Bolivia - From stabilization to sustained growth

Report No. 9763-BO Bolivia From Stabilization to Sustained Growth October 1, 1991 Country Operations Division I Country Department III Latin America and the Caribbean Region FOR OFFICIAL USE ONLY B= ,s~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~C i'm of ,. ' ' This docuffent has a restricted distribution and maybe used by recipients mWy in fth perf*ffance of the4r official duties. Its contents may not othewise be dtsciosed without World Bank authorization.  FISCAL YEAR January 1 to December 31 CURRENCY EOUIVALENTS Currency Unit: Boliviano (Bs) Exchange Rate Effective December, 1990 US$1.00 = Bs 3.40 Bs 1.00 = US$0.29 tBBREVIATIONS BAB - Banco Agricola de Bolivia (Bolivian Agricultural Bank) BAMIN - Banco Minero (Bolivian Mining Bank) BANEST - Banco del Estado (Bolivian State Bank) BCB - Banco Central de Bolivia (Central Bank) CRA - Certificado de Reintegro Arancelario COMIBOL - Corporacion Minera de Bolivia (Bolivian Mining Corporation) ENDE - Empresa Nacional de Electricidad (National Eelectricity Company) ENFE - Empresa Nacional de Ferrocarriles (National Railways Company) ENTEL - Empresa Nacional de Telecomunicaciones (National Telecom Company) ESF - Emergency Social Fund FONEM - Fondo de Exploracion Minera (Mining Exploration Fund) GSF - Gerencia del Sistema Financiero (Financial System Unit) GD - Gerencia de Desarrollo (Development Unit) IDA - International Development Association IDB - Inter-American Development Bank IMF - International Monetary Fund LAB - Lloyd Aereo Boliviano (Bolivian Airline) LIBOR - London Interbank Offering Rate NEP - New Economic Policy SAFCO - Sistema Integrado de Administracion Financiera y Control SISIN - Sistema de Informacion sobre Inversiones SNIP - Sistema Nacional de Inversiones Publicas VAT - Value Added Tax YPFB - Yacimientos Petroliferos Fiscales de Bolivia (Bolivian Petroleum Company)  FOR OFFICIAL USE ONLY Page 1 of 2 BOLIVIA - COUNTRY DATA SHEET AM: 1098.6 POPULATION (1990): (millions) 7.31 DENSITY: 6.46 pop./sq. km. (thou. sq. km.) Rate of Growth: 2,8% POPULATION CHARACTERISTICS HEALTH Crude birth rate (per 1000): 42.0 Infant mortality (per 1000 live births): 106 Crude death rate (per 1000): 13.5 Population per physician: 1538 ACCESS TO SAFE WATER % of population - urban: 82 - rural: 27 NUl2J1O-N EDUCATION Daily calorie supply per person: 2086 Primary school enrollment-(%) of Per capita protein intake (g/day): 57 relevant age group: 91 % GNP Per cavita (USS 1990) 619.4 GROSS NATIONAL PRODUCT 90 USS Mn % ANNUAL RATE OF GROWrH (% CONSTANT PRICES) 1980-85 1985-89 1990 GDP at Market Prices 4473 100.0 -2.6 2.5 3.0 Gross Domestic Investment 510 11.4 -18.5 0.2 0.2 Gross National Saving 153 3.4 Current Account Balance -357 -8.0 Exports of Goods, NFS 9S6 21.4 -5.5 10.2 12.6 imports of Goods, NFS 1092 24.4 3.0 -3.5 3.3 VALUE ADDED IN 1990 1980 Bolivianos as % of GDP Agriculture 25,190 21.1 Industry 37,820 31.7 Mining 10,821 9.1 Hydrocabons 7,789 6.5 Manuf. and Contruct. 19,210 16.1 Services 56.480 47.3 TOTAL 119,490 100.0 GOVERNMENT FINANCE Consolidatet Public Seoctor General Govermment ,(mil. Ba8) % of aD (mil. RS) X -of GD 1990 1220 1989 1990 1989 1990 Current Receipt 3235 22.7 2329.0 3001.5 19.2 21.1 Curret Expenditure 2876 20.2 2424.4 2922.4 20.0 20.5 Current Surplus 359 2.5 -95.4 79.2 -0.8 0.6 Capital E _endtu 1084 7.6 819.2 920.3 6.8 6.4 |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 withotut World Bank authorization.  Poggu 2 of 2 BqLWIA - COUNTRY DATA SHEEr MONEY. CRBDfr & PICES 1985 1986 1987 t988 1989 1990 (Dn. of B4 outstanding at end of pefiod) Money Supply (M2) 290 822 1175 1682 2244 3339 Dank Credit to Public Sector -215 -508 -408 -159 364 525 Bank Cedit to Private Sector 409 947 1376 1852 2629 3710 Money as % of GDP 12.9 11.0 13.3 16.2 18.5 23.5 General Price Index (1980- 1I 18159 68278 78265 90795 104596 122482 Annual percentsag cbhnges in: General Price Index 11770.0 276.0 14.6 16.0 15.2 17.1 fan Credit to Public Sector .. .. .. BcnkCreditto PrivateSecotor 14450.0 131.5 45.3 34.6 42.0 41.1 BALA CE OF PAYMENTS MERCHANDISE EXPORTS (AVG 88-90) 1986 1987 1988 1989 1990 USS Miu % Export of Goods, NFS 704.5 652.7 673.1 868.5 955.9 rm 111.1 15.8 Inport of Ooods, NFS 816.0 920.5 914.7 1034.1 1092.5 Zinc 70.2 10.0 Trade Balance -111.5 -267.8 -241.6 -165.6 -136.6 Silver 37.6 5.4 Natural Gas 267.7 38.2 Net Factor Services -308.9 -238.8 -260.0 -249.3 -242.5 Other 214.3 30.6 Net Private Trnsfers 17.0 17.9 12.8 21.9 21.6 Total 700.9 100.0 Currnt Account Balance -403.4 -508.7 -488.8 -393.0 -357.5 EXTERNAL DEBT, DECEMBER 31. 1990 Capital Account 358.1 173.7 312.8 379.5 381.1 Net Official Transfers 82.0 103.2 123.9 133.9 138.4 Public Debt, incl. Guar. 4157.1 Private Capital Flow 1' 10.0 36.4 30.0 35.0 35.0 Non-Gu2r. Priv. Debt 200.0 Net LT Lending 292.2 84.0 161.8 239.5 94.7 Total Outst. & Diab. 4357.1 Disbursements 395.8 375.7 401.8 451.5 367.4 AmortizationY 103.6 291.7 240.0 211.9 272.6 Other Flows -26.1 -49.9 -2.9 28.9 112.9 DEBT SERVICE RATIO FOR 1989 Change in Reerve -110.4 41.0 29.8 139.8 -98.9 Public Debt, inc. Guar. 47.7 Non-Guar. Priv. Debt Excepuional Fumncini 155.7 294.0 146.2 -126.3 75.3 Outstading & Disb. 47.7 Gross Reserves Level 505.3 424.7 408.8 361.2 363.9 IBRD/IDA LENDING (12/31/90) Mil USS RATE OF EXCHANGE (sell Annual Averaege (USS Bn) IBRD IDA 1956 1987 1988 1989 1920 USS1.00-Cr S1.922 2.055 2.350 2.692 3.180 Outandwig & Dis. 193.6 393.3 CrSI.00-US $ .520 0.487 0.425 0.371 0.314 Unsbursed 0 233 Outs. incl. Undisb. 193.6 626.5 I/ Mosoy net direct foreign invedtment ZI Includes Capitalized interest It Amortfization paid only 41 Iicludes Short-erm cpital, privato non-guaranteed, errore and omissions, and unpaid gs receipts from Argentine 5/ Includes required rescheduting of amortization from bilateal creditors and changes in arrear.  This report is based on the findings of a World Bank mission which visited Bolivia in January 1991. The mission was comprised of Messrs./Mmes. Barbara Mierau (Mission Leader), Bill Shaw (Economist), Robert Taylor (Public Enterprise Specialist), Felipe Morris (Financial Economist), Mark Dutz (Industrial Economist), and Luisa Ardila (Consultant), assisted by Juan Carlos Aguilar of the Bank's Resident Mission. Katherine Baer (Consultant) provided a background paper on tax policy and administration, and Ceyla Pazarbasioglu (Consultant) provided a background analysis of annual manufacturing data. Jamil Mubarak assisted in the production of tables and the preparation of the projections. Marta Cervantes assisted in the production of graphs and coordinated the production of the report.  BOLWIA FROM STABILIZATION TO SUSTAINED GROUi`TH Table of Contents SUMMARY AND CONCLUSIONS ........................ i-ix L INTRODUCTION AND OVERVIEW .......................1 II. HISTORICAL BACKGROUND AND STRUCTURAL POLICY CHANGE . 3 A. Resource Base. 3 B. HEstorical Background. 4 C. Structural Policy Change in the Aftermath of the 1985 Reforms. 8 1. Reforming Incentive Structures. 8 2. Fiscal and Institutional Reforms .11 3. Redefining the Role of the Public Sector .12 IH. MACROECONOMIC PERFORMANCE .13 A. Economic Growth and Inflation .13 B. Fiscal Policy .16 C. Monetary Policy .19 D. Trade and the Balance of Payments .24 E. External Debt and Debt Service .27 F. Employment and Wages .29 G. Summary of Economic Performance .31 IV. A MACROECONOMIC FRAMEWORK FOR SUSTAINED GROWTH ... 33 A. Introduction .33 B. Medium-Term Macroeconomic Outlook .33 C. Conclusions. 40 V. CONSMRAINTS TO PRIVATE SECTOR GROWTH .41 A. Introduction and Summary .41 B. Structure, Size and Characteristics of the Private Sector .43 C Supply Response to the Ntw Policy Environment .45 1. Agriculture .46  - 2 - 2. Hydrocarbons ...................................... 48 3. Mining ....................................... 49 4. Manufacturing ........................... .............. S1 5. Summary of Main Findings .55 D. Constraints to Private Sector Investment .56 1. Restricted and Costly Credit .57 2. Infrastructural Deficiencies .60 3. Limited Domestic Markets .62 4. Low Confidence Levels .63 5. Obstructive Government Regulation .63 E. Recommendations for Accelerated Investment and Growth .64 1. Mobility-Enhancing Policies .65 2. Resource Augmenting Policies .65 VI. FINANCIAL SECTOR CONSTRAINTS TO GROWTH .67 A. Introduction and Summary .67 B. Structure, Size and Performance of the Sector ...................... 68 C. Main Issues Affecting the Sector .70 1. High Interest Rates .70 2. Financial Fragility of the Commercial Banks .73 3. Weaknesses of Supervision and the Regulatory Framework ......... 75 4. Misallocation of Credit by Public Banks ....................... 76 5. Distortions Caused by Development Credit ...... ............... 77 6. Impediments to Capital Market Development ..... ............. 79 D. Recommendations for Further Reform ............................ 81 VII. PUBLIC SECTOR MANAGEMENT FOR SUSTAINED GROWTH ...... 85 A. Introduction . ................................................ 5 B. Public Resource Mobilization ................................... 85 1. Introduction ............... ............................ 85 2. The Tax Reform and Remaining Tax Policy Issues ..... .......... 87 3. Summary and Recommendations ............................ 90 C. Public Enterprise Management .................................. 92 1. Structure and Performance of the Public Enterprise Sector .... .... 92 2. Current Initiatives ........... ............................ 95 3. Issues and Recommendations for Further Reforms ..... .......... 95 D. Managing Public Sector Investment .............................. 99 1. Introduction ............... ............................ 99 2. Structure of the Public Sector Investment Program ..... ......... 99 3. Performance of the Public Sector Investment Program .... ....... 99 4. Monitoring of the Investment Program ...................... 103 5. Constraints on Investment Performance ...................... 104  ANNEX A. The Bolivian Tax Structure ......... . ..... 107 ANNEX B: License and Control Requirements .111 ANNEX C: List of Public Enterprises by Ministry .113 STATISTICAL APPENDIX .117 MAP:  List of Text Tables Chapter III 3.1 Macro-Economic Accounts, 1980-90 ...............................13 3.2 GDP by Sector, 1980-90 ........................................... . 16 3.3 Consolidated Non-financial Public Sector Deficit, 1980-90 ....... .. .... 17 3.4 Monetary Aggregates, 1980-90 ......................... 20 3.5 Average Annual Interest Rates 1980-90 ..... ................... 23 3.6 Summary Balanice of Payments ...... .. . . . . . . . . . 27 3.7 External Debt Indicators 1980-1990 ........................ . 28 3.8 Labor Force and Employment ... ...................... ... ..... 30 Chapter IV 4.1 Base Case Projections, 1989-2000 .......................... 34 4.2 Medium-Term Export Projections .......................... 36 4.3 Balance of Payments Projections .......................... 37 4.4 Investment Financing, 1989-2000 .......................... 37 Chapter V 5.1 Performance of AgriculturalForestry Products .......................... 47 5.2 Main Mineral Exports. ........... I ... s@.. *v 50 5.3 Major Exporting Manufacturing Industries ...................... 52 5.4 Major Declining Manufacturing Industries .......................... 53 5.5 Capacity Utilization in Manufacturing. ................ 53 5.6 Major Investing Manufacturing Industries ....................... 