Peru - Economic and Sector Reforms to Sustain Stabilization and Lay the Foundations for Development

Docummt of The World Bank FOR OFFICIAL USE ONLY Report No. 10361-PE J A PERU ECONOMIC AND SECIOR REFORMS TO SUSTAIN STABILIZATION AND LAY THE FOUNDATIONS FOR DEVELOPMENT FEBRUARY 18, 1992 Country Operations Division Country Department I Latin America and the Caribbean Region This document has a rstricted 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. 4 4 PERU: ECONOMIC AND SECTOR REFORMS TO SUSTAIN STABILIZATION AND LAY THE FOUNDATIONS FOR DEVELOPMENT Page No. PREFACE EXECUTIVE SUMMARY INTRODUCTION . . . . . . . * . * * * * * * * * * * * * * * *o * * @- I. TOWARDS A NEW DEVELOPMENT STRATEGY . . . . . . . . . . . ... . . A. The Strategy . . . . . . . . . . . . . . . . . . . . . . . . . 1 B. The Macroeconomic Program of August 8, 1990 . . . . . . . . . . 2 C. The Structural Reforms of March - April 1991 . . . . . . . . . 3 II. MACROECONOMIC PERFORMANCE UNDER THE STABILIZATION PROGRAM . . . . . 6 A. The Initial Results and the Assessment . . . . . . . . . . . . 6 B. Fiscal, Monetary and Exchange Rate Policies . . . . . . . . . . . 7 C. The Problem of Exchange Rate Real Appreciation . . . * . . . . . 9 III. RESTRUCTURING THE STATE'S ECONOMIC ACTIVITY AND ITS FINANCING . . . 11 A. Tax Reform . . . . . . . . . . . . . . . . . . . . . . . . . . 11 B. Reform of Central Government Administration . . . . . . o . . . 13 The Basic Approach . . . . . . . . . . . . . . . . . . . . . 14 Reforming Tax Administration (SUNAT) . . . . . . . . . . . . 15 Reforming Customs Administration (SUNAD) . . . . . . . . . . 16 Case Study: Reforming IPSS . . . . . . . . . . . . . . . . . 17 Case Study: the Housing Sector . . . . . . . . . . . . . . . 18 Reforming Government Ministries . . . . . . . . . . . . . . . 18 C. Reforming the Public Enterprise Sector . . . . . . . . . . . . 19 Scope for Divestiture . r. . . . .. . . . . . . .. . . . . 20 IV. REFORMING THE ECONOMYS KEY MARKETS . . . . . . . . .. .... . . 22 A. Financial Sector Reform . . ................ 22 Background and General Lines of Reform . . . . . . . . . . . 22 Strengthening the Solvency of the System . . . . . . . . . . 22 Reform and Divestiture of Public Banks . . . . . . . . . . . 23 Monetary/Fiscal Policy and Financial Sector Development . . 24 Improving the Financial System's Efficiency . . . . . . . . . 25 B. Foreign Trade Reform . . . . . . . . . . . . . . . . . . . . . 25 Background . . . . . . . . . . . . . . . . . . . . . . . . . 25 Recent Developments..... . . .o. .. .. . 26 Reforms Needed to Improve Allocative Efficiency . . . . . . . 27 Safeguard Mechanisms . . . . . . . . . . . . . . . . . . . . 27 *Page No. C. Agricultural Credit and Marketing . . . . . . . . . . . . . . 27 Background . . . . . . . . . . . . . . . . . . . . . . . . . 27 Reforms Needed to Solidify Stabilization . . . . . . . . . . 28 Reforms Needed to Improve Market Efficiency . . . . . . . . . 30 D. Labor Market Reform . . . . . . . . . . . . . . . . . . . . . . 31 Background . . . . . . . . . . . . . . . . . . . . . . . . . 31 Legal Framework . . . . . . . . . . . . . . . . . . . . . . . 31 Employment Trends and Real Wage Evolution . . . . . . . . . . 32 Labor Market and Structural Adjustment . . . . . . . . . . . 33 V. REFORMING SECTORAL POLICIES . . . . . . . . . . . ........ 35 A. The Transportation Sector . . . . . . . . . . . .bs ... 3 Institutional Framework . . . . .. ... .. ... 35 The Problem of the Subsectors and the Lines of Action . . . . 35 Transportation Sector Investment Strategy . * . . . . . . . . 37 3. The Power Sector . . . . . . . . . * . 0 . . . . . . . . 37 Institutional Framework . .. .. . .. . . . . . .. . . 37 Diagnosis of the Sector . *. .. . . .. . .. . . . .. . . 37 Legal and Regulatory Framework . .. .. .. .. . .. . . . 37 Rehabilitation Requirements . . . . . . . . . . . . . . . . 38 C. The Water Supply and Sanitation Sector . . . . . . . . . . . . 39 Diagnosis of the Sector ........ .... .. ..... 39 Institutional Problems ................... 39 Private Sector Participation .9. . . . . . . . . . . .. . 40 D. The Oil and Gas Sector . . . . . . . . . . . . . . . . . . . . 40 Restoring Foreign Participation . . . . . . . . . . . . . . . 40 Pricing of Petroleum Products and Deregulation of the Market . . . o . . . . . . . . . . .. . . . . . . . . . 41 Targets for Privatization . . . .. . . . . . . . . . .o. . 41 Camisea Field Development . . . . . . . . . . . . . . . . . . 41 E. The Mining Sector . . . .. . . . . . . . . . . . . . . 42 Diagnosis of the Sector . . *. . . . .. . . . . .. . .. 42 Emergency Investment and Divestiture . . . . . . . . . . . . 43 Legal and Regulatory Framework . . .. . . . . . .. . . . . 44 F. The Fisheries Sector . . . . . . . . . . . . . . . . . . . . . 44 Prognosis of the Sector . . oo. .. .. . . . . . . .. . . .. 