow inflation to below 20% per year, and reduce the incidence of poverty. The centerpiece of the EMP is a trade reform program aimed at increasing the competitiveness of the tradeable good3 sector. Complementary financial sector and industrial restructuring policies are designed to improve resource mobilization and ensure an adequate supply response of the productive sectors. Public sector reforms, to be supported by the proposed operation, would improve productivity of public sector assets and efficiency in resource use and allocation in areas dominated by the public sector. These structural reforms would be underpinned by stabilization measures in fiscal and exchange rate policies to maintain internal and external balan'e. 13. The Gaviria administration has reaffirmed the Government's commitment to the objectives of the EMP, but has announced its intention to implement reforms more aggressively with the objective of achieving 6-7% GDP growth and levels of inflation below 20% per year by 1994. Economic reforms have been proposed or undertaken to increase fiscal discipline, to accelerate trade policy reform, to implement a program of agricultural trade liberalization and agricultural policy reform, to reform the financial sector and to accelerate public sector reform. 14. Macroeconomic oolicies. The medium-term macroeconomic policy framework for the EMP is based on the continued pursuit of prudent macroeconomic policies and the maintenance of an adequate level of external competitiveness through the implementation of an active exchange rate policy. In addition to the beneficial effects on growth and prices, the implementation of these policies over the medium term is expected to produce a decline in the external current account -ficit and the maintenance of an adequate level of international reserves, thus c.,ntributing to the achievement of a viable external payments situation. The macroeconomic framework envisages a gradual reduction of the nonfinancial public sector deficit to 2% of GDP or less in 1991 and a further decline to less than 1% of GDP in 1992. The fiscal deficit would improve on the basis of strict control of current expenditure, improvements in tax administration, higher revenue from international trade taxes stemming mainly from the replacement of quantitative import restrictions by tariffs, and adjustments in selected p'blic sector prices. The public sector investment program will emphasize investments in human and physical infrastructure in order to raise productivity and foster investment by the private sector. The reduction in the fiscal deficit will enable the nonfinancial public sector to eliminate its need for credit from the domestic financial system, so that expansion of financial system credit to the private sector will be in line with the growth of nominal GDP during this period. The Government of Colombia has recently communicated to the Bank a Medium-term Macroeconomic Framework describing the macroeconomic objectives and targets the Government will pursue in the implementation of the EMP. The table below sets forth the targets included in the framework which will serve as the basis for the Bank 's assessment of macroeconomic performance.  -5- COLOMBIA Medium-Tenn Macroeconomic Framework Specific Targets 1990 1991 1992 Fiscal deficit (as % of GDP) 2.3 2 ores les than I Extenal curreat Account deficit 2% 1% lais than 1% International Reserves (as monts of imports of goods and scrvices) 5 5 S Expansion of Financial Credit - to the Public Sector (as % of GDP) I 0 0 - to the Private Sector slightly same as nominal me as nominal above GDP GDP nominal GDP Expansion of Net Donestic 15% of the Assets of Banco de la currency issue Republica at the beginning Of 1990 Extenal Debt (as % of GDP) 40% 35% (1994) Debt Setvice Ratio more than 45% 33% (1994) 15. Trade 2olicv reform. The Government has concluded that the main instrument to increase competition and efficiency in the productive sectors will be an opening of the economy to external competition and a reduction in the anti- export bias of the trade regime. Tho EMP set out a five-year program of trade reform consisting of two phases. The first phase seeks elimination of quantitative import restrictions (except those required for health and safety reasons) over an eighteen month period, replacing them with equivalent tariff protection. The second phase, to occur over a three and one-half year period, would reduce the levels and dispersion of tariff protection. Implementation of  - 6 - the first phase began with the transfer of 861 positions to the free list in February 1990, followed by another 585 in July. 16. The Gaviria administration announced an acceleration of the trade reform with the transfer of an additional 465 positions in September. As a result, the proportion of freely importable items increased from 39% of total tariff positions before the reforms were initiated to 76% currently. In the manufacturing sector, the coverage of QRs fell from 82% of domestic production before the reforms to 44% currently. The new Government intends to complete the transfer of positions from the prior license to the free list, by July 1991, thus completing phase one of the program six months ahead of schedule. It has already initiated the second phase of the program to reduce and rationalize tariff protection. The objective is to arrive at an average tariff of 20% to 25%, including the surcharge. The number of tariff rates was reduced from 23 to 13; the maximum tariff fell from 200% to 100% (automobiles); and the average tariff reduced from 26.6% to 22.1%. In addition, the tariff surcharge was reduced from 18% to 13%. In the area of export promotion, the Government intends to reduce indirect tax rebates to exporters (CERTs) to eliminate overcompensation for indirect taxes actually paid, and to restructure PROEXPO to become an export- import bank. 17. Agriculture Policy Reforms. The Government has announced its intention to eliminate IDEMA's monopoly over the import of agricultural products by increasing the participation of the private sector and to convert QRs on agricultural products to a variable tariff scheme. Internal prices of agricultural products and raw materials will be gradually liberalized; the use of price supports will be minimized to allow market prices to guide production and consumption decisions. Support prices will cease to be an incentive to raise domestic production of certain agricultural commodities, but rather will be used on an exceptional basis to provide a minimum level of income to producers of competitive products. IDEMA's role will be restricted to well-targeted interventions in marginal areas and to poor farmer:s. *.gricultural credit subsidies will be reduced, in line with the Government's program of financial policy reform. Any remaining subsidies will be carefully targeted (e.g. to small farmers) and funded out of the fiscal budget. 18. Financial Sector Reform. The Government's program of structural reforms in the financial sector is intended to lead to a sector characterized by greater competition, a size capable of mobilizing domestic and external resources to finance investments in the productive sectors, and a wide range of financial instruments provided at market prices by private financial institutions, including voluntary long term credit and capital market instruments. The Government will expand the scope for the use of market determined interest rates within the financial system, phase out the policies of directed credit supported by forced investments that currently segment financial markets, and improve the regulatory framework in order to promote competition. 19. To promote competition and contestability, the Government will allow free entry of new financial institutions; simplify procedures governing liquidations, mergers, and conversions; reduce and clarify the role of the public sector in financial intermediation; encourage greater availability of market information; and increase monitoring and control of noncompetitive behavior. Competition  policies will include the re-privatization of banks that fell under Government control as a result of the 1982-85 financial crisis (to be supported under the proposed operation). Reserve requirements will be reduced as far as the fiscal deficit and monetary and external conditions permit. Forced investments will be gradually eliminated by freezing the nominal stock at existing levels, and in the future resources to finance directed credit will be mobilized from domestic and international capital markets. The reform of the directed credit system will be accelerated by gradually increasing rediscount rates to at least the average deposit rate of the banking system (DTF) and by increasing interest rat-e to final borrowers toward market levels and harmonizing terms across sectors. By the end of the administration the Government intends (to the extent that competitive conditions permit) to liberalize interest rates fully to final borrowers, retaining rediscounts only for purposes of term transformation. In a limited number of cases where the most effective way to achieve equity objectives is through subsidized credit, these subsidies will be carefully targeted and funded from the fiscal budget. 20. Industrial restructurinc. The Government will initiate an industrial restructuring program in order to facilitate the supply response by the private sector to the trade reform program. The program will assist private firms via technical assistance and credit: (a) to renovate existing industrial production capacity and build new capacity to reduce costs, increase product quality and service, and change product mix toward goods in which Colombia has a dynamic comparative advantage; and (b) to phase out capacity which is unlikely to produce acceptable long run returns in an internationally competitive business environment. The program includes a set of regulatory and institutional adjustments to increase domestic competition, increase the mobility of resources (particularly labor) across sectors, among firms, and within individual firms, and facilitate the acquisition of technology. Also to be included will be a labor adjustment assistance program and technical assistance to restructuring enterprises. 21. Proiections of medium-term economic Performance. Macroeconomic projections for the expected outcome of the medium term policy framework have been recently updated by a joint IMF-Bank mission that visited Colombia from October 15 to November 3, 1990. According to these projections, the medium-term policy framework is estimated to result in a recuperation of economic growth to about 5% per year (from present rates of about 3.5%) through increases in productivity, savings and investment, while reducing inflation from the present high level of about 30% to 22% in 1991 and 14% by 1994. 22. The estimates of the current account balances reflect -- in addition to recent changes in the external environment -- the effects of a serious stabilization effort aimed at absorbing the adverse output and balance of payment effects of a 50 percent drop of coffee prices in early 1989 and the deterioration of the investment climate resulting from the Government's efforts against illicit drug trade. As part of this effort, the peso was depreciated by 3.2 percent in 1989 and the current account deficit improved from 0.6% of GDP in 1988 to a small surplus in 1989 (USS 100 million, or 0.2% of GDP). In 1990 the Government has pursued an aggressive devaluation of the peso (real depreciation reached 6-8% in the first half of 1990 and is projected to reach a devaluation of about 10% in real terms for the year). This has contributed to a slower growth of imports  - 8 - in 1990 and a better rate of growth of non-traditional exports, which, added to the external developments in the oil industry and better coffee prices in 1990 (compared to late 1989), is leading to an improvement . the expected current account balance to a slightly higher surplus of about US$ 340 million (0.7% of GDP) by the end of the year. 23. The net effects of higher oil prices on Colombia's current account balance are expected to be modest due to constraints on crude output resulting from shortages in oil transport facilities in the near term, to the increase in royalty payments associated with a significant share of foreign ownership in the oil industry, and modest increases in future output due to depletion of reserves. It is estimated that each USS 1 increase in oil exports is offset by about 45 cents in royalty payments and about 13 cents of additional costs of imported refined products, resulting in a net improvement in the current account balance of about 41 cents. Projected volumes of crude oil exports increase modestly from 183,000 bbl/day in 1991 to 207,000 bbl/day in 1993, and fall back to 171,000 bbl/day in 1994 due to depletion of reserves (from about 13 production years in 1989 to an estimated 7 production years in 1995, unless exploration results improve). The projections are based on crude oil prices of US$ 23.8/bbl in 1991 and US$ 18.5/bbl thereafter. 24. Non-petroleum imports are expected to increase by about 15% in 1991 mainly due to a recent decision of CONPES (Consejo Nacional de Politica Economica y Social) on October 29, 1990, to further accelerate the trade liberalization program. Effective immediately, all remaining prior import license requirements were eliminated, except for a few agricultural products, medicines and weapons. In addition, the number of import tariff rate categories was reduced from 14 to 10, and it was announced that the program of tariff reduction would be accelerated, decreasing the average tariff from 35% to 15% by 1993, instead of 1995 as programmed earlier. The auction system and the associated foreign exchange budget in practice last year for those products subject to prior import license was also eliminated. As part of the adjustment process, and in addition to a real effective devaluation of about 10% in 1990, the Governemnt envisages to continue its policy of gradual adjustments in the real exchange rate. As a result, the expected surplus of the current account balance of about US$ 340 million in 1990, will become a deficit of about USS 30 million and US$ 140 million in 1991 and 1992 respectively, and small surpluses in 1993 and 1994 (see Table 1 in the Annex). The EMP calls for maintaining reserves at an average of five months of imports of goods and services which has been considered as a safe level to cushion the economy from the uncertainties derived from the accelerated trade reform process initiated by the Gaviria administration and the high price volatility of Colombia's main exports. Based on the projected growth of imports and exports, and the levels of financing available (including the expected commercial bank refinancing and the US$ 600 million in loans from the Bank and IDB for the proposed operation) reserves would decline to about four months of imports of goods and services by 1994. 25. Although the projected increases in the prices of coffee and petroleum products result in some improvement of the balance of trade in 1990, given the high historical volatility of petroleum and coffee prices, these improvements should be regarded as transitory. The authorities have therefore indicated that any additional revenues associated with petroleur. prices higher than projected  - 9 - will be saved. Since recent exploration has not produced positive results, the Government has decided that revenues up to US$ 1.20/bbl above the Governments projected prices (of USS 18.2/bbl in 1991 and US$ 19.0/bbl in 1992) will be devoted to an exploration fund, and that any further price increases will be kept as reserves in a special oil fund that will be maintained outside the country to facilitate internal fiscal discipline and macroeconomic stability. 26. Oil production and exports could be higher than projected if increased exploration produces positive results, preventing oil reserves depletion. Sensitivity tests were performed assuming higher volumes of crude exports (236,000 bbl/day in 1992; 263,000 bbl/day in 1993; and 290,000 bbl/day in 1994; compared to 198,000 bbl/day, 207,000 bbl/day, and 171,000 bbl/day respectively). The results show a decrease in the current account deficits to USS 26 million and US$ 10 million in 1991 and 1992, respectively, and an increase to a current account surplus of US$ 244 million and USS 588 million in 1993 and 1994, respectively (see Table 2 in the Annex). Given the projected increases in other exports and in imports, and the expected external financing, reserves would still decline, from about 5.4 months of imports of goods and services in 1990 to 4.4 months of imports of goods and services in 1994. D. Bank Sumoort for the Economic Modernization Program 27. The Government has requested the Bank's assistance for the implementation of the EMP through a policy based loan to support its public sector reform program. This reform program has been identified as a critical element of the EMP strategy. The proposed operation would be followed-up by investment loans which will build upon and seek further implementation of the proposed reform program, including financing investment requirements derived from reforms implemented in the infrastructure sectors (i.e., railways, ports, highways), and further implementation of the Government's strategies for the low-income housing, industrial and financial sectors. 