55 5.7 Major Constraints to Investment by Trade Orientation and Activity .............................................. 58 5.8 Sources of Financing for Gross Capital Formation ......... .............. 59 5.9 Major Infrastructure Constraints by Trade Orientation and Activity ............................. 61 5.10 Fuel and Electric Energy Prices in Bolivia ............................. 62 Chapter VI 6.1 Financial Sector Indicators, November 1990 ....................... 68 6.2 Structure by Type of Instrument ........................... .. . . 69 6.3 Banking System Loan Portfolio by Sector ....................... 69 6.4 Average Yearly Interest Rates .................71 6.5 Recent Interest and CD-Rates ................................ 72 6.6 Commercial Bank Performance Indicators .................... 74 6.7 Classification of Loan Portfolio of Public Banks ................ 76  6.8 Effective Leinng Rates . ........................................... 78 Chapter VII 7.1 International Comparison of Value Added Tax Collections .................. 86 7.2 Domestic Tax Revenue as Percentage of GDP, 1980-90 .................... 87 7.3 Tax Revenue Collections, 1987-1990 ................................. 88 7.4 Relative Importance of Public Enterprises, 1989 ......................... 93 7.5 Performance Indicators of the Public Enterprise Sector, 1980-89 ..... ....... 94 7.6 Structure of Investment Expenditures ................................ 100 7.7 Execution of Public Sector Investment Program ........ ................ 101 7.8 Budgeting of Public Sector Investment Program ......... ............... 102 List of Grapbs Chapter m 3.1 Broad Money as Percent of GDP .21 3.2 Interest Rates on Dollar Accounts .23 3.3 Export Performance 1980.90 (Current US$ Million) .25 3.4 Non-Traditional Exports, 1980 (In US$ Million) .25 3.5 Wage Trends (Index 1985= 100).30 Chapter V 5.1 Private Sector Investment ......................................... 45  - j - SUMMARY AND CONCLUSIONS MACROECONOMIC PERFORMANCE AND OUTLOOK 1. The 1985 Adjustment Program. During the carly 1980s, Bolivia experienced rapidly deteriorating cconomic conditions, political instability, accumulation of an unsustainable debt burden, and severe macroeconomic mismanagement lcading to a hyperinflation crisis in mid- 1985. In order to restore control of the economy, the Paz Estenssoro Government, which took power in August 1985, adopted a radical stabilization program, including a massive devaluation of the exchange rate, increases in public sector prices, and reductions in Government expenditures to levels financable by available funds. As a result, the public sector deficit was lowered rapidly, and inflation was brought under control shortly after the announcement of the program. The stabilization measures were combined with an extensive liberalization of markets. Interest rates were freed, foreign exchange controls were eliminated, an auction mechanism was instituted to determine the exchange rate, restrictions on labor mobility were relaxed, virtually all quantitative restrictions on imports were eliminated, a low and uniform tariff was instituted, all restrictions on capital flows were lifted, price controls in almost all markets were eliminated, and prices of publ:c sector goods were adjusted to market levels. At the same time, the Government initiated programs to strengthen public institutions and to improve banking supervision. It also implemented a major tax reform to put public finances on a more sustainable basis. 2. The Success of the Program. The adjustment program has been highly successful in stabilizing the economy and in reducing internal and external imbalances. It was sustained even during severe terms of trade losses as international tin prices collapsed at the end of 1985. For the first time in nearly a decade the economy attained a positive GDP growth rate of 2.6% in 1987, and prudent macroeconomic management permitted the recovery to be sustained with steady GDP growth of 2.7% on average through 1990. Exports were the most dynamic element of the economy, expanding 18% annually between 1987 and 1990. Inflation was contained at 16% on average during this period and the fiscal deficit was reduced to 3.3% of GDP in 1990. The Government also made substantial progress in regularizing its relations with external creditors based on three Paris Club reschedulings (one on Toronto terms) and repurchases of two thirds of its commercial bank debt at 11 cents to the dollar, using funds provided by official donors. In addition, significant amounts of Bolivia's bilateral debt was written off in separate agreements with Argentina, Brazil and the U.S.A.. 3. Key Issue: Slow Growth. The key issue facing the Bolivian economy is that, since the 1987 recovery, GDP growth has stagnated at an average level of 2.7% per annum. While this recovery is in itself a remarkable achievement following the economic chaos during the early 1980s, the rather drastic changes in the economic policy framework following the implementation of the adjustment program, and the significant terms of trade losses since 1985, the current GDP growth rates remain below population growth of 2.8%. As a result, per capita income and consumption continue to decline, which may eventually lead to political pressures endangering the sustainability of the economic program. The fundamental challenge facing the Bolivian economy in the 1990s will therefore be to make the transition from stabilization at low levels of growth to more vigorous growth.  - ii - 4. Prospects for Acceleratina Growth. Several signs are emerging that would support cautious optimism about a possible acceleration of growth. Preliminary estimates by the National Statistical Institute based on data for the first three quarters of 1991 suggest that GDP growth may reach 4% for 1991 as a whole. Export growth over the past three years has been spectacular, with mining exports in current dollars increasing on average 25% per annum, agriculture and forestry exports increasing 49% per annum and manufacturing exports increasing 35% per annum, supporting a rapid expansion of export-oriented activities in these sectors. Also, according to preliminary data, private investment increased at a positive rate of about 4% in 1990 (arter nearly a decade of declining investment), suggesting a possible turn-around of private sector investment behavior, away from the retrenchment and "wait-and-see" attitude prevalent so far. In addition, foreign investors have shown an increasing interest in Bolivia, particularly in the mining and hydrocarbons sectors, since the passage of the Mining, Hydrocarbons and Investment Laws in 1990 and early 1991. These developments indicate that, in order to achieve higher rates of GDP growth, the Government should persevere with its present successful macroeconomic strategy geared towards maintaining economic stability and the continued implementation of the structural reform program to which it has committed itself. 5. Requirements for Medium-Term Growth. Assuming that Bolivia does persevere with its on-going program of macroeconomic stability and structural reform, it is pro;ected that domestic savings and investment will increase significantly during the 1990s. This would make possible not only GDP growth rates of 4-5% per annum but also modest increases in per capita consumntion and a gradual reduction in the nation's dependence on external capital flows. Continuing macroeconomic stability based on prudent fiscal and monetary policies will be the key to increasing overall confidence in the economy and to stimulating the necessary savings and investment. In addition, Government policy efforts in the next few years should be directed toward the following objectives: - Reducing constraints to private sector growth. Achieving GDP growth of 4-5% implies that private investment and savings rates need to double by 2000. This in turn will require reducing remaining impediments to private sector growth, especially cumbersome administrative procedures and infrastructural deficiencies. - Eliminatingfinancial sector constraints to growth. Private setL - performance will depend crucially on successful implementation of the Government's program for financial sector reform, which is supported by the new Structural Adjustment program (supported by IDA and the IDB, with additional cofinancing being considered by bilateral donors). These reforms will facilitate the mobilization of additional savings and increased efficiency in their allocation. - Improving public sector management. Despite the success to date in improving fiscal and monctary discipline, public savings must double from present levels in order to achieve the targeted GDP growth rates. Under current circumstances, the most important means to increase public savings will be improved tax collection and enforcement efforts. Higher public savings would provide the means to finance the physical infrastructure and the improvement in human capital, which are indispensable for accelerated growth. In addition, improving public sector management requires timely implementation of Government's program for public enterprise reform, which will privatize directly productive enterprises and improve the efficiency of enterprises remaining in the public sector. Finally, last year's successful efforts to  - iii - improve the overall management of the public investmcnt program need to be sustained and further strengthened so as to increase the level and efficiency of public investment. - Focusing public expenditure on the poor. Since savings rates need to increase significantly to achieve the targeted growth rate, per capita consumption will only recover gradually. Given the overall budget constraint, progress in reducing povcrty would therefore depend on efforts to redistribute Government expenditure on education, health and nutrition from the middle and the wealthy classes to the poor. 6. T'his report will focus on the first three of these priority objectives - reducing constraints to private sector growth, eliminating financial constraints to growth, and improving public sector management. The objective of focussing public expenditure on the poor and other issues of poverty alleviation are not addressed in this report because they have been covered extensively in a recent World Bank report. The report develops a reform agenda in pursuit of the above objectives, with a set of short and medium term policy measures for accelerated growth. Implementing these measures will be necessary to achieve long-term growth, but, looking ahead, Bolivia's future Governments will continue to face significant development challenges posed by the country's weak infrastructure, the underdevelopment of its human capital base, and its fragile environment. CONSTRAINTS TO PRIVATE SECTOR GROWTH 7. Lack of Investment Response. The adjustment program enacted in 1985 was based on the presumption that the private sector would act as the main "engine of growth" in the reactivation of the economy. Central to the design of the program was an increased reliance on the price system, on market mechanisms and on private initiative. Since the implementation of the stabilization and liberalization program, however, aggregate private investment has basically remained at the record low levels of 1985. While public investment accounts for nearly 8 percent of GDP, private investment accounts for merely 4 percent of GDP. The low levels of aggregate private investment to date suggest that producers may still be maintaining a "wait-and-see" attitude to the new policy environment, and that a proper supply response has not yet set in. This is worrisome since sustainable long-term growth depends on significant new investment in line with the changed structure of economic incentives. 