28. The proposed policy based loan in an amount of $304 million to support its public sector reform program is central to ensuring the viability of the financing plan proposed for the implementation of the EMP and, thereby, Colombia's balance of payments equilibrium in the medium-term. The Bank's support through the proposed operation will assist Colombia in financing the projected current account deficit and in avoiding an excessive decline in reserve levels (to no less than about 4.0 months of imports of goods and services by 1993 as shown in the table below). In addition, it will enhance the Government's prospects of completing in a satisfactory manner a crucial step in its commercial debt strategy. For the period 1991-94, Colombia's external financing requirements are expected to be met by a slight increase in multilateral exposure, a moderate decrease in commercial banks' exposure and a slight increase in bilaterals and suppliers credits. The following table describes Colombia's financing requirements consistent with the macroeconomic framework described in Table 1 in the Annex and the proposed contribution from the main groups of creditors.  - 10 - Colombia: Financing Plan, 1991-1993 (in U.S. millions) 1991 1992 1993 Average Current Account Balance - 27 -138 54 - 37 Available Fmancing: Net -24 66 36 26 disbursement of Medium-and Long-Term debt I/ IBRD - 67 - 7 63 - 4 IDB 198 180 150 176 Bilateral 16 23 8 1S Supplies Credits 73 17 - 24 22 Commercial Banks -192 -126 -140 -153 Other (incl. bonds) - 52 - 21 - 21 -31 Other Capital Movements 2 0 -127 - 42 Increase in Reserves - 49 - 72 - 37 - 53 Total Reserves (months of imports) 4.8 4.5 4.1 4.5 1/ Inluding the proposed Bank and IDB loans for a total of USS 600. milion. Annual average amortization projections are: IBRD, US$441.4 million; IDB, US$ 161.6 million; Bilarerals, US$277.3 million; Suppliers Credits, US$176.3 million and commercial banks, US$769 million. 29. Colombia's debt strategy has been aimed at a phased return to voluntary lending by avoiding debt restructuring and seeking semi-voluntary lending to maintain commercial banks' exposure constant in nominal terms. After three difficult, but successful, refinancing operations concluded with commercial banks since 1986, Colombia has been able to maintain commercial banks' exposure at nearly constant nominal levels and avoid debt restructuring. The new administration has decided to follow a longer term approach in its commercial debt strategy by seeking to refinance debt maturing during the next four years, rather than the two year period that was customary in previous refinancing operations. Ths Government has recently reached agreement with the steering committee representing creditor banks on a refinancing facility in the amount of US$1.5 billion and the floating of bonds in the amount of US$200 million. These amounts would represent the refinancing of about 90% of the repayments due on commercial debt during the 1991-94 period. The final outcome of the operation will be determined by the ability of the steering committee and the Government to obtain broad participation from Colombia's creditor banks. In the past, the  - 11 - cheap/free rider phenomenon has somewhat compromieed the lending targets that have been agreed with the banks' steering committee. In the present operation the reluctance of commercial banks to participate may become a aignificant factor. The proposed refinancing operation will be the last before Colombia's repayment obligations to commercial banks fall to a much lower level. if successful, this operation would represent a critical step towards the return of Colombia to voluntary commercial lending. It is envisaged that the commercial banks' decision to support Colombia's financing plan will be influenced, as in the past, by the perceived readiness of the Bank--as Colombia's main individial creditor--to maintain a burden-sharing largely in line with its current exposure position. 30. The proposed operation would result in a slower pace of reduction of Bank exposure and, as a result of IDB's associated cofinancing, in a positive net contribution of the multilateral institutions to Colombia's financing requirements. In the absence of the proposed operation, an additional financing gap of US$200 million would emerge and the net multilateral contribution to Colombia's financing requirements would be negative. 31. In addition, the proposed operation will assist the Government in financing the costs associated with restructuring inefficient public entities. This will imply mainly incremental fiscal transfers to finance staff reduction programs. Staff redundancies have been a major factor contributing to low productivity in the railways, ports and telecommunications companies and in the low-income housing agency. As part of the restructuring plans for these entities the Government will include staff reduction programs. Due to the financial condition of these entities, severance payments will have to be financed by the Government. Preliminary estimates of labor related costs for the restructuring of these companies exceed US$350 million. The Government has already initiated the process of liquidating the existing railways company. The total cash outlays to meet severance payments for this company have been estimated in the order of US$65 million for the period 1990-92. The cost of severance payments of the ports company have been estimated to exceed US$100 million. The resources required to fund the pension benefits accrued by the port workers has been estimated in an amount in excess of US$200 million. PART II: PUBLIC SECTOR IN COLOMBIA: STRUCTURE, PERFORMANCE AND RECENT DEVEIOPMENTS The Public Sector in Colombia 32. Sise and Composition. During the period 1981-86, the public sector in Colombia contributed about 20% of GDP and 18% of total final demand. The public sector's share of GDP has been generally increasing during recent decades, as reflected in the increase from 13.9% of GDP in 1970 to 21.5% in 1986. The sector's share of total wages in the economy is about 33%, and its contribution to total fixed capital formation has been about 50%, over the period 1982-86. The provision of health, education, and other social services continues to represent the sector's main economic activity. However, the share of these activities in total public expenditure has declined significantly during the  - 12 - period 1982-86, while the share of manufacturing has increased, mainly as a result of petroleum production increases starting in 1986. (Annexes 1-5). 33. Goods and services are provided through a widely dispersed network of national, departmental, and municipal governments and public bodies, adding up to a total of 1,892 entities (Annex 6). The basic administrative structure is described below: i) The Public administration sector, composed of national, departmental, and municipal governments totalling, 1,076 governmental institutions. The sector's main function is the provision of collective services and the execution of public policy goals. Its financing is provided mainly through mandatory contributions, such as taxes, charges, etc. ii) About 473 entities incorporated by national, departmental, or municipal governments as iublic authorities ("establecimientos pfiblicos), operating with legal and administrative autonomy. These are financed mainly through transfers or mandatory contributions of their government sponsors. iii) The non-financial public enterprise sector (NFPE2, composed of 273 companies with majority holdings of the public sector, which produce marketable goods or services. They are expected to finance their operations mainly through internally-generated funds. These companies are incorporated and operate in accordance with private sector regulations. They have traditionally had substantial autonomy from their respective governmental authority. iv) The financial nublic sector is composed of 28 financial entities owned by the Central Government, including the Central Bank, the state-owned commercial banks and insurance companies, and some specialized financial institutions, such as the industrial bank (IFI) and the housing banks (ICT and BCH). There are in addition some 42 development finance institutions at the departmental and municipal level. 34. Despite the abundance of governmental bodies and public entities, over 90% of the 1,892 agencies mentioned above correspond to entities at the departmental and municipal levels with very limited economic and fiscal significance. In fact, over 90% of total expenditures of the decentralized public sector (746 public authorities and NFPEs, representing about 12% of GDP and 50% of total public sector expenditures) are concentrated in about 30 entities at the national and municipal levels. The proposed operation will deal with issues arising from the management by the Central Government of those public entities. This limited group of public sector entities will be referred to as the decentralized public sector (DPS). Performance of the Decentralized Public Sector 35. Size, composition and Financial Performance. Based on figures issued by the National Planning Department (DNP), which monitors DPS cash operations, the DPS contributed about 12% of GDP, and about 60% of public savings and of public sector fixed capital formation over the period 1985-88.  - 13 - 36. The commercially-oriented public sect-r in Colombia shows substantial differences from the pattern of development in other countries in the Region. DPS operations are concentrated mainly in infrastructure. As reflected in Annex 7-A, the power and mines sector represent over 50% of total public sector revenue generation and expenditures, with the communications, transport and agricultural sectors also showing significant shares. A peculiarity of the public sector structure in Colombia is the significant role played by municipal companies in overall public sector operations. Central Government-owned enterprises are predominant in the mines, transport and agricultural sectors. There is a mixed participation of Central Government- and municipally-owned companies in the power and communication sectors and total control of water supply operations by municipal entities. The municipally owned companies showed a deteriorating financial performance during the period 1984-89 (Annex 7-B) as a result mainly of the financial difficulties faced by municipally-owned power companies and the Medellin Metro. Poor performance of these companies created increased pressures on the Central Government, which has met a substantial portion of their debt service requirements. 37. Despite DPS operating surpluses during the period 1985-88, internal cash generation did not keep pace with capital expenditures and debt servicing requirements. As a result, the DPS has become increasingly dependent on debt financing and inter governmental transfers, with the sole exception of ECOPETROL that has consistently shown strong financial performance since 1986 as a result of growing petroleum exports. During the years 1985-86, the DPS contributed over 50% of the consolidated public sector deficit, reducing its share to 40% in the years 1987-88. An analysis of the major economic sectors of DPS operations (Annex 7-C) confirms the very low reliance on the sectors' capacity to generate internal resources. 38. For the period 1990-94, the DPS is expected to improve its fiscal performance by 1.3 points of GDP, moving from a deficit of .95% of GDP in 1988 to a surplus of .55% of GDP by 1992. This will be the result of higher savings, while maintaining expenditures under control. Indeed, current savings are projected to increase from 2.64% of GDP in 1989 to 4.35% in 1994 as a result of higher current revenues. Current expenditures will continue to be restrained and capital expenditures will be reduced over the medium-term. This expected result will be a consequence of the improved pricing and investment planning policies pursued under the proposed operation. However, they do not take into account the additional efficiency and financial performance gains expected from the introduction of the performance planning and evaluation system which are difficult to estimate at this time. Initial diagnoses carried out in the preparation of the first round of performance plans show there is ample margin for additional efficiency and financial performance gains derived from the application of this system. 39. In the case of Colombia, public sector involvement in the manufacturing sector has been marginal, mainly through minority risk-capital operations of the Institute for Industrial Development (IFI). IFI had by July 1988 an investment portfolio consisting of minority participation in about 54 enterprises. IFI's investment exceeded 30% of total equity in only 20 of those enterprises. Since then, IFI has initiated an aggressive program of sale of  - 14 - equity participations which will be supported under the proposed operation. The only remaining majority-controlled operation of IFI is ALCALIS. The Government maintains significant interests in two other operations (Monomeros Colombo Venezolanos and Cerro Matoso) which are controlled and operated by the private sector. The DNP figures do not reflect financial performance of IFI holdings. 40. Economic Performance. The inadequate productivity of public sector resource use in Colombia constitutes a substantial contributor to the low productivity growth of the Colombian economy. This is reflected in the financial performance of decentralized entities and in the low productivity of capital use in the public sector, which contributed an average 42% of fixed capital formation during the period 1971-83. The Bank's latest Country Economic Memorandum calculated that the incremental capital-output ratio for the period was 7.8 for public capital compared with a rate of 2.9 for private capital. In the case of the DPS, there are three main factors explaining the eector's low levels of efficiency performance: 41. Inadeouate Public Sector Manacement Policies and Structure. The Central Government has lacked effective instruments to control DPS operations and investment decisions and to ensure DPS adherence to macroeconomic programming and sectoral priorities. The main linkage between the DPS and the Central Government has been provided by the entities' boards of directors, headed by the respective sector minister. In some cases, these boards were composed of presidential appointees, with no reporting responsibility to the planning or economic authorities, and, in other cases, of the main beneficiaries of the entities' operations. 42. Due to the technical weakness of sector planning in Colombia and the lack of effective mechanisms for the Central Government to set objectives for the DPS and to monitor their implementation, most DPS entities have been managed on an ad hoc basis, with no defined strategic objectives. With some very limited exceptions, DPS performance has been determined by bureaucratic and political pressures, the demands posed by its personnel and to satisfy the requirements of the interest groups benefitting from the entities' operation. 43. Additionally, DPS management has been hampered by poorly focussed and pervasive intervention by the Central Government in its operations. This has seriously affected DPS entities long-term planning capability and operational efficiency. Failure by the Central Government to define clear and permanent policies on pricing of public sector goods and services, the appointment and removal of senior managers based on political considerations, and Government's active participation in day-to-day personnel, procurement and organizational matters are examples of such undue interventioa. As a result, there have been serious investment mistakes, a generalized lack of financial discipline, increasing reliance on debt financing and Central Government transfers, and no sense of clear corporate objectives and strategy. These deficiencies are reflected in the serious administrative, operational, and labor crises faced by most entities in the DPS sector and the virtual abandonment of efficiency standards as the basis for measuring managerial and corporate performance. 44. The Existence of Public Sector Monopolies. Despite the relatively mild intervention of the State in the economy, the existence of some public sector  - 15 - monopolies has led to very low resource use efficiency, limited economic growth and the provision of low quality and high cost goods and services. The main sectors affected by the monopoly role of the public sector are the following: (i) Transport Sector. The Government has held a monopoly in ports and railways and has heavily regulated the shipping sector, providing a virtual monopoly to the Flota Mercante Grancolombiana (FMG), a quasi-public shipping company. These monopolistic arrangements have led to an inefficient provision of port, railways and shipping services to the productive sectors. Further, they constitute a barrier to increased productivity and economic growth and may become a major bottleneck to the Government's objective of opening the economy to external competition. In the case of railways and ports the public monopoly has led to sectors controlled by extremely inefficient public sector companies plagued with excessive labor costs and intractable operational, financial, and administrative problems. In the case of shipping, the Government's protection of the quasi-public shipping line has drastically limited the provision of services by potential competitors and led to the provision of very inefficient and costly services. FMG has hai poor operational and financial performance over the years, including continued reduction of its fleet capacity and increased reliance on conference partners and leasing of liners to cope with its captive demand. The public sector does not have a direct participation in the airline and trucking sectors. Governmenc regulations in those sectors do not unduly restrict entry or competition. (ii) Power and water Supply Sectors. These two sectors, which represent about 3.5% of GDP and 26% of total DPS expenditures, have been reserved for the public sector. Power sector development has been largely based in the power utilities owned by the municipalities in the main urban areas. The Central Government participates in the sector through two companies (ICEL and COPELCA) which, in addition to their generation and transmission operations, are the holding companies for a network of power distribution entities operating in areas not covered by the main municipal utilities and a company with a mix of Central Government and regional capital (ISA) designed to develop large hydro resources of national interest, provide interconnection services and rationalize investment planning in the sector. Sector investment has been influenced strongly by competition among the main municipal companies to develop the hydroelectric potential of their respective regions. There have also been imbalances among the generation, transmission and distribution shares of the sector's investment programs and periodic financial crises derived from poor investment planning. Tariff policies, have been traditionally set based on political considerations. The Central Government has recently strengthened its planning and tariff setting authority in the sector which is undergoing a serious financial crisis. The financial crisis remains to be resolved by the new administration. The authorities have indicated their intent to address the financial and institutional issues affecting the sector with the Bank's support. As a first phase, the Government-owned power utilities i.e., ISA, ICEL and CORELCA, will be subject to the performance planning and evaluation system supported under this operation. The development of the water supply sector has followed a different dynamic. While the main urban centers have been successful in developing their water supply resources and financing their investments and operations, the Central Government played an active role in financing the development and operation of water companies in middle- and small-size cities. This scheme led  - 16 - to gross inefficiencies in resource use, poor quality and low growth in water supply services and chronic shortages of financing to meet even operational needs in most companies. In 1987, as part of a wider process of decentralization, the Government introduced a wide ranging reform of the sector's structure by transferring to the municipal level the exclusive responsibilities for the development and administration of water resources. The Bank is supporting this process through a sector operation. At this point in time the Government has not considered opening these two sectors to private sector participation. (iii) Low-income Housing Sector. The Government assigned to the housing institute (ICT) the virtual monopoly in providing low-income housing by creating substantial disincentives for participation of the private sector through the establishment of highly subsidized interest rates for low-income housing lending and the provision to ICT of subsidized financing for its operations. The main mechanism for financing low-income housing has been forced investments by the financial sector in ICT bonds, paying rates substantially below market levels. ICT bonds represent about 15% of total forced investments by the financial sector and represented a stock of liabilities of about US$178 million as of December 1989. Net transfers from the financial sector to ICT to finance low-income housing have at this time become totally insufficient to meet ICT's investment targets, as a result of: (i) a mismatch between ICT's borrowing and onlending terms that creates significant losses to ICT; (ii) ICT's high administrative and operational costs, also financed through this mechanism; and (iii) ICT's extremely poor portfolio management. In addition, ICT's inefficient administrative performance has led to the delivery of an ever decreasing number of poor quality/high cost houses. The inability of ICT to provide low-income housing in efficient terms and the crisis in the arrangements for sector financing have led the Government to seek a substantial restructuring of the sector. (iv) Agricultural Marketing. The Government has in the past actively intervened in the marketing of agricultural products through three basic instruments: (a) an import quota regime for the main agricultural crops (rice, sorghum, maize, wheat, barley, soybeans and sesame) managed by the Ministry of Agriculture; (b) the monopoly on agricultural imports which is vested on the Governments marketing agency, IDEMA; and (c) a support price mechanism which is also operated by IDEMA. Government intervention in this field has led to a significant inefficiency in resource allocation in the sector, substantial fiscal losses (mainly as a result of aggressive support price policies) and the development of a contradictory and non-transparent incentive structure for producers as the Government tries to conciliate the conflicting policy objectives pursued through the micro and ad-hoc management of these instruments over time. 45. Inefficiencies in the Budgeting and Programming of Public Resources. Low productivity in the public sector has also been a result of the inefficiencies generated by the budget and investment programming regulations and procedures. (i) The recently modified budget law had a limited coverage, including only those public ensities that were dependent on Central Government transfers. Revenue generating public entities had ample autonomy to define their expenditure levels and investment programs. The Central Government had limited instruments to ensure the adherence of these entities to its macroeconomic program and  - 17 - investment priorities, e.g., approval of external borrowing and the tutelary role played by sector ministries. As a result, the scope for inefficiencies in the allocation and use of public resources was significant. This has been mainly reflected in the overinvestment in the power sector, poor investment decisions in the telecommunication company, the difficulties encountered by the Central Government in mobilizing resources within the public sector and a persistent trend to increase current expenditures (specially personnel costs) significantly above inflation. On the other hand, those entities that were subject to the budget process had serious constraints in carrying out their operations in an efficient manner due to the rigidities imposed by the budget process which prevented an adequate coordination between the planning, budgeting and treasury functions. The initial annual budget appropriations for these entities usually reflected only a portion of the actual expenditures planned for the year. This was a result of a requirement posed by the law that revenues derived from debt financing -the main source of public investment financing- could only be incorporated in the budget when the respective loan agreements had been signed. In order to comply with this requirement, budget appropriations were supplemented during the course of the year as the borrowing program materialized. Each supplemental budget required Congressional approval and hence implied a time consuming and politically burdensome process. The uncertainty in the programming of public expenditures was compounded by extremely cumbersome procedures for disbursing budget appropriations. (ii) A second source of inefficiency has been the lack of clear and uniform criteria in the evaluation of public sector projects and of an institutional arrangement that would enable consistency in the screening of project proposals in accordance with consistently applied economic criteria and Sector specific technical guidelines. As a result, the quality of public investments varies widely and political considerations, absorption capacity of the sectors and regional pressures have played a major role in deciding the content of the public investment program. (iii) The rigidities and uncertainties prevailing in the programming and budgeting of public resources under the old Budget Law led to an average earmarking during the 1980s of about 9% of total Central Government revenues. The main sources of earmarked revenues are constituted by the gasoline tax utilized for the financing of transport infrastructure investments (representing about 33.3% of total earmarked revenues), the tax on imports that benefits PROEXPO, IFI and Caja Agraria (equivalent to 19% of total earmarked revenues) and the payroll taxes benefitting ICBF, SENA and the compensation funds (representing 23.8% of total earmarked revenues). Of these sources of earmarked revenues, the tax on imports to finance mainly PROEXPO operations is the one that raises the most serious questions in terms of benefit rationale, potential for mismatch between the amounts assigned and expenditure requirements and the priority the Government should assign to this form of public expenditure.  - 18 - Recent Developments in Public Sector Reform 46. The Government has made significant progress in dealing with some of the issues described above. A description of the main reforms in public sector management introduced by the Colombian Government in the recent years follows. 47. The centerpiece of the public sector management reform effort is the New Organic Law of the Budget, approved in December 1988. This legislative initiative set the stage for major improvements in public sector management. (i) The lack of effective linkages between macroeconomic and sector programming has been dealt with through a significant expansion of budget coverage to include all public entities (except for the National Coffee Fund operations, covered under a separate agreement between the Government and the Coffee Federation) and with the creation of the Consejo Superior de Politica Fiscal (CONFIS). CONFIS is composed of the Ministry of Finance, the Chief of DNP, the Economic Secretary to the Presidency and two sector ministries designated by the President. CONFIS has been established as a high-level fiscal policy-making body with wide range monitoring authority to ensure consistency between fiscal and the macroeconomic program. CONFIS will, carry out this function through the establishment of multi-year financial plans for the public sector, that will set aggregate financial targets (investment, current expenditures and indebtedness ceilings and deficit/surplus targets) for each of the DPS entities. In addition, and based on the framework provided by the financial plan, CONFIS will approve the annual budgets for all decentralized public entities. The Government has initiated implementation of this aspect of the Budget Law this year, by approving for the first time the FY90 financial plan for the public sector and the budgets of the major DPS entities. (ii) The weakness in public investment programming and monitoring has been dealt with through the establishment of a nation-wide project evaluation and monitoring unit in DNP. This unit will be responsible for screening all project proposals in terms of their economic and technical viability and maintain a pool of eligible projects which may be selected for financing under the public investment program in accordance with the prevailing investment priorities. In addition, the unit will monitor efficiency in project implementation by public agencies. The Governnent is in the process of issuing the regulations, designing the information systems and developing the economic evaluation manuals and technical guidelines required to make the project unit operational. (iii) The issue of rigidity in budget programming has been resc:.ved by eliminating the requirement that loans should be contracted prior to their inclusion in the budget. The new budget law allows the appropriation in the budget of revenu2s the Government expects to secure during the course of the fiscal year through borrowings. In addition, the procedure for disbursing budget funds has been drastically streamlined. (iv) The issue of rationalizing the Central Government's role in the management of the DPS will be dealt with by establishing a performance plan and evaluation system with selected public entities, pursuant to the authority granted by the new Budget Law to CONFIS. This is an area the Government has developed and will implement as part of the proposed operation.  - 19 - 48. The Government has dealt with the issue of earmarking by taking actions in two fronts: (i) Law 55 of 1985 enabled the planning and sector authorities to finance with earmarked revenues programs which would extend the original objective assigned to the earmarked taxes. The application of this law resulted in the reassignment of 11.9% and 15.2% of total earmarking in the years 1986 and 1987. While the amount reallocated appears significant, the impact in terms of efficiency gains is not clear yet because the Government had to reallocate the earmarked funds within certain predetermined categories related to the original purpose of the earmarking; and (ii) the Government has announced its intention to gradually dismantle the tax on imports that mainly benefits PROEXPO and rationalize the public sector's role in export promotion. It reduced the total tax from 18% to 16% of CIF cost of imports last June and has announced it will further reduce it to 10% of CIF cost in the coming months. The announced final objective under the trade policy reform program is to bring average tariffs, including any applicable import tax, to an average 25% of CIF cost. This objective will imply the elimination of the import tax in the medium-term. 49. In addition, the Government has made significant progress in developing the institutional framework to ensure adequate coordination between macroeconomic policies and sector programming in two key sectors: (i) In late 1988, the Government renegotiated with the Coffee Producers Association the Coffee Fund management contract, introducing several covenants aimed at increasing Government's role in the management of the Coffee Fund resources. These cov.onants include Government approval of the Fund's annual budget, rationalization of existing subsidies to coffee producers, the need to ensure economic justification of investments, and a program of divestment. The Government's increased zole has been critical in defining and implementing the adjustment program aimed at containing and eventually eliminating the Coffee FundIs operational deficit which resulted from the plunge in international coffee prices. (ii) In late 1989, the Government obtained passage by Congress of a law establishing the National Energy Commission as a high level policy body in charge of formulating investment and pricing policy for the energy sector. This Commission has recently become operational. It will fill a significant vacuum in the policy decision-making process in the energy sector, while ensuring adequate coordination between sector developments and macroeconomic objectives and constraints. PART III: THE PUBLIC SECTOR REFORM PROGRAM AND THE PROPOSED LOAN A. Obiectives of the Progosed ooeration 50. The proposed operation will support the Public Sector Reform Program. The specific objectives pursued by this Program are improving productivity in the use of public sector assets and improving efficiency in resource allocation  - 20 - and use in sectors that have up to now been dominated by the public sector and which are critical to an adequate supply response to the EMP. 51. The objective of imlrovina productivity in the use of public sector assets will be achieved by: (i) the establishment of a performance planning and evaluation system for the public decentralized sector aimed at modernizing the management of public sector entities; and (ii) the privatization of public assets whose conti.:ued holding by the public sector is not justified on strategic or policy grounds, specifically in the financial and industrial sector. 