8. Signs of a Supplv Response. While aggregate investment growth has been slow, the overall supply response of the private sector to the new incentive framework has been remarkable. The relatively moderate aggregate growth rates experienced by the Bolivian economy over the past four years in fact mask a substantial reallocation of resources within sectors as well as productivity improvements, in line with the changed incentive structure of the economy. Several observations can be made about the direction of the supply response in the major sectors. First, in sectors where the public sector has either retrenched significantly (mining) or stagnated (hydrocarbons), the private sector has expanded very strongly, with growth rates in excess of 20% in real terms over the past two to four years, leading to significant increases in private sector participation in these sectors. Second, while aggregate agricultural growth was rather disappointing, the production of export crops has responded very strongly to changes in relative incentives, and accounted for the bulk of the recent surge in non-traditional exports, which  - iv - doubled in 1989 and increased by a further 40% in 1990 in current dollar terms. Third, in manufacturing relatively moderatc growth rates mask dynamic increases in production and investment in export oriented or imported input-intensive subsectors, hidden in the aggregate figures due to major downsizing and exit in othcr non-competitive subsectors. Fourth, for the most part the above trends are related to improvemcnts in productivity and improved capacity utilization. Fifth, some positive signs have been emerging that investment may be recovering too. According to preliminary data, private fixed investment increased in aggregate terms at a positive rate of 4 percent in 1990, indicating a possible turn-around of private sector attitudes. A recent survey by the World Bank of large investors (see below) further confirms that there may be cause for cautious optimism: many of the interviewed firms, particularly in mining and hydrocarbons, and to a lesser extent in agriculture and manufacturing, indicated significant investment plans for the next three years in order to expand capacity and production. In addition, foreign investor interest particularly in mining and hydrocarbons has increased significantly following passage of the new Investment, Mining and Hydrocarbons Laws in 1990 and early 1991. Obviously, whether these investment plans actually materialize will depend to a large extent on whether remaining constraints to investment growth will be successfully reduced. 9. Constraints to Private Sector Investment Growth. A survey was conducted by World Bank staff between January and March of 1991 to identify investment constraints facing private sector firms in Bolivia. The results of the survey point to several important constraints which continue to impede more significant increases in private investment levels. Restricted access to development credit and the high cost of commercial credit, weak infrastructure (especially in terms of transport and energy services), continued low levels of entrepreneurial confidence and obstructive government regulations were identified by the interviewed firms as the most important obstacles. Although small and large firms differ in their emphasis of the relative importance and severity of constraints, the main obstacles to increased investment and growth are very similar for all private sector enterprises. 10. Further Reform Requirements. To overcome these obstacles and thus to facilitate a more vigorous investment response, Government action is required in a number of key areas. Most importantly, macroeconomic stability is a precondition for sustained economic growth. All Government actions must be pursued with utmost clarity and consistency to further restore and maintain the confidence of entrepreneurs in the management of the economy. In addition, an improved climate for private sector investment depends on both mobility enhancing and resource augmenting policies. Policy measures to enhance mobility should include additional financial sector reforms to ensure more widespread access to institutional financial resources and to broaden the range of available financial instruments. In addition, regulatory policies, such as licenses and certificates that do not fulfill essential public policy functions and impose barriers to entry, exit and expansion, should be phased out and the remaining regulations should be streamlined. A number of these issues will be addressed under a Structural Adjustment operation. Overall, private sector-led growth will not occur in isolation in Bolivia. Public investment in areas strictly complementary to private sector activities is essential. Such resource augmenting policy measures are mnost urgently needed to improve transportation and power- generating facilities, and to increase levels of basic education and technical/management training.  - v - FINANCIAL SECTOR CONSTRAINTS TO GROWTH 11. Financial Sector Reform. Policies governing the operations of the financial sector and the overall level of development and depth of the sector can have important bearings both on the volume of credit being intermediated, the pricing of financial instruments and the efficiency with which scarce investment resources are being allocated. A proper policy framework is therefore important to encourage the development of the financial sector as a conduit to investment and growth and to prevent it from posing a constraint to recovery. Since 1985, the Bolivian Government has undertaken a series of reforms aimed at developing a more resilient and efficient financial system responsive to market forces. These reforms included the liberalization of interest rates and of the exchange rate, the rationalization of reserve requirements, the resolution of the "de-dollarization" problem, a reorganization of the Central Bank, enhancement of the autonomy of the Superintendency of Banks and its strengthening, and the establishment of more stringent accounting and prudential regulations to reduce bank lending concentration and risks. These far-reaching financial sector reforms have been supported by various IDA operations and the IMF. 12. Recovery of the Sector. The reform program combined with the overall recovery of the economy supported a recovery of the financial system from hyperinflation and the economic chaos of the early 1980's which reduced financial intermediation to negligible levels. Financial assets increased as a result of stabilization, and the deposit base of the system stood at US$820 million at the end of 1990, compared to US$480 million in December 1988 and US$68 million in mid-1985. Financial depth (measured as the ratio of M2 to GDP) also improved tremendously, jumping from 4.7% in 1985 to over 1&% at the end of 1990, almost entirely due to increases in dollar or dollar-indexed deposits, which accounted for 89% of deposits in early 1991. 13. Outstanding Issues. Despite improvements in the performance of the financial sector in recent years, several issues continue to affect the system a whole. First, high nominal and real and interest rates are of particular concern due to their impact on investment levels and composition. High dollar deposit rates are linked to the perception of high country risk and to high interest rates paid by the Government on Certificates of Deposit (CDs) in order to finance the fiscal deficit. High spreads in turn are linked primarily to unduly high operating costs of banks and large volumes of non-performing loans. In the course of 1q91 the Central Bank's efforts to lower CD rates have succeeded in lowering deposit rates by several percentage points, but increased spreads have so far prevented lending rates from declining. Second, the weak financial condition of banks and other financial institutions (including the four public financial institutions) have impeded the efficient allocation of investable funds, while contributing to the high interest rate levels. These conditions are in part still a result of the hyperinflation crisis of the mid-1980s and the transition following the implementation of the 1985 stabilization and liberalifzation program. Other contributing factors that encouraged imprudent lending practices were Government refinancing of previously granted credit to commercial banks and subrogations of losses of the public banks. Weak supervisory capacity and regulatory authority contributed to this. Third, the legal and regulatory framework continues to hamper the broadening of financial instruments and the incipient development of capital markets. All of these issues were identified several years ago as key constraints to investment and economic growth and some progress in tackling them has been made. It will take additional time and further policy efforts to overcome these difficult problems.  - vi - 14. Policy Reform. The following financial scctor reform program has been developed and embarked upon by the Paz Zamora Government, supported by the Structural Adjustment Credit, to address the above issues and to establish a more efficient allocation of credit, to ensure that credit is used productively and to reduce interest rate levels over time: (i) a new Banking Law has been submitted to Congress to consolidate the significant progress that has been made in banking supervision and regulation since 1987, (ii) the Superintendency is continuing to strive to strengthen its capacity to supervise the system; (iii) the Government has issued a resolution committing itself to refrain from providing subsidies or refinancing previously granted credit to banks; (iv) the Government has issued decrees to close and liquidate the insolvent and inefficient public banks; and (v) the legal and regulatory framework is being modified to overcome artificial barriers to lending and to encourage the development of capital market instruments. The Government has committed itself to implement these measures supported by a Structural Adjustment operation. To lower the levels of nominal and real interest rates, it is also important that further progress is made in reducing the fiscal deficit, which would alleviate pressure on interest rates via issues of high interest bearing CDs. Progress needs to be made in all of these areas for the financial system to support the growth of productive investment in an efficient manner, and to minimize misallocations of scarce resources. PUBLIC SECTOR MANAGEMENT FOR SUSTAINED GROWTH. 15. Key Issues. The supply of public goods - transportation, communications, power, water, sanitation, education and health services - is essential to growth. In Bolivia, the level of public goods remains severely inadequate. Lack of appropriate infrastructure and a sufficiently trained and healthy workforce greatly impairs the productivity of private sector investment. Lack of water, sanitation, health facilities, and education services are the key causes of poverty and poor living conditions. However, the Government faces severe constraints in financing the necessary rise in public sector inv:stment expenditures. Low levels of savings and limitations on the availability of external finance imply that public investment will rise only modestly in relation to GDP over the medium term. This dilemma can only be resolved through: (i) continued efforts to increase public savings through improved tax administration and tight current expenditure policies; (ii) a reallocation of public investment from directly productive sectors to the provision of public goods; and (iii) improvements in the efficiency of public investment through improved project selection and execution. 16. Bolivian Tax Efforts in Perspective. Bolivia has made substantial progress in mobilizing tax revenues since the introduction of a major tax reform in 1986, which established a new tax structure and major improvements in tax administration. The reforms emphasized the importance of few taxes, low rates and few exemptions to achieve revenue increases. At the same time, the introduction of the value added tax and the Complementary Tax to the value added tax encourage self-enforcement, facilitate administration and make tax evasion easier to detect and control, provided that effective auditing and enforcement procedures are in place. The increase in tax collection since the beginning of the reform effort has been impressive: tax revenues rose consistently from 2.9 to 7.7 percent of GDP between 1987 and 1990. While this increase is substantial in the Bolivian context, tax revenues still remain well below their potential, and below tax collectiotn rates in other countries of the region.  - vii - 17. Direction of Tax Policy Reform. Efforts to raise public savings need to rcly primarily on increasing tax revenues, given that the scope for savings via cutbacks in current expenditure is limited on account of the rather restrictive public expenditurc stance maintained over the past few years. The question now facing the Governmcnt is which strategy to follow in tax policy and administration to further increase tax revenues. Given the overall positive results of the reform of the tax structure, there should not be any fundamental changcs in the structure and rates of the tax system. The current low rates should be maintained and the tax base should be broadened by reducing evasion, primarily for taxes with the greatest collection potential, e.g. the value added tax. Ensuring the stability of the tax system, maintaining low tax rates across the board, and enforcing tax laws will not only result in increased revenues for the public sector, but will also provide greater economic and financial stability for both domestic and forcign investors. Frequent changes in tax rates and the introduction of new taxes create uncertainty in the investment climate and will unnecessarily hinder medium- and long-term investment plans in an economy in which new investment is crucial for renewed economic growth. Rather than alter the structure of taxation, therefore, the Government's major efforts at this stage of the retorm should be to increase value added tax collections, enforce existing tax laws and address serious managerial and administrative problems that are hindering increases in revenue collection. Success in overcoming these issues requires full political commitment, legal modifications (that would establish legal powers to carry out more effective tax audits, speed the process of collection of overdue taxes, and introduce the prison sentence for repeat offenders), targeted enforcement programs (directed towards tax payers with the greatest potential tax yields based on available computerized data), improvements in personnel policies and publicity efforts. The Government has initiated a number of these steps, but sustained further effort is required. Beyond these measures, if tax rate increases cannot be avoided due to unexpected macroeconomic imbalances, these should be applied to the value added tax, which has the highest revenue potential. 18. Evolution of the Public Enterprise Sector. The development strategy followed by Bolivia in the 1960s and 1970s relied heavily on state involvement in the productive sectors. In addition to the traditional public services (electricity, water, etc), state companies were created to undertake a wide range of manufacturing activities. At present, there are 159 non-financial state- owned companies, with about half of them directly responsible to the Central Government and the remaining companies under the regional development corporations. They account for about 12% of value added and are spread across numerous activities, including the production of goods which can be provided more efficiently by the private sector. One fifth of the country's total fixed investment is carried out by public enterprises. The stabilization measures of 1985 were successful in lowering transfers to public enterprises, which are estimated at less than US$3 million for 1990 and projected to remain at this level in 1991. In comparison, public enterprises are expected to contribute roughly US$500 million to national/regional governments in 1991, almost exclusively through hydrocarbon royalties. 19. Status and Future Direction of Public Enterprise Reform. The stabilization program initiated by the new Government in 1985 included a number of measures, inter alia, to eliminate revenue losses, reestablish control over the public enterprise sector, tighten financial monitoring and improve the financial self-sufficiency of public enterprises. Under the Paz Zamora Government, a series of further reforms aimed at medium-term reform of the public enterprise sector were implemented. These measures included: the introduction of a new financial management and control system (SAFCO); the adoption of performance contracts for major state enterprises to improve their efficiency and performance while increasing managerial  - viii - autonomy and accountability; and the design of a privatization program, focussing initially on the national airline (LAB) and a number of manufacturing companies operating in competitive markets. These are all important steps towards achieving the goals of effectively reducing the size of the public enterprise sector and of further increasing its efficiency. However, further efforts will be required, primarily in three areas. First, an effective privatization campaign will need to be implemented aimed at divesting all state entcrprises/assets in productive sectors. Following the recent issue of a Privatization Decree spelling out the Government's strategy and overall principles, the legislative instruments required for its implementation need to be developed. The implementation process should be facilitated by the decentralized ownership of the enterprises. Second, competition and private sector participation in enterprises remaining in the public sector in the medium term need to be increased. This should be based on a systematic review of all public services to identify opportunities for greater private sector involvement, and could include joint venture contracts with private sector firms in the mining and hydrocarbons sectors, where the Constitution precludes outright privatization, and allowing private sector competition in telecommunications and rail car operations. Third, an appropriate legal and regulatory framework for monopoly services (provided by both public and private companies) and enterprises remaining in the public sector needs to be developed. The Government is committed to carry out the necessary reforms in these areas, supported by the Structural Adjustment operation. 20. Improvements in Managing the Public Investment Program. In order to be able to channel scarce public resources into uses most conducive to promote sustained growth, sound management of an appropriate public sector investment program is required. The main management challenges are to reallocate public investment resources from directly productive sectors to the provision of public goods essential for a recovery of growth, and at the same time to raise the efficiency of public investment through improved project selection and execution. Public sector investment project selection and Monitoring have improved considerably over the past five years. Investments like the overly expensive and inefficient projects from the 1970s and early 1980s have generally not been authorized, the previous chaotic system for approving investment projects is being rationalized, and the Planning Ministry is building its capacity to monitor ongoing projects and evaluate new ones. Considerable progress also has been made in the collection of information necessary for the monitoring and evaluation of investment projects. A computerized system (SISIN) has been established to organize financial data on investment, which has been successful in maintaining up-to-date information on investment expenditures. This system is now being expanded to include additional information required for the evaluation of investment projects, including data on the economic impact of projects and physical indicators of project execution. Some progress also was made in increasing the allocation of investment funds to the social sectors. Of course, any change in the structure of public investment can only be done slowly. Most of the projects listed in the public sector investment program are already in progress, and only a small share of total investment expenditures are actually affected by changes in priorities in any one year. Elimination of undesirable projects and a reallocation of investment expenditures to the social sectors have been accompanied by important efforts to increase private sector investment in areas formerly reserved for the state. 21. 1990 Decline in Public Investment. Performance of the investment program in 1990 was disappointing; public sector investment fell by US$17 million below the relatively depressed level achieved in 1989. The decline in investment expenditures reflected both administrative problems and lack of financing and was particularly serious in the first half of the year. The Government reacted to this problem by forming a team in the Ministry of Planning to  - ix - review expenditures and to address specific bottlenecks to investment. This program was successful in that 65% of public sector investment in 1990 took place after June. At the time, it was hoped that this effort would facilitate an increase in external disbursements, but the achieved increases were not sufficient to support reasonable levels of investment expenditures, and the financing problem was compounded by increasing arrears on Argentina's payments to Bolivia. The Government compensated for the shortfall in both external disbursements and in revenues by increasing domestic credit. This prevented an even more substantial decline in investment, at the expense of an increase in domestic credit creation which contributed to some extent to the acceleration of inflation in the last quarter of 1990. 