52. The objective of imirovina efficiency in resource allocation and use will be sought by the elimination of public or quasi-public monopolies in sectors critical for EMP implementation and their replacement by an incentive structure promoting freedom of entry and a competitive sector environment. In this line, the Program is seeking implementation of substantial reforms in the railways, ports, shipping, low-income housing and agricultural marketing sectors. B. Main ComPonents of Proposed Operation Public Sector Manaaement Modernization - Performance Planning and Evaluation System 53. As a central element of its strategy to improve the productivity of public sector assets, the Government will seek the modernizaticn of the management system for public sector entities through the establishment of a Performance Planning and Evaluation System (PPES). The PPES, to be operated by CCNFIS, will constitute the main institutional link between the Central Government and its DPS entities. The PPES will, on the one hand, enable the Central Government to define clear sector and corporate objectives for each of its DPS entities and establish a transparent system for evaluating public sector managers' performance and, on the other hand, provide the DPS entities greater autonomy in pursuing their corporate objectives. 54. The PPES will enable the Government to define, through a process of negotiation among all parties involved (economic and sector authorities and the entity's management), the entity's corporate objectives pursuant to the Government's sector policies and macroeconomic objectives. Corporate objectives will be set with the aim of moving public entities towards commercially oriented performance and to market-driven discipline. Based on these objectives, the PPES will define the entity's main operational targets and objectives for efficiency improvement, translated into specific performance targets, and indicators for evaluating management's performance in achieving its objectives and targets. The Government has agreed to establish an explicit incentive system for public sector managers which will provide rewards and sanctions linked to their performance under the respective performance plan. Due to the current restrictions in the legal framework which does not envisage the provision of economic incentives to public sector managers, the initial incentive system will consist of honorary distinctions for managers who perform in a satisfactory manner and for sanctions ranging from admonitions to dismissal for managers who do not perform adequately. In addition, the Government has undertaken to present to Congress in the coming  - 21 - months legislation to enable the establishment of economic incentives for public sector managers. 55. The Letter of Development Policy has defined as the main objectives to be pursued by the PPES the modernization of the management policies and practices prevailing in the public sector with a view to moving public companies towards commercially-oriented performance under a market-driven environment. Specific objectives to be pursued under the PPES will be: (i) to maximize the economic return on public sector assets through the establishment of prices for public sector goods and services based on economic efficiency and the setting of performance targets that ensure cost efficiency in the operations of public entities. This should lead to a substantial improvement in the financial return of public sector enterprises and increased financial self-sufficiency of public entities; (ii) to limit the role of public sector participation in the provision of goods and services to cases where there are qualified policy considerations which would be made explicit in the definition of the strategic objectives of the DPS entities and to cases of market failure; and (iii) to establish an incentive structure in those sectors where the Government has decided to maintain its presence that would promote competition between the publLc and private sector in the provision of goods and services. The Government, in the course of preparing this operation, has defined the methodological, organizational, and legal aspects related to the establishment of the PPES and has made it operational. The process of preparation and negotiation of performance plans has been assigned to two senior advisors that receive technical and logistic support from DNP. 56. The performance plans content will be defined on a case by case basis, given the prevailing conditions of the entity, and the consistency of its operational and investment objectives with the Government's sector policies and corporate objectives. While in some cases performance plans will focus on efficiency improvements to bring an entity's performance in line with already sound sector policies, in other cases the performance plan exercise will become the principal instrument to adjust public entities to major reforms in sector policies. In these cases, performance plans would lead to substantial restructuring of the entities. A key objective of the performance plans is the definition and implementation of pricing and investment policies for each of the selected entities. These will be consistent with the general policy objectives set forth in the Letter of Development policy. Some additional aspects which are expected to be systematically covered under the performance plans is the improvement of managerial practices and structures and the strengthening of accounting and commercial practices. 57. The objectives pursued in the case of the four entities selected for the first round of performance plans (ECOPETROL, TELECOM, ICT and HIMAT) vary based on the specific issues affecting the respective sectors. These entities were selected based on their fiscal significance (ECOPETROL and TELECOM are the major contributors to public sector finances representing over 45% of DPS revenues in the year 1989) and the efficiency problems they represent (in the case of ICT a major sector restructuring; in the case of HIMAT, improvement of cost recovery and divestment of operations).  - 22 - 58. ECOPETROL's corporate objectives are generally consistent with the Government's sector priorities. The Government has defined as the main objectives to be pursued with the performance plan for ECOPETROL during calendar year 1991: (i) a definition of the macro economic framework under which the company will operate, including a ceiling in total current and capital expenditures and indebtedness and the company's transfers to the Central Government; (ii) an agreement on ECOPETROL's investment plan; and (iii) specific efficiency improvement and profitability targets. As a medium term task, the performance plan will include the carrying out of studies for the establishment of a cost accounting system. The lack of a cost accounting system to assist management in planning and controlling routine operations and in the formulation of major plans and corporate policies have been identified as a major constraint to a sustained effort of efficiency improvement in ECOPETROL. This system will become the main managerial tool to improve overall efficiency in the medium-term. The studies will be financed out of the technical assistance component of the loan. 59. The Government recently introduced significant reforms in the telecommunications sector. These are aimed at opening to private sector participation the provision of some selected services (publifax, teletex, videotex, electronic mail and data transmission); allowing municipal companies to compete with TELECOM in national long distance and cellular communications; enabling municipal companies to subcontract the provision of basic telecommunicazions services with the private sector and to provide international long distance services in association with TELECOM; and transferring to the Government the planning and regulatory role that TELECOM had exercised in the sector. The Government's main objective in the case of the performance plan for TELECOM will consist in restructuring the company to enable it to compete in the new sector environment. This will require defining performance targets for each of the services provided by TELECOM which will be treated as separate profit centers. As in the case of ECOPETROL, TELECOM will undertake to establish a management cost accounting system to improve management's capacity to plan and control operations. In addition, TELECOM will carry out a study to review its current tariff structure and will undertake to revise it to reflect the long- run marginal cost for the provision of those telecommunication services which are not going to be initially subjected to competition (i.e., provision of local and international long distance services). Finally, the performance plan will define the macroeconomic framework for the company (total current and capital expenditures, total indebtedness and transfer to Central Government) and specific efficiency and profitability targets. 60. In the case of ICT, the plan will consist of a major restructuring effort including financial, operational and administrative reforms aimed at streamlining and reducing the scope of ICT's operations in the financing and construction of low-income housing and to improve its financial and operational performance (see paras. 92-93). This plan reflects the initial actions to adjust ICT to the new sector framework the Government intends to implement. In the case of HIMAT (the Government's irrigation agency), the basic focus of the plan will be to strengthen the cost recovery practices of this entity, ensure an appropriate administrative decentralization of its operations and define targets for the transfer of the operation and maintenance of the irrigation districts operated by HIMAT to its beneficiaries. The performance plan for ICT and HIMAT have been  - 23 - finalized and negotiated between the Government and the respective entities. The Bank has reviewed and approved their content. 61. The Bank has received the performance agreements for ICT and HINAT reflecting the agreed objectives, performance targets and timetables. The Government has initiated detailed discussions regarding the performance plans for ECOPETROL and TELECOM and intends to have those plans signed and effective by December 31, 1990. As a condition of second tranche release, the Bank will expect satisfactory progress in the initial operation of the PPES, including that all first-round performance plans are being implemented in accordance with their objectives, terms and timetables or that remedial action has been taken to ensure compliance with agreed objectives. In addition, performance plans would have been signed and made effective with COLPUERTOS, CORELCA, IDEMA and ICEL consistent with the objectives set forth for the PPES. As a condition of third tranche release, the Bank shall be satisfied with the operation of the PPES, includings (i) evaluation of public sector managers subjected to the first- round of performance plans has been carried out and the incentive scheme has been applied in a consistent manner; (ii) there is continued compliance with the objectives, terms and timetables set forth for the first- and second-round of performance plans or that remedial action has been undertaken to ensure compliance with agreed objectives; and (iii) performance plans would have been signed and made effective with SENA, ISA, CVC and ISS consistent with the objectives set forth for the PPES. The Government and the Bank have selected the entities to be subjected to the PPES based on the fiscal significance and efficiency problems faced by the entities. The Government will seek Bank concurrence before replacing any of the entities selected for the second- or third-round of performance plans. In authorizing a change in the list of selected public entities, the Bank will ensure that the entity proposed presents equivalent challenges in terms of fiscal and efficiency performance. = Improvement of the Policy and Institutional Environment for the Manaaement of DPS Ooerations. 62. A scenario where DPS entities are evaluated in terms of their efficiency in carrying out specific mandates from the Central Government Lequires clear delimitation of the entities' sphere of management responsibilities, rationalization of Government intervention in their management processes, and streamlining of administrative and legal procedures, with a view towards increasing the entities' autonomy and accountability. Under the current environment, the pervasive ad hoc intervention of the Central Government in such areas as pricing, managerial appointments, labor benefits, and organizational structure, as well as the inefficiencies derived from the existing regulations on procurement and reporting requirements, undermines the role of the boards of directors and managers of public entities. 63. The Government has presented to the Bank a Letter of Development Policy defining its basic policies and strategies in managing the DPS and in streamlining the regulatory environment under which the DPS operates. In addition, this Letter includes the Government policy objectives and schedule of actions to improve public sector productivity and efficiency in resource allocation and use in areas where the public sector has up to now played a  - 24 - dominant role, including the elimination of public monopolies and changes in the regulatory framework of key economic sectors to enable free entry and increased competition. A translated version of the Letter received by the Bank has been attached as Annex 8. As a condition of second and third tranche release, the Government will have complied with the policy objectives and the corresponding programs of action in the various sectors set forth in the Letter of Development Policy. 64. The Letter of Development Policy includes the Governmentfs policy for the rationalization of DPS management. Pursuant to this policy, the Central Government will limit its intervention in the management of its DPS to specific strategic roles, i.e., ensure consistency of the entity's operation with macroeconomic constraints (Financial Plan); define the strategic objectives to be pursued by the entity, based on sector policy priorities (performance plans); appoint the entity's board members and senior management; evaluate management's performance (performance plans); define clear and permanent pricing and investment policies to be followed by each entity (performance plans); and refrain from taking any other action. To minimize interventionism, the Bank will seek regulatory changes aimed at transferring responsibilities in such areas as personnel and procurement. 65. The Government has undertaken in the Letter of Development Policy to seek a substantial reform of current procurement regulations, which are a major contributor to public sector inefficiency. It has agreed to seek Congressional authority to reform the existing procurement regulations. This reform will focus on eliminating the countless review procedures applicable to procurement decisions, reducing the focus of current regulations on the compliance with the letter of formal and legal requirements to a- extent that has perverted the basic economic nature of procurement procedures, and eliminating preferences granted to domestic producers under the public procurement laws that exceed the tariff protection levels under the general trade regime. The Government will undertake to present the corresponding legislative initiative not later than December 31, 1991. 