22. Long-Term Constraints to Investment Performance. Bolivia can well expect to achieve higher levels of public investment in the near future, as hopefully the shortfall in finance experienced in 1990 was only temporary. However, the level and efficiency of public sector investment is impaired by a number of longer-term problems that must be addressed by the Government if acceptable levels of GDP growth are to be achieved. These problems include inadequate levels of public savings, the operation of the procurement system, and weaknesses in the administration of investment. Continued increases in public savings will be essential, not only to finance domestic projects, but also to ensure the smooth execution of donor-financed projects, which often require counterpart funding as a condition of disbursement of external resources. Government procurement is currently carried out by three external procurement agents and considerable improvement in the operations of the procurement system has been reported since its inception in 1988. Over the long term, the Government will need to consider how the procurement function can be returned to Bolivian hands. Measures to be considered in managing the transition to Bolivian procurement would include appointments of local boards to oversee procurement (with technical assistance from the procurement agents), a gradual increase in the threshold above which procurement must be entrusted to foreign agencies, encouraging the agencies to hire progressively more Bolivians and continuing efforts to strengthen accounting systems and financial management in public enterprises. Public sector investment also continues to suffer from serious administrative problems, despite considerable improvements in recent years. In particular, weaknesses in the information provided at the sector level severely impairs the effectiveness of investment programming by the central ministries. The effectiveness of the newly implemented information systems, however, depends on the quality of data provided from the sectors. Improvements in the planning and evaluation of investments at the sector levels are essential for investment programming to have a real impact on the quality of investment projects undertaken.  I I - CHAPTER I INTRODUCTION AND OVERVIEW OF THE REPORT 1.01. Bolivia enters the 1990s having successfully stabilized its economy after a period of rapidly deteriorating economic conditions leading to hyperinflation during the first half of the 1980s. Over the past six years, the 1985 stabilization program has proven to be quite resilient and has been sustained even in the face of severe external shocks. Prudent macroeconomic management helped to reduce internal and external imbalances and, together with extensive structural reforms, supported a recovery of the economy to sustained but low levels of growth. Bolivia's fundamental economic challenge for the 1990s is to make the difficult transition from stabilization at low levels of growth to more vigorous future growth while maintaining macroeconomic stability. This would permit - for the first time in nearly a decade - to gradually increase per capita income and consumption levels, to improve living standards and to further develop the country's human resource base. 1.02. Chapter II provides the background against which the challenge of achieving more vigorous growth needs to be met. Rich natural resource endowments provide ample opportunities for recovery and expansion, but infrastructural and human resource constraints need to be overcome to achieve this growth potential. The historical background discusses the events that led up to the economic crisis of the early 1980s and that have shaped the performance of the economy since then, with a particular focus on trends that have tended to discourage private sector development in the past. The following description of the nature and extent of the structural policy change that resulted from the 1985 adjustment program provides an overview of the current policy framework which sets the environment for a recovery of growth. 1.03. Chapter III analyzes the impact of the 1985 adjustment program on the macroeconomic Derformance of the Bolivian economy. The 1985 program has been highly successful in stabilizing the economy and continued prudent macroeconomic policy management has permitted a recovery to sustained but overall low levels of growth. Despite continued low levels of private investment, there is evidence of a positive supply response to the adjustment measures in a number of areas. Public savings and the efficiency of public investment have improved, but remain low. A more detailed discussion of these issues is presented in Chapters V to VII. This report does not analyze issues of poverty alleviation since this important topic was recently covered by the World Bank Poverty Report (8643-BO). 1.04. Chapter IV deals with the macroeconomic framework for sustained growth. analyzing the conditions under which Bolivia can achieve more vigorous future growth rates of 4%-5% per annum during the remainder of the 1990s. The Chapter brings out the need to maintain stability through continued prudent macroeconomic management as a prerequisite for more vigorous growth, and the need to mobilize savings and investment and to allocate them efficiently. 1.05. Chapter V analyzes the private sector response to changes in the business environment in the aftermath of the adjustment program of 1985. While signs of a significant  -2- supply response emrerge, which warrant cautious optimism with regard to more vigorous future growth, a number of remaining private sector constraints to growth remain to addressed. These are analyzed in the second part of the Chapter, followed by policy recommendations to overcome them. 1.06. Chapter VI analyzes the key financial sector constraints which are likely to have an impact on investment behavior and growth in the economy. The Chapter provides an overview of the overall size and structure of the financial sector, and analyzes key issues affecting its performance: high real interest rates, the fragility of the financial system, state of the regulatory system, impediments to capital markets, and lending practices of the public financial institutions. The Chapter concludes with a discussion of policy recommendations to address these issues and thereby to increase savings and to achieve a more efricient allocation of scarce investment resources. 1.07. Chapter VII discusses public sector management for sustained growth. Three main areas are analyzed. The 1986 reform of the tax system and the tax administration are reviewed in order to arrive at recommendations on how to increase public savings. The analysis focusses on shortcomings in tax administration and enforcement and measures to overcome them. Second, based on a description of the structure and performance of the public enterprise sector public enterprise reform measures are analyzed that would achieve a reduction of the Government's role in the production of goods which can be provided more efficiently by the private sector, and that would permit increases in efficiency in public enterprises. The last part of the Chapter discusses efforts that are needed to overcome institutional problems in planning, budgeting and implementation of public expenditure programs in order to achieve improvements in the efficiency of public investments.  CIIAPTER 11 HISTORICAL BACKGROUND AND STRUCTURAL POLICY CIIANGE 2.01. The objective of this chapter is to provide the necessary background information towards a better understanding of Bolivia's recent economic performance and the analysis of constraints to growth in the following chapters. Readers familiar with the background material discussed here, may wish to proceed directly to the analysis of the country's macroeconomic performance in the next chapter. Section A provides an overview of Bolivia's resource base, pointing to some fundamental development constraints facing the country. Section B provides a discussion of Bolivia's historical background. It focusses on events that have led to the economic crisis of the early 1980s and that have shaped Bolivia's economic performance since then. It also points out key trends, such as political instability and growing state involvement in the economy until 1985, that have a bearing on the current behavior of different economic agents, in particular the private sector. Section C provides an overview of the main features of the 1985 policy reforms and subsequent policy adjustments. It indicates the broad extent of policy shift that has taken place over the past six years and identifies the main aspects of the current structural policy regime. A. RESOURCE BASE 2.02. Natural Resources. Bolivia is a landlocked country of 1.1 million km2, made up of three distinct geographical regions. The Altiplano is a highland at an altitude of 3,000 to 4,000 meters, characterized by rich mineral deposits and harsh climatic conditions. Nearly half of Bolivia's 7.1 million population lives in this area, engaged in subsistence agriculture and in mining. Silver mining during the Spanish colonial rule and subsequently tin mining hav._ been influential factors in Bolivia's history and economic development. The Llanos, or lowlancls in the Eastern part of the country provide extensive tropical forest resources, and pastures which are considered to have rich agricultural potential. This region has experienced rapid expansion and growth in the last decade on the basis of both, consecutive agricultural commodity booms and the discovery of significant petroleum and more importantly natural gas deposits. Since the completion of a gas pipeline to Argentina in 1972, exports of gas started to gather relative importance in competition with the traditionally dominant mineral exports. Third, the fertile valleys between the Altiplano and the Eastern lowlands, where the main economic activities are agriculture and livestock, providing food for the urban areas of the highlands. Overall, Bolivia's landlocked position and mountainous terrain render transport costs high and access difficult. In addition, both internal communications and links to neighboring countries are poorly developed, posing difficult development challenges for the country's future. 2.03. Human Resources and Social Conditions. Bolivia is one of the poorest countries in Latin America with a per capita income of US$630, which is reflected in poor social conditions and an inadequate development of the country's human resource base. The education level of its 7.1 million inhabitants is very limited: about one fifth of the population is illiterate, with functional illiteracy estimated to affect more than half of the adult population. Health indicators are among the worst in the continent, with infant and maternal mortality about twice the regional average and widespread malnutrition. Less than half of the total population has access to piped water and only a quarter has access to sanitation facilities.  