66. The Government has recently issued regulations freezing in real terms the aggregate recurrent expenditures for each public entity and delegating to each entity's management the power to make the adjustment i terms of organizational structure and personnel plant necessary to comply with the ceiling. As an incentive, public managers are authorized to keep and assign with no restrictions any portion of the aggregate recurrent expenditures which are not utilized for those purposes. - Extension of PPES to Municivally-Owned Entities Benefittinc from External Credit. 67. A constitutional provision establishing the autonomy of municipalities and municipally-owned entities from the Central Government has prevented the Government from including some municipally-owned DPS entities under the newly established controls for DPS operations. Some of these entities have significant macroeconomic impact derived from their financial results, borrowing requirements, and investment programs. The main utility companies are  - 25 - municipally-owned and have in the past relied on Central Government guarantees for access to external credit markets. While some of these utilities have consistently presented satisfactory financial results, others have become significant burdens on the Central Government, which has in practice no effective recourse to seek compensation or urge remedial action from the respective municipal authorities. 68. In order to ensure greater financial discipline by municipally-owned companies, the Government has agreed in the Letter of Development Policy to define as a general policy, that, in considering requests for Central Government guarantees from municipally-owned companies, the Government will require that the prospective borrower has agreed on a performance plan aimed at ensuring the companies, debt servicing capacity. The Government will closely monitor, through CONFIS, the compliance with the plan's targets and seek remedial action in case of failure to meet the agreed targets. The Government has indicated it will issue a policy directive to that effect by December 31, 1990. The Letter of Development policy reflects the understanding reached on this matter. Privatization 69. Financial Sector. The financial sector in Colombia has shown steady improvement since the crisis in the early eighties that led to the nationalization, liquidation or temporary intervention of a significant share of the private banking sector. The group of five banks nationalized in the 1980s, represents about 25% of total banking sector assets. The nationalized banks faced serious liquidity and solvency problems. The largest bank in the group is the Banco de Colombia (representing 61% of total nationalized assets), followed by Banco del Estado (18.8%), Banco del Comercio (16.5%), Tequendama (3%) and Trabajadores (2.23%). Of these five banks, only the three smallest ones have substantially recuperated their financial soundness. Although the Banco del Estado has also improved its financial performance, it is the subject of a court claim that, if successful, would wipe out the bank's capital and reserves. Finally, the Banco de Colombia is still in a process of strengthening its financial position and there is uncertainty as to the type and level of financial assistance that would be required to put it in sound financial footing. Public sector participation in commercial banking is constituted also by ownership of Banco Popular (representing about 10% of total banking sector assets) and two quasi-public banks which are owned and administered by trust funds established with the participation of the Government and the coffee growers (Banco Cafetero) and the cattle raising associations (Banco Ganadero). These two quasi-public banks represent about 23% of total banking sector assets. 70. The sector shows at this time substantial improvements in terms of overall solvency, profitability and capitalization. In addition, the Government has significantly strengthened prudential regulation of the sector. The policy priorities for the Government in the financial sector are rapidly shifting towards the need to increase competition in order to improve allocative efficiency, reduce intermediation costs and seek more responsiveness from the sector to meet the financial needs of the economy. The financial sector's oligopolistic structure is recognized as a major obstacle to competition. The sector is characterized by a few large financial intermediaries, including a dominant presence of Government-owned banks, combined with a number of small  - 26 - inefficient institutions. Recently, the Government has taken significant actions to eliminate barriers to entry in the financial sector as a means to improve competition and strengthen the sector's capital base. It obtained passage of a law in December 1989 allowing foreign investors' control of financial institutions. The Government intends to use the privatization of nationalized banks as an instrument to attract foreign investment to the sector. The Government's intention is to bring to the market all nationalized banks that have reached a financial position that would make them attractive to the private sector. Unfortunately, the two main banks do not meet that condition. Banco de Colombia is still in a very weak financial position, requiring additional Government equity contributions and further restructuring of its operations. Banco del Estado faces a major uncertainty derived from pending judicial processes. The Government has agreed to explore restructuring strategies for Banco de Colombia that could lead to its partial or total divestment. In the case of Banco del Estado, the Government has no other alternative than to wait for the outcome of the judicial processes. 71. In mid-1989, the Government issued regulations for the privatization of publicly-owned banks. Last March, the Government brought to the market one of the nationalized banks - Banco de los Trabajadores. Despite active interest from both foreign and private investors, the bidding period expired in July with no firm offers having been received. The failure has been attributed to the relative rigidity of the current privatization rules (mainly the requirement that the controlling package that is auctioned cannot exceed 51% of the bank's shares), the concern of investors that the potential value of some contingent liabilities - derived from pending judicial processes - may have been underestimated by the Government and the small asset and capital base of the bank. The Government has recently revised the privatization procedures (including the possibility of awarding the totality of a bank's shares to one individual investor), and will explore the possibility of merging banks to present investors with more attractive packages in terms of asset and capital base. 72. As a condition for second tranche release, the Bank will require that the Government has brought to the point of sale the Banco de los Trabajadores, Banco del Comercio and Banco Tequendama, either individually or after modifying their asset structure to ensure packages that will be more attractive to potential investors. As a condition of third tranche release, the Government will have defined a strategy and a satisfactory related schedule of actions to privatize or restructure, with the aim of total or partial divestment, Banco de Colombia and any of the other nationalized banks brought to the point of sale for which no acceptable bids have been received. The strategies for all these banks should include a definition of the viability and costs associated with bringing them to the stage of privatization and an assessment of alternative courses of action available to the Government, with their respective cost-benefit analysis. The technical assistance component of the loan will provide for the financing of the studies required to define the strategy for privatization of the referred banks. 73. Industrial Sector. IFI's industrial investment activities have made it the principal instrument for public sector participation in the industrial sector (see para. 39). IFI has initiated an aggressive program to sell its investment portfolio as part of a broader restructuring plan aimed at its financial  - 27 - rehabilitation and the redefinition of its role as the Government's bank for industrial development. The 1989-90 Privatization Program included the sale of IFI's equity participations in 18 companies with an estimated value of US$158 million. As a result of this program, IFI has sold seven equity participation for a total of about US$150 million. This amount pertains mainly to the sale by IFI of two sizable companies (PAPELCOL and SOFASA). In addition, the remaining 11 companies included in the 1989-90 Privatization Program have been brought to the point of sale. 74. IFI has already completed the terms of reference and the selection of consultants to carry out a study to determine the feasibility of restructuring ALCALIS, with a view to its later privatization or, alternatively, a plan for its liquidation. ALCALIS, a company wholly owned by IFI producing basic chemical inputs and raw materials for domestic industries, represents IFI's third largest investment and its second largest debtor. It is the only remaining manufacturing concern controlled by the public sector. ALCALIS has been facing serious financial and operational problems for the last decade as a result of Government price controls, technological obsolescence, and excessive labor costs and pension burden. The Government has been reluctant to order its liquidation since it is the sole provider of chlorine for water supply and refined salt for private consumption. No private sector interest has been expressed in acquiring the company. A study to define a strategy for ALCALIS will be financed out of the technical assistance component of the proposed operation. The Government has undertaken to complete the study and prepare a restructuring plan aimed at ensuring the financial viability and eventual privatization of the company. 75. The Letter of Development policy contains the Government's commitment to continue satisfactory progress in the privatization of IFI's portfolio, including definition of a 1991-92 Privatization Program that will include the remaining IFI's mature investments which are in a condition of being brought to the point of sale and the definition during the course of 1991 of a satisfactory strategy to deal with ALCALIS. Private Sector Development 76. This component will seek improved efficiency of resource use through the promotion of private sector participation and competition in sectors dominated by the public sector, through public monopolies, over-extended public sector presence or by public regulatory restrictions on entry and competition. It will build upon recent Government decisions aimed at promoting private sector development in railways, ports, shipping, low-income housing, agricultural marketing and in the industrial and financial sectors. The proposed operation will assist the Government to deepen and broaden its decisions, and ensure their implementation leads to the establishment of adequate competitive incentive structures. 77. Railways. The Government has taken significant actions to deal with the inefficiencies generated by the public sector monopoly in railways. After obtaining Congressional authority in late 1988, the Government issued in July 1989 various decrees liquidating the existing company, terminating the public sector monopoly in railway operations and establishing the free entry of private  - 28 - investors to operate in the sector, either by the establishment of wholly- private enterprises or through joint ventures with the public sector. 78. The public sector monopoly has been replaced initially by the establishment of two officially-sponsored companies: (i) a Government-owned company in charge of the operation, rehabilitation, and maintenance of the rail system (FERROVIAS) that will be in charge of providing track infrastructure services and regulating traffic and security matters, and (ii) a rolling stock company which has inherited all Government-owned rolling stock material and will provide rail transport services on a commercial basis (STF). The Government's policy is to seek maximum private sector participation in the capital and management of STF and to facilitate the establishment of all private sector ventures for the provision of rail transport services on a commercial basis. For these purposes, the Government has determined that railway operators will be free to determine tariffs and the terms for the provision of their services, subject exclusively to their compliance with traffic and security regulations. 79. The Government has made significant progress in implementing its new railway sector policy. Liquidation of the existing Government-owned railways company has proceeded on schedule. A total of 1,240 workers had accepted voluntary termination with compensation by December 1989. No serious problems are foreseen in meeting the personnel reduction targets, since a climate of cooperation has developed among the unions, the company, and the Government. The newly established companies are expected to engage only 1,000 workers, down from the total of 7,000 of the previous company. The operational, investment, and financial plans for FERROVIAS and STF have been finalized and the promotional efforts to attract private sector participation have been initiated with very promising results. Private sector investors representing coffee growers, a leading brewery and industrial interests have formally indicated their intention to subscribe 49% of STF's capital and the Government has agreed to relinquish its right to control STF's directory. The Government is at an advanced stage of negotiations with a leading coal firm for the establishment of a private venture for the transport of about two million tons of coal for export annually through ports in the Atlantic. 80. The Government has included in the Letter of Development Policy a statement of the policies it will continue to implement in the railways sector. The statement includes the Government's commitment to : (i) promote the comparative advantages of this transport mode in order to ensure the development cf an efficient transport infrastructure; (ii) limit its role in the sector exclusively to the formulation of sector policy, the regulation of the sector, the operation of the rail infrastructure system through the operation of FERROVIAS and the provision of rail transport services through joint venture operations with the private sector operated on a commercial basis; (iii) limit FERROVIAS' investment program to those expenditures which are economically and financially justified and which have been identified as necessary to meet the operational requirements of STF or private operators; (iv) make FERROVIAS financially sustainable through the establishment of a tariff policy for FERROVIAS that would recuperate the full operational, maintenance and investmenit costs related to rail infrastructure; and (v) maintain a personnel plant for FERROVIAS which will be strictly related to its routine operational needs and the obligation to sub-contract all maintenance, rehabilitation and expansion needs of the firm. As a consequence  - 29 - of the extremely deteriorated condition of the rail infrastructure and to create minimum conditions of operation for the private sector, the Government has agreed to contribute to the initial investment and operational costs of FERROVIAS with the objective of putting the railway sector in a position to develop its comparative advantages over other modes of transport. Once these minimum operational conditions have been achieved, the sector will be financially self- sustainable through the consistent application of the tariff policy defined above. 81. The Government has made substantial progress in implementing the commercial, operational, investment and financial plans for the establishment of the two officially-sponsored companies. Adherence to the above-summarized policy conditions, contained in the Letter of Development Policy, will be assessed within the context of the objectives of the Public Sector Reform Program prior to release of the loan tranches. 82. The technical assistance component of the loan will finance a study to define a tariff system for the provision of rail infrastructure services by FERROVIAS. The study would be completed by June 1991 and will be aimed at ensuring FERROVIAS' financial autonomy through the full recovery of its operational and maintenance costs and a reasonable contribution towards rehabilitation and expansion of the rail system. The Government will undertake to implement the conclusions and recommendation of the study by December 31, 1991. In addition, the technical assistance will include a study to review the economic and technical justification of the proposed investment program for the rehabilitation of FERROVIAS' rail infrastructure. The study will be completed and the recommendation implemented not later than June 30, 1991. 83. Ports. COLPUERTOS' monopoly in the handling of trade cargo has been tempered by the Government over the years by allowing, on a discretionary basis, the handling of port operations by third parties (both public and private) to avoid bottlenecks and to enable the viability of certain economic activities that were especially vulnerable to COLPUERTOS' inefficiencies. As a result of this process, by 1988, COLPUERTOS was handling only 14.8% of total import/export cargo, with the public specialized ports for oil, coal, and banana handling 63.4% of the cargo and private docks handling 20.8% of total cargo (Annex 9). In the area of ger.eral cargo handling, however, COLPUERTOS continued to have substantial participation (41.6% of total general cargo) and a monopoly on the provision of port services to the public (Annex 10). Private docks have only been allowed to handle cargo directly related to the operator's industrial or commercial operations and must pay a fee to COLPUERTOS for the use of areas under the latter's concession area. The previous Administration had authorized two private sector investors to provide public port services that would compete with the services provided by Colpuertos. The new port terminals would be located in three of the four cities where Colpuertos' terminals operate, e.g., Santa Marta, Cartagena and Buenaventura. Negotiations with the approved private investors on the specific conditions of the investment and the regulatory framework (tariff regime, compensation for the use of public resources, etc.) for their operation have come to a virtual standstill. This has been due to the limitations posed by the existing regulatory framework that grants COLPUERTOS an inordinate capacity to restrict sector competition and the previous Administration's  - 30 - intention to impose to the private sector a tariff regime that would limit the competition COLPUERTOS would face in the initial stages of the reform program. 84. COLPUERTOS continues to provide extremely inefficient operations as a result of poor management, obsolete equipment, poor maintenance practices and the concessions granted to the labor unions in the organization and implementation of port operations. COLPUERTOS is in addition facing mounting financial difficulties as a result of excessive labor and pension costs and a distorted tariff system. The Bank made a loan to COLPUERTOS in 1985 aimed at improving basic infrastructure and providing technical assistance to improve corporate performance. Project execution has been very slow, and COLPUERTOS' operational and financial condition has continued to deteriorate. 85. In order to overcome the difficulties that have prevented the start-up of an effective reform program in the sector, the new administration -in a major breakthrough - has undertaken a full restructuring of the port sector aimed at establishing a transparent and comprehensive regulatory framework to enable open competition among private and public operators. The main elements of the sector restructuring program are the following: (i) the establishment of a uniform tariff policy for private sector operators. In the initial stages the Government would set tariffs for port operators based on the long-run marginal cost concept. As soon as the supply of port services guarantees an adequate level of competition, the Government would move to a system of free prices for port services. The tariff regulations would be made applicable to COLPUER1LOS in the medium-term; (ii) the establishment of uniform criteria and methodology to determine the compensation the Government will charge port operators for the use of public resources and facilities. The compensation will be based in the scarcity value of the resource assigned, alternative uses, the potential for contamination, etc. To the extent possible, the Government would apply market mechanisms to determine the level of compensation for the use of public resources. In the medium-term compensation would be applicable to both public and private sector operators; (iii) the clear separation of the regulatory and operating function within the sector. The Government, through the Ministry of Transport, would become the exclusive regulatory and planning authority in the sector and will ensure transparent and equal treatment for private and public sector operators. This will relieve COLPUERTOS of its current regulatory role and monopolistic position in the provision of port services; (iv) the establishment of a transparent system to grant licenses to operate in the sector. This system should take into consideration various factors, (i.e., technical and economic aspects, environmental concerns, alternative economic use of resources) relevant to the granting of a port license and to the extent possible rely on competitive mechanisms to award licenses among interested parties, and v) the restructuring of COLPUERTOS aimed at adjusting its functions and operations to the proposed sector strategy of enabling open competition between public and private sector operators. The Government has undertaken to carry out the technical studies required to define the mechanisms and specifics needed to implement the new regulatory framework. The terms of reference for the studies have been prepared and it is expected that they will be completed during 1991, including the draft regulations dealing with the matters referred to in sub- paragraphs (i) to (iii) above.  - 31 - 86. In order to implement the propoEad sector restructuring program, the Government has already sought legislative authority from Congress to modify the current sector regulatory framework. Finally, the Government has undertaken to reinitiate the negotiations with those private investors who had been originally authorized to enter the sector and seek an early resolution of the pending issues in accordance with the policy objectives described above. 87. As a condition of second tranche release, the Government will have defined a restructuring program for COLPUERTOS aimed at adjusting COLPUERTOS operations and functions to the new sector environment, including ensuring the financial and operational autonomy of the entity's terminals. The performance plan for COLPUERTOS which is required as a second tranche condition will contain the first year actions of the restructuring plan. As a condition of third tranche release, the Government would have carried out COLPUERTOS' restructuring program in accordance with its respective objectives, action plans and timetables. Aa- sDecial condition of tranche release (see para. 101), the Government would have restructured its port sector, including its tariff regime, the scheme of compensation for the use of public resources, the system for granting licenses to port investors/operators and the separation of the regulatory and operating furctions within the sector. 88. Shilnin . Flag law protection, which reserves for national shipping lines a portion of the country's foreign trade, has been applied to its fullest extent in Colombia during the last decade. The objective was to enable the development of a strong national shipping line by granting FMG virtual monopolistic protection that would allow it to operate in the liner services market which has been characterized by the prevalence of cartel arrangements. The result has been that FMG has actually reduced its tonnage during the recent years and operates a technically obsolete fleet which provides inefficient services at high costs. Moreover, flag law has increased the country's dependency on foreign liners since about 60% of general imports protected by flag law are transported in foreign liners associated with, or leased by, FMG (Annex 11). 89. Consistent with the objective of ensuring an adequate supply response following the launching of the EMP, the Colombian Government has indicated its intention to gradually dismount the protection granted to FMG and other minor carriers in order to improve the availability, quality and costs of services provided to importers/exporters. In March 1990, it issued a decree reducing the reserve for national liners on bulk cargo to 10% (against the prior requirement of 50% of the total bulk cargo) and reduced protection for general import cargo to a level not exceeding 50% (against th-u prior requirement of not less than 50% of total general import cargo, which had resulted in an effective reserve average of about 75%). In addition, the decree provides for more flexible procedures and controls for the administration of the qucta system. 90. Some positive developments have followed the reforms introduced in the flag law regulations. Shipping ratea for coffee exports and some selected imports in the routes to Northern Europe have declined in percentages ranging from 10% to 28% and the FMG has announced a restructuring program that will include staff reductions, the modernization of its fleet and the reorganization of its operations to rationalize costs and operate only those services which are  - 32 - profitable. On the other hand, some obstacles remain that limit the potential for competition generated by the recent measures: (i) foreign shipping companies are only authorized to remit abroad up to 80% of their freight rates creating a serious disincentive for participation in the Colombian market to those foreign companies that do not benefit from flag law protection; (ii) the mechanisms to control compliance tith the reserve quota continue to be burdensome, limiting the ability of users to seek the most advantageous liner service; and (iii) the maintenance of a 10% reserve quota for bulk cargo. As a condition of second tranche release the Government will: (i) eliminate the remittance ceiling imposed on foreign liners; (ii) streamline mechanisms to control compliance with reserve quotas, and; (iii) further reduce reserve quotas on bulk imports to a maximum level of no more than 5% of total bulk imports. 91. In addition to the action referred to above, the Government has proposed to review the shipping protection system to assess the impact of the recent reforms, identify alternatives to the current quota-based protection system and define a time-bound plan of action to improve competition in the sector that may include the phasing-out of the quota-based system. As a condition of third tranche release, the Government would have defined an action plan to reform the institutional and regulatory framework of the shipping sector aimed at improving sector competition, and, taken initial actions in the implementation of such plan to substantially reduce the reserve cargo quota for general imports. The Bank has informed the Government it would consider as s-sbstantial a reduction of the reserved quota to a level of about 30% of total general imports. 92. Low-Income Housinc. The Government has defined a new strategy for the low-income housing sector. It is aimed at rationalizing the administration of subsidies, which have traditionally been provided by ICT via credit, and at reducing the role of the public se.tor as financier and constructor. The public sector is to be replaced by the private sector, municipalities and NGOs, which would become the main operators in the low income housing sector. The proposed strategy will require ICT's restructuring to become mainly the administrator of the new sector subsidy scheme. While the sector reform is put in place, the main features of ICT's restructuring plan would be: (i) reducing the scope of ICT's operations to specific targets of beneficiaries (ICT would provide housing for families earning up to two-and-a-half times the minimum wage) and housing costs (not to exceed US$6,000 per unit and averaging about US$4,000); (ii) improving ICT's financial position through programs of staff reductions, asset divestment, and aggressive portfolio recuperation (providing for the sale of the existing loan portfolio to the loan beneficiaries at a discount in exchange for up-front cash payments); and (iii) gradually reducing ICT's operation by subcontracting with the private sector the planning and development of construction projects, redefining credit policies and operations for its target population, and providing up-front subsidies to eligible families who will obtain housing finance from the private sector. 93. In addition to ICT's restructuring, under the proposed loan the Government will carry out a comprehensive program for qradually dismantling the forced investment financing of ICT and establishing a new strategy for financing low- income housing. This strategy will consist of increasing the incentives for private sector financing of low-income housing by substantially reducing interest rate-related subsidies (interest rates would, in any case, remain positive in  - 33 - real terms) and promoting the provision of subsidies to target groups through up-front Government grants financed from the budget. As a special condition of tranche release (see para. 101), the Government would have implemented the main elements of the sector restructuring: (i) divested ICT of its role as financier and constructor of low-income housing, except for a limited role of channelling budget resources through the financial sector to private and municipal entities developing housing projects for family groups with an aggregate income below US$180 equivalent, such resources to be borrowed and on-lent by the financial sector at the relevant market interest rates; (ii) established a well targeted and efficient system of subsidies to low income beneficiaries through direct and transparent means; (iii) eliminated financial sector's forced investment as a net source of financing to the sector and defined a plan for phasing-out ICT's liabilities to the sector; and (iv) established a satisfactory incentive structure promoting private sector and NGO participation in the sector, including a substantial reduction of interest rate-related subsidies. In the Letter of Development Policy, the Government has undertaken to phase-out these credit subsidies, subject to improved fiscal capacity. 94. Agricultural Marketing. The Government has announced its intention to rationalize the role the public sector has played in agricultural marketing. It is the Government's intention to eliminate IDEMA's monopoly on agricultural imports and to replace the import quota system administered by the Ministry of Agriculture with a tariff-based protection system. The Government does not intend at this stage to reduce the protection levels afforded to domestic producers. However, in the medium-term it would reduce protection in terms consistent with the objectives of the overall trade reform program. 95. The technical assistance component of the loan will finance a study aimed at defining the technical and economic work required to carry out the proposed sector reform, including the possibility of establishinj a system of variable tariffs and price bands, the consistency of the proposed protection regime with the current price support system and the restructuring of IDEMA in line with the new role assigned to the public sector in agricultural marketing. 