B. HISTORICAL BACKGROUND 2.04. The First Half of the 20th Century. Until the middle of the 20th century, Bolivia's monetized economy was largely confined to mining and mining-related activities. Only limited linkages developed between this enclave sector and the rest of the economy. The vast majority of the population (over 70%) continued to live in a quasi-feudal rural economy, and was generally excluded from political decision making (until 1952 less than 3% of Bolivians were entitled to vote). Income, wealth and political authority were heavily concentrated in the hands of owncrs of mines and of large land-holdings. The lack of linkages between the mining sector and thc rest of the economy was related to two factors. Local and foreign mining entrepreneurs generally chose to reinvest the profits generated in the mining sector abroad, and mining interests successfully blocked significant taxation of their profits. (Bolivia's political instability in the first half of the 20th century, evidenced by frequent changes in government, was in fact related to some extent to conflicts between successive governments' attempts to tax mining activities and mining entrepreneurs' resistance to these efforts). Thle lack of significant mining taxes resulted in very low levels of public revenues and inadequate provision of public services. Infrastructure investments primarily focused on transport necessary to ship minerals to foreign markets. Investments essential for Bolivia's long-term development, such as basic transport infrastructure, power generation, basic health, education and sanitation services were neglected. 2.05. The 1952 Revolution. The distribution of income and wealth before 1952 was highly unequal (probably one of the most unequal in South Arnerica at the time), accounting for growing popular unrest. The 1952 revolution brought the Paz Estenssoro Government to power, which attempted to address these issues through agrarian reform and nationalization of the major mines. The latifundia land-holdings were broken up and distributed to the peasants working on them, and the large mines were nationalized under the management of the state-owned Bolivian Mining Corporation (COMIBOL). These measures held the promise of a significant redistribution of income and a more equal distribution of political power, as well as a growing involvement of the role of the state in the economy. The immediate results of the agrarian reform and the nationalizations, however, were mixed. Inadequate investments and lack of support services prevented the agrarian reform from producing sustained and vigorous agricultural growth. In the case of mining, a conflict developed between the Government's attempts to extract taxes from the sector as a way to finance investment in other sectors of the economy and the miners' attempts to raise their living standards. As a result of this conflict, an adversarial and increasingly radicalized relationship developed between the Government and the labor unions, which continued to generate political unrest during most of the second half of the 20th century. Overall, the major redistribution of wealth implied by the agrarian reforms, the nationalization of mines and the associated political and institutional changes initially destabilized the economy. Between 1952 and 1958, inflation soared and GDP fell at an average annual rate of 2%. 2.06. Economic Growth during the 1960s and 1970s. During most of the 1960s and 1970s the Bolivian economy prospered. Between 1958 and the late 1970s, GDP grew at an average rate of 5%, although per capita GDP did not recover its 1952 level until 1970. Highly favorable international market conditions for minerals as well as sizeable foreign capital inflows from international donors and commercial banks were the main factors contributing to these historically high rates of growth. Foreign commercial bank capital was attracted to Bolivia during the 1970s, following the discovery of hydrocarbons in the Santa Cruz area, which indicated the  - 5 , possibility of sizeable petroleum and gas deposits in Bolivia. TIhe attractivencss was further increased by the cxtended period of political stability undcr the Banzer Governmcnt (1971-1978). Capital inflows grew, reaching US$300 million a ycar at their peak in the period of 1975-1978 (equivalent to 50% of total exports). 2.07. Girowing State Involvement in the Economy. A large part ol the intlow of resources during the 1970s was spent on public investments, incrcasing the role of the state in the economy. In addition to public investments in the largely nationalizcd mining, hydrocarbons and energy sectors, the 1970s saw the creationi of relatively large, complex andl often inefficient state- owned metallurgical, industrial and agroindustrial plants. Many of tlhese public investments financed projects of dubious quality, which were in somc cases poorly designed, in others based on distorted prices or political pressures. As a result, these projects did not improve the country's capacity to service the debt they created. lncrcasing state involvement in the economy was not limited to the area of investment. Throughout the 1960s and 1970s, the public sector developed into a complex entity which increasingly intervened in economic dccision making through policies such as subsidized credit programs directed at particular sectors, an extremely complex and highly protective system of tariffs and quotas, allocation of foreign exchange, marketing boards and price controls for most agricultural commodities. This process of growing state involvement in the economy was qt ite steady and relatively independent of the political orientation of successive governments. More radical governmcnts activcly cxpanded the scope of state activities, including through repeated nationalizations of foreign multinationals, while more conservative governments tended to emphasize measures to increase the efficiency of the public sector. Overall, the expanding role of the state in the economy remained unchallenged. 2.08. Private Investment Behavior. In this climate, private investors generally did not find investing in Bolivia an attractive longer-term proposition, even during the unprecedented political stability under the Banzer Government in the 1970s. Although the Banzer Government issued policy statements encouraging foreign and private sector entrepreneurs to invest in Bolivia, new private foreign direct investment remained low, while errors and omissions in the balance of payments (suggesting capital flight) doubled during this period. Private fixed investment briefly rose to above 10% of GDP between 1973 and 1975, reflecting the oil, gas and commodities booms, but then settled back to its pre-boom range of 6%-7% until 1978 and then declined further following the ouster of Banzer from power by a coup. The political stability and the pro- business stance of the Banzer years was recent from a historical point of view, and memories of the post-1952 nationalizations ana continuously shifting policy environments were still fresh. Investors consequently perceived the risks of long-term investments in Bolivia to be out of proportion to the expected returns, which were subject to the vagaries of government policies and restrictions of a highly regulated economy. 2.09. The Legacy of the 1970s. The problems inherent in Bolivia's development strategy of basing growth on large investments financed by external capital did not become apparent until the late 1970s. The expansion of the 1970s came to an abrupt end in 1978-79, when commercial banks began to reevaluate Bolivia's export potential ard debt servicing capacity. By this time it had become evident that Bolivia's petroleun, resources were not as ample as had been expected, and that the opening of markets for the country's considerable gas reserves required substantial additional investments. This, in combination with renewed political instability, led the commercial banks to try to reduce their exposure, leaving Bolivia without the substantial foreign inflows needed to help service its large external debt. Since the external debt in the past  - 6 - had financed a series of investments of dubious quality, these could not contribute to repaying the debt. These developments, combined with the international debt crisis led to the ceonomic crisis Bolivia experienced during the first half of the 1980s. In rctrospect, together with betting on large future petroleum exporis (which did not matcrialize), the main error of economic policy during the 1970s was the case with which the government granted its guarantee to external financing of both public and private sector investment projects of often questionable profitability. While officially guaranteed capital was flowing in, private capital was moving out: estimates of capital flight amounted to ovcr 60% of the value of the dcbt accumulated during 1971-1981. The government's foreign borrowing for public investment thus effectively financed the accumulation of privately owned assets abroad. 2.10. The 1980-1985 Economic Crisis. In response to the reduction of external financial flows, the government attempted to initiate a structural adjustment program which was interrupted by a coup in 1980. The following three military governments could not muster the political support needed for aii adjustment program, and eventually turned power over to the democratically elected Siles-Suazo Government in October 1982. During its nearly three years in power, this Government was also unable to implement a coherent economic program, with no less than six failed attempts to implement stabilization packages. The problem of reduced external capital flows thus remained unaddressed, and economic conditions deteriorated, developing into a major economic crisis of unprecedented severity and length due to the disastrous economic management during this period. Political instability and social conflict prevented sufficiently large cuts in expenditures to reduce the huge public sector deficit (approaching 25% of GDP by 1985) in line with the sharp fall in external finance. The deficit was increasingly financed through issuing money and building up arrears to domestic and foreign creditors. The overvalued exchange rate!' and declining tin prices reduced the export receipts on which the Government depended for substantial part of their revenues. As revenues declined, the government issued more money to cover its bills, and inflation accelerated, leading to intensified competition over wage increases. Real money holdings dropped substantially as the public sought to protect the real value of their assets, a process given impetus by the forced conversion of dollar deposits into local currency at the overvalued official exchange rate. The shrinking of the monetary base in turn required an accelerating rate of money creation to finance government expenditures, while rising inflation sharply reduced the real value of tax revenues. Inflation reached 28,000% at an annual rate during the first nine months of 1985. The decline in economic activity as a result of the crisis was substantial. Official estimates show a fall in real GDP of over 10% frorn 1980 to 1985, 24% in per capita terms. Per capita consumption is estimated to have dropped by over 16%, and private fixed investment averaged only 3% of GDP between 1983 and 1985, compared to 7% in 1980. Due to lack of funds, payments to foreign creditors were suspended in 1984. As the economy started to get out of control, the major labor unions withdrew their support of the populist government early in 1985, resulting in a call for elections. 2.11. The 1985 Stabilization Program. The Paz Estenssoro Government, which took power in August 1985, viewed the perilous state of the economy as the triggering event to repeal the development model pursued since the 1952 revolution. It radically changed the direction of 1/ The Latin America Region defines the exchange rate as units of domestic currency per unit of foreign currency. Therefore an increase in the exchange rate implies a depreciation of the Boliviano (prior to January 1987, the Bolivian Peso).  