96. The Letter of Development Policy contains the general policy objectives and specific undertakings the Government will pursue in the agricultural marketing sector. As a special condition of tranche release (see para. 101), the Government would have established a transparent and automatic system to allow the private sector to freely import selected agricultural products which are currently reserved for import by IDEMA and the conversion of the import- quota based regime for these products into a tariff-based protection system. C. LoaA Historv 97. Discussions regarding the proposed operation were initiated in December 1989 as part of the dialogue that was initiated with thte Government on Bank's assistance to the Economic Modernization Program. The Government agreed at that time to define a public sector reform program that would build upon actions recently taken to improve public sector manageme t and would seek to undertake reforms aimed at supporting the objectives of the Economic Modernization Program. Preparation missions took place in January and March of this year leading to the definition of the Public Sector Reform Program and che conditionality for the  - 34 - proposed loan. The program was appraised in June 1990. Loan negotiations took place in Washington D.C. beginning November 1, 1990. The Colombian negotiating team was led by Ms. Monica Aparicio. D. Loan Amount and Tr-pnchina 98. The proposed loan would be for US$304 million. The IDB has committed in principle parallel financing for the proposed operatlon in the amount of UC$305 million. Loan disbursements would be linked to satisfactory progress in the implementation of the reform program and the maintenance of macroeconomic performance consistent with the objectives of the Economic Modernization Program. Due to the phased nature of the program, it is proposed that loan disbursements be made in three separate tranches over a two-year period equivalent to US$100 each. In addition the loan will finance a US$4 million technical assistance component that will not be subject to tranching. The Closing Date of the proposed operation is December 31, 1992. E. Loan Conditions 99. The following are specific conditions for second tranche release: (a) Maintenance of a macroeconomic framework consistent with the objectives of the Economic Modernization Program. (b) Compliance with the policy objectives and programs included in the Public Sector Reform Program described in the Letter of Development Policy. (c) Performance plans with COLPUERTOS, ICEL, CORELCA and IDEMA have been signed and made effective consistent with the objectives set forth for the PPES. (d) First-round performance plans are being implemented in accordance with their objectives, terms ant timetables or that remedial action, has been taken ensure compliance with agreed objectives. (e) The Government has defined a restructuring program for COLPUERTOS aimed at adjusting its operations and functions to the Alew sector environment. (f) The Government would have taken the following actions to improve competition in the shipping sector: (i) eliminate ceiling on remittance of freight receipts applicable to foreign liners; (ii) reduce the reserved quota on bulk import cargo to no more than 5% of total bulk imports, and (iii) streamline mechanisms to control compliance with reserve quotas. (g) The Government has brought to the point of sale the Banco de los Trabajadores, Banco de Comercio and Banco Tequendama, either individually or after merging these banks in any combination.  - 35 - 100. The following are specific conditions for third tranche release: (a) Maintenance of a macroeconomic framework consitent with the objectives of the Economic Modernization Program. (b) Compliance with the policy objectives and programs included in the Public Sector Reform Program described in the Letter of Development Policy. (c) Performace plans with SENA, ISS, ISA, and CVC have been signed and made effective consistent with the objectives set forth for the PPES. (d) Implementation of the PPES in accordance with its objectives, including the evaluation of public sector managers included in the first-round performance plan and application of the agreed management incentive scheme. First-and second-round performace plans are being implemented in accordance with their objectives, schedules and targets or remedial action, has been taken to ensure compliance with the above mentioned objectives. (e) The Government will have defined an action plan to improve competition in the shipping sector and substantially lowered flag law reserve quotas on general imports. (f) The Government will have defined a strategy and satisfactory related schedule of actions to privatize or restructure, with the aim of total or partial divestment, Banco de Colombia and any other nationalized banks brought to the point of sale for which no acceptable bids have been received. (g) The Government will have implemented the restructuring program for COLPUERTOS in accordance with its respective objectives, action plans and timetables. 101. The following are special conditions of tranche release aimed at providing the Government with some flexibility in the management of its legislative agenda (see para. 111). The Government will be required to comply with at least one of these conditions at the time of second tranche release and with the two remaining conditions at the time of third tranche release: (a) The Government will have restructured its port sector, including a uniform tariff regime, the scheme of compensation for the use of public resources, the system for granting licenses to port investors/operators and the separation of the regulatory and operating functions within the sector. (b) Implementation of the following reforms in the low income income housing sector: (i) eliminate ICT's role as financier and constructor of low income housing; (ii) establish a well targeted and efficient system to low- income beneficiaries through direct and transparent means; (iii) establish an incentive forced investment by the financial sector as a source of net financing for the sector and adopt a plan for phasing out ICTs liabilities to the financial sector.  - 36 - (c) The establishment of a system allowing the private sector to freely import selected agricultural products currently reserved for import by IDEMA and the conversion of the current import quota system to a tariff-based protection system for these products. F. Disbursements. Procurement and Auditina. 102. Disbursement of the policy component of the loan (equivalent to US$300 million) will be linked to satisfactory adherence to the policy objectives defined iin the Letter of Development policy and compliance with the specific conditions of tranche release (see above). This component will be used to finance the CIF cost of eligible imports by the public and private sectors. Ineligible imports comprise goods financed by other multilateral or bilateral sources, luxury goods, goods intended for military purposes and other included in a negative list. Disbursements against contracts valued in an amount not exceeding US$5 million equivalent may be financed out of the loan proceeds on the basis of statements of expenditures, with the documentation retained by BR fcr review by the Bank as required. Disbursements against contracts exceeding said amount will require full documentation. No prior approval by the Bank of the individual contract and corresponding procurement procedures will be required. Retroactive financing in the amount of US$60 million equivalent would be available for eligible expenditures incurred after September 1, 1990. 103. In addition the loan will finance the cost of consultants' services included in a technical assistance component aimed at providing the technical, economic and legal underpinning for the sector reforms and restructuring programs included in the Public Sector Reform Program. In this line this component will finance the preparation and implementation of performance plans by selected public entities and studies required to define policies and action plans in tne areas of shipping, railways, ports, banking, public enterprise restructuring and agricultural marketing (Annex 13). The cost of this component has been estimated at US$8.0 million equivalent of which US$4.0 million will be financed out of the proposed loan. The disbursement of this component will coincide with the disbursement of the policy component of the loan. Consultants financed by the loan will be employed in accordance with procedures and criteria set forth in the "Guidelines for the use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency" and with terms of reference and conditions of employment satisfactory to the Bank. 104. Procurement of general imports will be carried out in accordance with the Bank's Procurement Guidelines. Contracts for goods estimated to cost in excess of US$5 million equivalent will be procured through ICB, with simplified requirements in terms of advertising and currency provisions. Public sector contracts valued below US$5 million may be carried out following the standard procedures of the purchasing institutions. Public sector procurement procedures in Colombia have been reviewed by the Bank and found satisfactory for these purposes. Private sector contracts valued below US$5 million will follow established commercial practice. The Bank has been satisfied in the past--in the coniext of its industrial development lending and the previous quick disbursing operations--with the procurement practices followed by the private sector in Colombia. Although competition has been adversely affected by the inward orientation of the trade regime and some domestic policies (i.e.,  - 37 - regulation of selected prices and barriers to entry), the private sector has been oriented towards seeking efficiency and cost effectiveness in acquiring the goods and services required for investment and production purposes. The Government's decision to open the economy to external competition and remove domestic barriers to competition constitutes a substantial improvement of the incentive framework to further promote efficiency and cost effectiveness in private sector procurement. 105. Some limited procurement of equipment (estimated not to exceed US$1 million) maybe required under the Technical Assistance component. Contracts for equipment estimated to cost le3s than US$25,000 maybe procured through local shopping; contracts estimated to cost over US$25,000 and less than US$100,000 maybe procured through limited international shopping procedures and contracts estimated to cost more than US$250,000 shall be procured in accordance with ICB. The Bank will require prior review of contracts exceeding US$300,000 and the first two contracts estimated to cost less than US$100,000. 106. BR will be responsible for the coordination and collection of relevant documentation to support withdrawal applications. It will maintain separate accounts to record and monitor loan disbursements under the quick disbursing component. These accounts will be audited not later than 90 days after completing disbursements under each of the loan tranches in accordance with sound accounting principles by independent auditors acceptable to the Bank. Disbursements of the technical assistance component will be channelled by the Government to the relevant agencies. G. Monitoring and Reportina. 107. The proposed operation will require monitoring of the implementation of the various elements of the EMP and, more specifically, c-f the various institutional reforms and actions included in the Public Sector Reform Program. The Bank will carry out its monitoring of the EMP through regular supervision and exchange of views with the Government. The areas to be covered in the monitoring are: (i) the Government's macroeconomic program to ensure the attainment of the objectives of the EMP; and (ii) the Public Sector Reform Program. The Government of Colombia has recently agreed that a soecial procedure be followed to provide the Bank staff with the basis for assessing the adequacy of macro-economic perform: ce for the purpose of the tranche releases. Under this procedure, the Bank and the Fund would collaborate in assessing performance through joint missions to the country twice a year. As part of the agreement the Colombian authorities have formally communicated to the Bank and the Fund the main targets of the economic program, including specific macro-economic indicators that would serve to provide the needed elements for the Bank's overall judgement on the appropriateness of macro-economic performance. The specific macro-economic indicators include annual targets for the 1990-1992 period on the fiscal deficit, the external account deficit, international reserves, expansion of financial credit to the public and private sector, expansion of net domestic assets of the Banco de la Republica, external debt, and external debt service ratio. It is envisaged that the Bank's overall assessment of macro-economic performance will incorporate and take into account the Fund's review and assessment of progress. The monitoring of the Public Sector Reform Program will require evaluating progress in the carrying out of the institutional reforms and  - 38 - specific actions which have been specified as conditions of tranche release. Performance of public entities included in the PPES will be carried out in accordance with the targets set out in the respective performance plans. The Government has assigned to CONFIS the responsibility for monitoring and evaluating the public entities' performance semi-annually. H. Benefits and Risks. 108. The proposed reforms are expected to result in significant improvements in the public sector's resource use efficiency and financial performance. Those areas that are likely to continue to be dominated by the public sector, e.g., petroleum and power, are expected to improve their efficiency and financial performance initially as a result of improved investment planning and pricing policies. For the period 1990-92, the DPS is expected to improve its fiscal performance by -bout 1 point of GDP, moving from a deficit of .56% of GDP in 1990 to a surplus c .55% of GDP by 1992, as a result of higher revenue generation, while maintaining expenditures under control. The improvement in the DPS' fiscal performance will contribute to attain overall fiscal balance, or even a small surplus, by 1992. Improved fiscal performance constitutes a basic condition for the successful implementation of the EMP. It is difficult to estimate at this time other efficiency and financial performance gains derived from the introduction of the PPES, such as those deriving from cost reductions, improved managerial practices and increased administrative efficiency. However, initial diagnoses carried out in the preparation of the first round of performance plans show there is ample margin for additional gains derived from improvements in those areas. 109. The elimination of entry and competition constraints in railways, ports, shipping, banking, agricultural marketing and low-income housing will lead to increased efficiency in the allocation and use of resources in those sectors, and consequently, to a more dynamic growth pattern and substantial improvements in output quality and cost efficiency. In the case of the transport and financial sectors, this reforms will also be essential to satisfy the productive sector's needs under a more competitive incentive structure derived from the Government's trade reform program. 110. There may be some adverse social effects derived from the need to lay off personnel from various public entities that have gross overstaffing problems e.g., railways, ports, ICT and telecommunications. The recent experience in the railways shows that the short-term negative effects can be substantially neutralized by providing adequate compensation packages, allowing early retirement for people that have completed a significant period of service, and phasing lay-off s over a period of time, thereby providing staff with a transition period to seek otner employment opportunities. The labor related cost for the restructuring of the public companies in the railways, ports, low-income housing and telecommunications sectors have been estimated to exceed US$350 million. 111. The Government has made a strong commitment to carry out the sector reforms included in the program and has made substantial progress in defining the strategy elements and costs associated with their implementation. In the case of the reforms proposed for the ports, housing and agricultural marketing sectors, the Government has decided to seek legislative changes to put into  - 39 - effect the proposed reforms as the most expedient and effective means to ensure their timely and successful implementation. In order to reduce the risks involved in ensuring congressional approval for the proposed reforms, the Government has decided to seek as early as possible the corresponding authorizations. In case the Government fails to obtain Congressional approval for the sector reforms proposed, it is expected that it could still achieve the reform objective within the existing regulatory framework. However, in this case the risks of incurring significant delays in implementing the proposed reform program and, in some cases, of compromising its policy objectives would be higher. The strong support enjoyed by the new administration - both from public opinion and in Congress - and its decision to give priority in its legislative agenda to the matters included in the reform program mitigates the risks involved and implies favourable prospects for a successful and timely implementation of the reform program. In addition, to provide added flexibility to the Government in managing its legislative strategy, those conditions of tranche release which will require some form of Congressional approval have been grouped in a special category of conditions (see para. 101). The Government would have to comply with any one of those conditions prior to second tranche release and the two remaining conditions prior to third tranche release. PART IV - BANK GROUP OPERATIONS Lending Oierations and Economic Sector Work 112. Since the World Bank Group started its operations in Colombia in 1949, it has approved 128 loans totalling US$6.3 billion, and one credit of US$23.5 million (both net of cancellations). As of June 30, 1990, the amount of loans disbursed was US$5.23 billion, leaving an undisbursed amount of US$1.09 billion. Of these amounts, US$2.22 billion has been repaid. One Hundred and two lo...s totalling US$3.6 billion and one IDA credit of US$23.5 million have been fully disbursed. IFC has a total gross commitment of US$181.3 million in 34 enterprises, of which US$195.1 million was loans and US$36.2 million equity. 113. After steady lending in the 1977-83 period, averaging US$340.7 million per year, lending levels increased to over US$700 million a year in FY85-86, then dropped to US$180 million in FY87. During the period of higher than normal lending, the central focus of the lending program was three quick-disbursing loans (Power Development Finance (FEN), Trade Policy and Export Diversification (TPED), and Trade and Agricultural Policy (TAP)). These operations played a key role in mobilizing external resources (commercial bank loans) in support of the Government's macroeconomic program. The Government complied with specific conditionality and overall macroeconomic performance was excellent. In FY88, the lending program picked up substantially totalling US$465 million (including an adjustment loan for the Power Sector for US$300 million). It then dropped to US$180 million in FY89, and was constituted by project investment operations, based on sector development program. In FY90 lending amounted to $1S7 million for three investment projects. 114. As a result of an ongoing economic policy dialogue with the Government and in response to Colombia's evolving needs, the profile of Bank lending has  - 40 - changed over time. Though the Bank has financed projects in virtually all sectors of the economy, the focus, in the early years, was mainly towards the power and transport sectors. In the mid-60s, 88% of Bank loans were made in these two sectors. By contrast, from the late 1970s, about 50% of the loans made to Colombia were for a more diversified set of sectors, though power still played a major role. 115. The Bank has had a productive dialogue with the Government on a wide range of economic and sector issues based on the Bank staff's analytical work. The Bank discussed with the Government an Economic Memorandum (Report No. 7629- CO) in May 1989, which addressed the most pressing issues affecting development in the medium term and efficiency of production. The Bank's survey of Trade Policy and the seminar organized to discuss the report and present the experience with trade liberalization in other countries, were important in strengthening the Government's resolve to proceed with further trade liberalization. In the past few months the Bank has also discussed with the Government studies on Industrial Policy and Performance, Decentralization, Irrigation, and Technical and Vocational Education. In the area of poverty alleviation, the Bank's work has been welcomed and widely discussed in the country. For example, Community Child Nutrition and Development Project (FY90) an operation focussed on the feeding and protection of children in the poorest communities of Colombia, grew directly from the work of the report. In the Primary Education II Project (FY89), report recommendations helped target additional lending to children in poor urban neighborhoods with no prior access to schooling. Bank Assistance StrateQv 116. The new Government's economic policies reflect a strong commitment to accelerate the pace of reforms begun by the previous government and to broaden their scope in order to establish the basis for sustained growth. The speed and comprehensiveness of policy initiatives begun or proposed in trade policy, agricultural policy, financial sector development, and privatization/public sector reform are unprecedented in Colombia, a country which has been characterized by prudent macroeconomic management but a very gradual pace of economic policy reform. The Government has at the same time reaffirmed its commitment to poverty alleviation through better targeting of social programs and improvements in the efficiency of delivery of social services. In responding to these important initiatives the Bank has designed its lending program to support the opening of the economy, policy reform in the agricultural sector, improved productivity of public investments in infrastructure, and human resources development targeted at poverty alleviation. In addition, all proposed operations which provide credit to the private sector will be developed within the context of the proposed financial sector reform program of the Government. Bank lending operations will be focused on each of these objectives and will support policy reform and institutional development in each area. 117. In addition to the assistance provided to the Government through the proposed operation, the Bank will support the Government's efforts to increase private sector productivity through investment lending operations, technical assistance, and economic and sector work to support reforms in trade, agricultural, and financial sector policies. An industrial restructuring project, a project to support privatization and restructuring of the industrial  - 41 - development bank (IFI), and a possible export development project are intended to support the trade reform. Projects for agricultural diversification, agricultural technology transfer, and a possible agricultural credit operation will be developed to support reforms in the agricultural sector. Bank agricultural sector lending will also incorporate an important element of environmental protection via land use and forestry components or stand alone operations. 118. All proposed operations which channel resources to the private sector via the financial system (eg. industrial restructuring, IFI, agricultural credit, and export development) will also support the financial sector development strategy of the government, which emphasizes liberalization of financial markets and enhanced competition among financial agents within a strong prudential regulatory and supervisory framework. The Bank is in the process of agreeing with the government on a financial sector framework which will set out the objectives, instruments, and goals to be pursued in the financial sector during the current administration. Individual credit operations will be developed within the context established by the framework and will support specific improvements in the efficiency of resource allocation in the financial system. Sector work on the competitive structure of the financial system is planned to begin in FY90 and be completed in FY91. 119. A second major area of focus of the Bank program will be on enhancing the productivity of public investments through reforms in public enterprises, 3upport for decentralization, and selected investments in infrastructure. The proposed Public Sector Reform Loan will establish the basic policy framework within which future investments in infrastructure will occur. Proposed lending operations and sector work in the power sector, transport for trade, urban development, and water supply and sanitation will deepen reforms and improve the efficiency of public investments in these sectors, thereby facilitating the supply response of the economy to the reforms of incentives discussed above. 120. Poverty alleviation and human resources development is the third element of the Bank's assistance strategy. The government has requested Bank support for initiatives to improve the efficiency of the primary health care and education systems, as well as continued support for its successful initiatives in child nutrition and maternal care. The Bank has proposed that the government select either health care or education as a sector of focus for 1990-1992. It will then define, together with the government, a program of sector work and lending development which will lead to a substantially strengthened lending pipeline in the sector. The process will be repeated for the other sector in 1992-1994. By focusing our resources in one sector and taking a comprehensive approach to policy analysis and project development, the Bank should enhance the efficiency of its operations in human resources development and poverty alleviation. 121. The overall lending program for FY91-93 consists of ten loans in the above sectors for an amount of about $1,500 million. With rapid implementation of the policy reforms described above and improved project development the program could increase to twelve loans with an average commitment level of US$600 million per year. Our lending strategy calls for a major focus on investment programs and lines of credit for the private sector. No new quick-disbursing  - 42 - operation would be contemplated under the proposed lending program. Experience has shown that financing of a time-slice of subsectoral investment programs with a sectoral policy focus (an intermediate approach that lies between a specific investment and adjustment lending), although time consuming, has proven to be more effective in Colombia than lending simply for specific investment projects. This approach has already been initiated in the human resources and water supply sectors. We plan gradually to incorporate this approach in other sectors such as agriculture, highways and energy. Important institution building efforts will continue to be incorporated in sectoral lending. 122. There has been a marked decline in the size of the overall portfolio: 41 projects at end FY87, 31 at end FY89, and further declines are expected as old loans come to their closing dates. This decline reflects reduced project ler. iing from 1984 to 1987, while focusing on fast-disbursing and sectoral loans. As fast-disbursing loans have been phased out, net disbursements declined and b .ame negative in the second semester of CYSS. The Government has started to Luild up its project preparation efforts and to remove obstacles to disbursements of existing loans. A recently established system of high level program reviews between the Government and the Bank has been designed as a vehicle to discuss issues affecting ongoing loans and the policy agenda. 123. Overall, project performance is good. However, there are still some problems affecting project implementation due to constraints on counterpart funds and weaknesses in administration and management of procurement. These issues have been and will continue to be addressed through the Annual Country Implementation Reviews, by supervision missions and by our Resident Mission. Risk Analvsis 124. IBRD exposure in Colombia, in terms of share in guaranteed debt, has historically been high. In 1988 the ratio of IBRD debt service to exports was 9.7% and the IBRD share in MLT guaranteed debt was 27.9%. These large shares are the result of several factors, among them: the sharp appreciation of non- dollar currencies in the IBRD portfolio; the quick-disbursing loans in the period 1984-87 in support of the major readjustments in the Government's macroeconomic policies; and the relatively low borrowing of the country from other sources. The Bank's exposure in Colombia is expected to decrease significantly in the coming years in the absence of quick disbursing operations, bringing exposure levels in line with Bank guidelines by 1996. From an economic perspective, Bank risk can be considered only moderate given the strong creditworthiness indicators projected for the medium term. In addition, the country's demonstrated sound and conservative macroeconomic and debt management, and its strong prospects for export growth and for increased fiscal revenues, are factors which further attenuate the risks of Bank's exposure in the country. 125. IFC's involvement in Colombia is long-standing. Between 1959 and September 30, 1989, total gross commitments were US$239.3 million of which US$195.1 million was loans and US$36.2 million equity. IFC has recently made intensive efforts to broaden its involvement. Projects in cement, textiles, petrochemicals, coal, and energy are currently under review. Privatization and expansion of a government-owned ship repair yard is also proceeding and corporate credit lines with several large integrated groups are being developed. Advisory  - 43 - services are under consideration as well as further assistance in development of Colombia's capital markets. Although foreign private investment restrictions were loosened in 1987 and the Government has indicated it would welcome joint ventures and other forms of investment to develop the economy, IFC's operations are still somewhat constrained by the time consuming regulatory framework surrounding foreign investment, and security issues are seen as a growing constraint. PART V - COLLABORATION WITH THE IMF 126. IMF staff have maintained an active role and closely collaborated with the Bank and the Government in the preparation of the operation, specifically in assessing the appropriateness of the medium-term macroeconomic framework proposed by the Government for undertaking the EMP. Arrangements have been agreed to ensure IMF participation in the monitoring of progress in the implementation of the macroeconomic program. These arrangements ensure that the very close and effective collaboration between the Bank and the Fund in dealing with Colombia will be maintained in the future. PART VI - RECOMMENDATION 127. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank, and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Attachments November 26, 1990 Washington, D.C.  - 44 - TABLE 1 Colotbia rediuf-Torm Balance of P$Yrents - BASE CASE 1/ (in U.S. million) ----- ----- Prelim Projected -------------.-------.--- 1985 1966 1967 1988 1989 1990 1991 1992 1993 1994 CURRENT ACCOUNT -1596 S35 -50 -197 100 341 -27 -138 54 187 Trade Balnce 109 2024 1461 827 1481 1874 1791 1493 1715 1678 Exports, f.o.b. 3782 5433 5255 5343 6030 6894 7532 7813 8654 9336 Coffee 1702 2742 1633 1621 1477 1393 1493 IS60 1644 1761 Hydrocarbons 409 619 1342 988 1400 1962 2037 1690 1714 1461 Coal 126 201 263 304 457 565 626 701 857 1007 Gold 365 460 385 413 365 371 400 430 463 498 Nickel 55 48 76 161 188 138 129 129 128 127 Other 1125 1363 1556 1856 2144 2465 2847 3303 3848 4482 Imports f.o.b. 3673 3409 3794 4515 4549 5020 5741 6320 6939 7658 Nonpetroleun 3207 3279 3692 4368 4338 4770 5479 6067 6678 7361 Petroteum 466 130 102 147 211 250 262 253 261 297 Services (net) -2166 -2274 -2512 -1988 -2408 -2583 -2818 -2631 -2661 -2491 Credit 1068 1364 1360 1653 1614 1693 1785 1899 2042 2207 Factor 208 233 220 335 341 369 357 374 403 440 Vonfactor 860 1131 1140 1319 1274 1324 1428 1525 1639 1767 Debit 3234 3638 3872 3641 4023 4276 4603 4530 4703 4698 Factor 1/ 1918 1985 2194 2094 2360 2550 2701 2563 2614 2490 o01: public nt. 877 964 1109 1154 1211 1244 1255 1282 1308 1317 private imt. 426 381 262 274 281 226 226 238 248 259 other (profit remit) 61S 640 823 666 868 1080 1220 1043 1058 914 Nonfactor 1316 1653 1678 1-47 1663 1726 1902 1967 2089 2208 TransferS (net) 461 785 1001 964 1028 1050 1000 1000 1000 1000 ......*.................... .................. ..................................... _................ ...................... ....... ............_ CAPITAL ACCOUNT 1863 825 -160 585 48 *41 -22 66 -91 -239 Public sector (ret) 1386 800 -179 616 408 199 -69 46 16 -157 Disbursements 19M 280? 1202 2247 2109 2033 1807 1737 1744 1643 Amortization 646 928 1245 1627 1707 1858 1831 1671 1708 1780 Short-term (net) 239 -1079 -136 -4 5 25 -45 -20 -20 -20 Nonfinancial pvt sector (not) 495 560 86 -236 -325 -183 -18 -37 -168 -150 Direct investment (net) 1016 562 287 179 546 344 380 472 338 332 Long-term loan (net) 193 189 -59 45 -180 -11 -16 -103 -81 -39 Other (net) 2/ -714 -191 -142 -460 -692 -517 -382 -407 *426 -443 Financist pvt sector (net) -18 -535 -68 205 -34 -57 65 St 61 68 .........................