economic policy towards a system where economic activity was to bc guided by market mechanisms in a stable and transparent economic policy cnvironmcnt, with the public sector limiting itself to providing necessary social and economic public services. In ordcr to restore control of the cconomy, the Government immediately adopted a radical stabilization program, including a massive devaluation and a unification of the cxchange rate, increases in public sector prices (in particular of domestic petroleum products), and reductions in Government expenditurcs to levels financeable by available funds. As a result, the public sector deficit was lowered significantly, and inflation was brought under control within weeks of the announcement of the program. The stabilization measures were combined with an extensive liberalization of markets. Interest rates were freed, foreign exchange controls were eliminated, an auction mechanism was instituted to determine the exchange rate, restrictions on labor mobility were relaxed, virtually all quantitative restrictions were eliminated, a low and uniform tarifT was instituted, all restrictions on capital flows were lifted, virtually all price controls wcre eliminated, and prices of public sector goods were adjusted to market levels. The Government also initiated programs to strengthen public institutions and to improve banking supervision. It further implemented a major tax reform to put public finances on a more sustainable basis. 2.12. The Economy after Stabilization. Economic conditions in the first year following the implementation of the stabilization program remained extremely difficult, given that it coincided with a collapse of tin prices in internatioiaal markets in late 1985. GDP declined by 2.6% in 1986 and unemployment rose, as the Government had to adopt even more restrictive policies in order to contain the impact of the fall in tin revenues on the budget. Eventually, however, the Government program led to a sustained stabilization of the economy, and led to a return of positive GDP growth starting in 1987. The Government also made substantial progress in regularizing its relations with external creditors. Two Paris Club reschedulings in 1986 and 1988 led to a rescheduling of about US$710 million of debt service payments in arrears. Bolivia also repurchased approximately two thirds of its commercial bank debt at 11 cents to the dollar, using funds provided by official donors. Overall donor support for the Bolivian stabilization efforts, including a program under the IMF Enhanced Structural Adjustment Facility, started to generate the necessary international capital inflows to the country to sustain the adjustment efforts. Overall, GDP growth has been around 2.7% a year since 1987, less than the rise in population, but a dramatic improvement over the early 1980s. A number of factors contributed to the relatively slow growth: continued uncertainty over the permanence of policy reforms kept savings low; perceptions of high country risk, macroeconomic policy management, and the fragility of the banking system, have kept real interest rates at exceedingly high levels; entrepreneurial activity remained sluggish given the recent experience of hyperinflation and past failures at stabilization; terms of trade declines and lack of payment by Argentina for Bolivian gas exports limited Government revenues, thus requiring overall restrictive fiscal and monetary policies; and rigidities in the economy due to lack of infrastructure and human capital slowed the ne essary adjustments to the collapse of tin mining and the sharp change in incentives under the new policy regime. 2.13. The Paz Zamora Government. Following democratic elections, the Paz Zamora Government took office in August 1989. Despite the considerable achievements of the previous administration, the new administration faced some serious financial difficulties upon assuming power. This was largely the result of uncertainty over the outcome of the elections and future economic policies (which led to significant withdrawal of funds from the financial system), combined with some relaxation of fiscal discipline in the months leading up to the elections. The  - 8 - new Government under Paz Zamora moved quickly to restore stability by adopting appropriate fiscal and exchange rate measures, and to restore overall confidence by affirming its commitment to maintaining the policy framework instituted by thc previous administration. These measures succeeded in restoring private sector confidence, and bank deposits started recovering. The restrictive macroeconomic policies were successful in improving fiscal performance and restraining inflation: the deficit of the nonfinancial public sector declined to 5% in 1989 and fell further to 3.3% in 1990, while average inflation remained at 16% and 17% respectively. The Government also made further progress in alleviating its debt burden: in 1990 the Paris Club granted Bolivia the concessional "'loronto Terms", and agreements were reached to settle the outstanding bilateral debts with Brazil and Argentina. Export revenues continued to increase significantly, both in 1989 and 1990, due to increased private sector mining and surprisingly strong rises in non- traditional exports. GDP growth, while sustained and positive (2.7% both in 1989 and 1990), remained below population growth, thus implying a continued fall in per capita income and consumption. C. STRUCTURAL POLICY CHANGE IN THE AFTERMATH OF THE 1985 REFORMS 2.14. The adjustment program implemented in 1985 represented a fundamental change in the development policies Bolivia had been pursuing over the previous 30 years. The program was in fact termed the "New Economic Policy" (NEP). It constituted a consistent and comprehensive program designed to increase reliance of productive activities on the price system and on private sector initiative, to reduce the influence of the state on production, and to increase the efficiency of public sector administration. Both the Paz Estenssoro Government and the PAz Zamora Government have built on the oiiginal reform program, and have extended and strengthened it in many areas over time The result today is a comprehensive policy framework based on market principles and geared towards inducing greater efficiency, touching nearly every aspect of the Bolivian economy. The following paragraphs summarize the main features of the policy reforms under the NEP and swL sequent policy adjustments in order to provide an overview of the broad extent of policy shift since 1985 and at the same time to provide an overview of the main aspects of the current policy regin. 1. Reforming Incentive ' tructures 2.15. External Policy Reform. External sector policies were radically revised in 1985. The exchange rate was unified and substantially devalued (the black market exchange rate had exceeded the official rate by a factor of over 15 prior to these measures). Foreign exchange controls and prohibitions against denominating domestic transactions in foreign currency were eliminated. A weekly (later converted to daily) auction mechanism was instituted to determine the exchange rate, which has since been operating effectively to maintain a largely competitive exchange rate through almost continuous nominal depreciations. At the same time the highly protectionist trade policy regime of the past thirty years was dismantled, and Bolivia became a member of GAIT in 1990. Quantitative restrictions were eliminated (with the exception of sugar and edible oil), and licensing requirements were abolished. The system of high and variable tariffs, resulting in extremely distorting effective rates of protection, was replaced by a low and uniform tariff rate, initially at 20%, which has since been lowered to 10% (with the exception of  - 9 - capital goids which carrv a rate of 5%). The extent of duty exemptions has been largely reduced to gra;it exemptions only to the diplomatic corps and charitable or education-rclated institutions, although exemptions amounted to about 30% of imports in 1990, indicating primarily enforcement problems. Several piecemeal attempts have been carried out to reform the customs service, which have, however, not been able to ove come the overall weakness and alleged high degrce of corruption in the customs administration. A more fundamental customs reform program has been planned for some time, and its preparation is now scheduled for 1991. In order to compensate exporters for duties paid on their imported inputs, initially a flat 10% rebate had been provided for non-traditional exports (the so-called "CRA", or Certificado de Reintegracion Arancelaria), which in fact had amounted to a significant subsidy primarily in favor of low value added exports. This rebate has been replaced in April 1991 by a duty drawback system. In addition, since 1990, a temporary admission system has been operating, so far, however, benefiting only a relatively small number of large manufacturers (18 producers). Several steps have been taken to improve export procedures, but a proper streamlining of the bureaucratic process has not yet been achieved; preparation work on this issue is now scheduled for 1991. The Government has developed the necessary legal framework for privately operated export processing zones/duty free areas, of which currently 5 are under construction and 2 applications are pending. Overall, the measures taken since 1985 resulted in a more realistic exchange rate, a nearly complete elimination of trade policy induced distortions, and, as a result, a reduction in distorting differences between domestic and international prices. These in turn provide the proper incentives for increasing efficiency in domestic production and for increasing exports. 2.16. Domestic Price Reforms. Upon taking power in 1985, the Paz Estenssoro Government abolished price controls in virtually all markets and eliminated marketing boards. State subsidies and guaranteed prices were removed, and the procurement of the public sector was transferred to international procurement agents. Public sector prices were raised, using international prices as guidelines, resulting, among others, in a ten fold increase of gasoline prices. Overall, the Government imposed markel, discipline and reliance on the price system for the allocation of resources. 2.17. Financial Sector Reform. The Paz Estenssoro Government instituted fundamental reforms in financial sector regulations shortly after taking power in 1985. All controls on interest rates were abolished, financial transactions in foreign currency and in dollar indexed local currency were authorized, domestic residents were permitted to borrow and lend abroad, and a number of directed credit schemes at subsidized rates were eliminated. Reserve requirements on sight deposits, which had been between 60% and 100% prior to 1985, were lowered initially to 0% on foreign currency deposits and 50% on local currency deposits, and were unified in July 1987 at 20%. Reserve requirements on fixed term deposits were lowered from 30% to 10%, with foreign currency deposits also exempt until 1987. Since late 1990 half of the required bank reserves on dollar denominated deposits are being remunerated at LIBOR. Several measures were further adopted to strengthen the banking system, including the resolution of outstanding problems from the dedollarization-' of 1982, reorganization of the Central Bank, strengthening of banking supervision through creation of an independent Banking Superintendency, tightening of banking regulations and mandatory comprehensive audits of banks. To increase the range of financial instruments and to improve techniques of monetary control, the 2/ Forced conversion of dollar accounts at the overvalued official exchange rate.  - 10 - Central Bank began issuing certificates of deposit (CDs) at the end of 1987. In order to overcome distortions caused by the provision of development credit3' at bclow market rates, the Govcrnment recently removed all constraints on the interest rate charged to final borrowers of these credits and instituted an auction mechanism for the allocation of development credit. The Paz Zamora Government further issued a decree in mid 1991 to halt lending operation and to close/liquidate loss making, inefficient public banks. Overall, the measures taken since 1985, in conjunction with greater economic stability, have helped to strengthen the banking system. Remaining issues in financial sector reform are discussed in Chapter VI. 2.18. Labor Market Reforms. A key element of the Paz Estenssoro Government's liberalization program was reduced state intervention in the labor markets. Three important changes in labor market legislation were introduced in 1985. First, restrictions on employment decisions were eased, making it easier for employers to fire workers. Second, wages were allowed to be determined through collective bargaining at the level of individual firms, and all Government restrictions on private sector wage levels were abolished, with the exception of the minimum wage. Finally, the previous variety of forms of compensation in the public sector were consolidated into a basic wage, abolishing most bonuses, eliminating access to goods at subsidized prices and abolishing in-kind payments, which had made up 70% of public wage payments in 1982. These changes in labor regulations provided a structure of incentives conducive to harder work, greatly reduced the incidence of strikes and labor disruptions, and allowed firms to increase productivity through more flexibility in their use of labor. The Government also moved to control public sector wage expenditures through reducing staff and consolidating compensation into the basic wage. These reforms achieved a more transparent system of wages and reduced the costs of administering the public sector compensation system. 2.19. Investment Policy Framework. The incentive framework adopted under the NEP and subsequent reform initiatives have been designed to encourage greater private sector participation in the economy. All of the measures discussed above - free convertibility of foreign exchange, elimination of price controls, liberalization of the financial system, reduced Government intervention in labor contracts, simplification of the tax structure (see below), and commitment to price and overall economic stability - greatly improved the climate for private investment. In addition to these indirect measures, the Government undertook the following steps specifically to encourage domestic and foregn investment. In order to promote increased exploration and development of Bolivia's oil and gas reserves, the Government settled a long-standing dispute over outstanding payments with Occidental and Tesoro, the two private sector contractors in petroleum production. The host of specific investment incentives in place until 1985 were eliminated, in the understanding that these policy instruments are generally of limited effectiveness in inducing increased investment, while representing a major strain on the budget. (Grandfathering clauses were established for firms benefiting from these provisions in order to ease the adjustment process). In place of these investment incentives, measures were taken in order to improve the legal framework governing investment in Bolivia. The intention was to provide legislative sanction to internationally accepted investment rules, many of which were already in force in Bolivia in the form of decrees, which were regarded as providing insufficient legal certainty. An Investment Law, a Mining Law, and a Hydrocarbons Law were drafted under J/ Credit lines provided by external donors that are channeled through the commercial banking system.  - 11 - the Paz Estenssoro Government, but did not obtain Congressional approval prior to the change in Government. The Paz Zamora Government undertook some extensive revisions of the draft laws, and finally managed to get all three laws passed during the second half of 1990 and early 1991. While the delay in implementing these laws is unfortunate, they finally eliminated the important investment impediment of legal uncertainty, allowed for greater private sector participation in areas so far reserved for the public sector, and provided a tax regime for minerals and hydrocarbons in line with international practice. The laws thus provide the legal framework and certainty that should facilitate attracting foreign investors to Bolivia, as well as motivate domestic entrepreneurs to undertake increased investment efforts. 2. Fiscal and Institutional Reforms 2.20. Fiscal ReformY As part of its macroeconomic stabilization effort, the Paz Estenssoro Government undertook a comprehensive tax reform in 1986, which aimed at broadening the Government's fiscal revenue base and at improving the fiscal balance. The tax reform introduced a greatly simplified tax system, compared to the previous system of over 400 different taxes. The new tax structure created a simple, neutral and broad-based tax system, with generally low rates to encourage compliance. The largest source of revenue shifted from income- to consumption-based taxes (particularly the new value added tax). The tax rules were carefully designed to simplify administration by sharply reducing the number of taxes, by defining a tax base measurable with available data, and by providing incentives for self-enforcement. To further facilitate the administration and enforcement efforts, the Government established a computerized system to control taxpayer compliance, established registration and collection systems through the private banking system, and set up special control procedures for large tax payers in the three largest cities. In terms of revenue collections and increased administrative capacities, the tax reform has achieved impressive results: domestic tax collections climbed from 1% of GDP in 1985 to nearly 8% in 1990. While these increases are substantial in the Bolivian context, tax revenues still remain below their potential, and below tax collection rates in other Latin American countries. Some efforts are under way to improve the revenue collection performance, supported by technical assistance, but further policy commitment is needed to facilitate the improvements necessary to sustain improved fiscal performance. 2.21. Public Sector Management Reforms. The Paz Estenssoro Government initiated a comprehensive package of reforms to overcome the severe erosion of the effectiveness of the public sector administration during the political and economic turbulences of the early 1980s. These reforms have continued and were extended in some areas under the Paz Zamora Government. The measures adopted so far include (i) improvement of basic financial management systems (standardized accounting and auditing procedures, cash management, budget programming) in key ministries and public entities under the SAFCO5' program; (ii) improvements and strengthening of the public investment planning system (introduction of economic criteria in project analysis, establishment of a financial information and monitoring system for all public investment projects); (iii) hiring of procurement agents as an interim solution 4. Note that the tax reform and tax policies will be discussed in more detail in Chapter VII. N/ Integrated System of Financial Administration and Control.  - 12 - to the cumbersome procurement procedures; and (iv) revision of public service employment and compensation policies. These measures have helped to enable the Government to reduce expenditures, improve the control of public sector funds, and generally improvc thc efficiency of the public sector administration. The passage of the SAFCO law in mid 1990 was fundamental in providing the legal foundation for a number of these measures and is essential in ensuring their permanency. Further progress in extending the SAFCO provisions to additional public sector entities and a consolidation of the successes achieved so far is required to further improve Bolivia's institutional capacity for informed and effective decision making, and for raising the efficiency of public investment. 3. Redefinin the Roleof the Public SectoO' 2.22. Privatization. An essential conceptual component of the 1985 roform program was a redefinition of the role of the public sector. Rather than being directly involved in (often loss-making) productive sector activities better left to the private sector, the public sector was to concentrate its efforts on providing essential public goods, such as infrastructure, social services and environmental protection. With this concept in mind the Paz Estenssoro Government started some preparatory work towards privatizing public enterprises, but failed to obtain the necessary political support for proceeding with any initiatives. The Paz Zamora Government has re- initiated the preparation work for a comprehensive privatization program, but progress was stalled in 1990 due to the absence of enabling legislation. In mid 1991 a privatization decree was issued and progress is being made in working towards its implementation. The divestiture of the national airline (LAB), which could be started without special legislation due to its legal status as a joint venture company, is the most advanced of the Paz Zamora Government's initiatives. 2.23. Public Enterprise Reforms. In order to deal with the immediate problem of reducing losses resulting from inefficient operations of many state enterprises and in order to raise their fiscal contribution, the Paz Estenssoro Government implemented a number of strong measures, including a drastic reorganization of COMIBOL. The Paz Zamora Government has since initiated a number of further reaching measures to deal with the longer term problem of the need to increase the overall efficiency of those public enterprises that will remain in the public sector for some time to come. Efforts are currently under way to fundamentally restructure COMIBOL, transforming it into a holding company with individual mines being operated through joint ventures with the private sector. In addition, the Government has recently launched a program to adopt performance contracts for major public enterprises. In 1990 and 1991, four contracts of this kind have been signed for ENDE (the national power company), ENFE (the national railway company), ENTEL (the national telecommunications company), and YPFB (the national hydrocarbons company), with provisions for annual review. The performance targets are company-specific and generally include indicators related to financial profitability, labor productivity and cost per unit of output. Overall the contracts are expected to improve the performance of the above enterprises, but they should not distract from continuing efforts to explore the scope for leasing or privatizing of at least selected activities and services performed by the affected enterprises.