44 Privatization . . . . . . . . . . . . . . . . . . . . . . . 45 Regulatory Framework . . . . . . . . . . . . . . . . . . . . 45 G. Public Investment Program . . . . . . . . . . . . . . . . . . . 46 The Investment Program . . . . .9. . . .o. . . . . . ... 46 Investment Decision Making Process . . . . . . . . . . . . . 47 Pate No. VI. POLICIES FOR POVERTY ALLEVIATION AND SOCIAL EMERGENCY . . . . . . 48 A. The Social Situation in August 190 . . . . . . . . . . . . . . 48 B. Measures Since'AuSust 1990 . . . . . . . . . . . . . . . . . . 49 C. Social Sector Policies . . . . . . . . . . . . . . . . . . . . 49 Education . . . . . . . ................... 49 Health . . . . . . . . . . 50 VII. THE REINSERTION OF PERU INTO THE INTERNATIONAL FINANCIAL COMMUNITY . . . . . . . . . . . . . . . . . . . . . 51 A* The Default . . . . . . . . . . . . . . . . . . . . . . . . . . 51 B. Steps Toward Roinsertion .. .. . .. .. . .. .. .. .. . 51 C. The Debt Work-Out . . . . . . . . . . . . . . . . . . . . . 52 D. The Medium-Term Outlook of the Peruvian Economy . . . . . . . . 55 PERU: ECONOMIC AND SECTOR REFORMS TO SUSTAIN STABILIZATION AND LAY THE FOUNDATIONS FOR DEVELOPMENT INTRODUCTION 1. The Long-Term Trend. The development potential shown by Peru in the 1960s has been frustrated by almost three decades of heavy Government intervention in economic activity, protectionist import substitution policies and macroeconomic instability. Per capita income in 1990 was comparable to that of the 1950s 'nd real exports were 40 percent lower than in 1979. Real wages fell systematically after 1970 and an increasing proportion of the labor force was unemployed or had joined the ever-growing informal sector. The uncertainty of land tenure following agrarian reform translated into a dismal performance by the agricultural sector, which has grown only half as fast as the population over the last 20 years. In turn, the overexpansion of the state into economic activity, through a growing number of public enterprises and administrative and regulatory bodies, has led to resource waste and economic stagnation. Chronic macroeconomic imbalances and market distortions ultimately resulted in hyperinflation, deep recession and a decline in all social indicators (Table 1). Table is PUFOWANCE 1W' TOILS Of THE PUNI ECONKT 1931-90 (average annual percentage rates) Esport Trade to GOP lavestwent GOP Population A10 re Inflation eaI Wage Growth aatall Productivity? Growth Growth CL Bate Growth 19514962 9.1 37.2 0.292 7.0 2.6 2.4 7.6 U.e. 1963*1967 3.0 32.5 0.243 3.6 2.8 3.5 10.2 -0.2 1968*1977 1.7 26.9 0.173 3.9 2.6 1.6 16.6 0.6 1978*1982 3.0 36.9 0.097 2.6 2.7 1.6 64.9 -0.3 1983-1990 0.6 26.5 *0.001 .2.0 2.6 0.7 1397.8 *6.1 11 Dmpoes plus Esports divided by GOP. kl Ratio o GDP growth and Investment to GDP. nits of real GDP increase per each additional unit of real investment. A decreasing trend means a lower productivity, that is. a less efficient use, of capital. 2. Macroeconomic Instability. Peru's recent hyperinflation lasted from September 1988 to September 1990 1 and peaked at 12,000 percent in the 12 months ending in August 1990. It was caused by sustained resort to Central Bank financing by the Treasury since 1986 and by the additional need to finance large Central Bank quasi-fiscal losses. In attempting to control inflation, the previous Administration fell into the trap of recurrent sporadic adjustments to administered prices and wages followed by short-lived price freezes and other ineffective price containment measures, while fiscal and monetary imbalances kept escalating. The fiscal imbalance, including Central Bank foreign exchange and financial losses, surpassed 10 percent of GDP in 1987 and 1988. The system of multiple exchange rates resulted in losses from exchange rate subsidies that stood at 6 percent of GDP during the third quarter of 1988. 3. Uncontained monetary expansion led to a progressive decline in the demand for domestic money, as shown by a fivefold increase in the velocity of circulation of money from 1987-90 (Table 2). As can be seen in Charts 1 to 4, hyperinflation also brought about a collapse of fiscal revenues and financial intermediation. Moreover, the completely distorted and continually changing 1/ Defining the trigger point of hyperinflation at 50 percent inflation per month--Philip Cagan's (1956) popular threshold--Peru's period of hyperinflation began in September 1988, when the inflation rate reached 114 percent, and ended in September 1991, when the rate declined to 13 percent as a result of the stabilization initiated in August by the Fujimori Administration. - ii - incentive system--with as many as 11 exchange rates, widespread price controls, 15 import tariff levels ranging up to 160 percent, etc.--together with the recessionary effects of hyperinflation itself led to an unprecedented decline in production and real wages. Table 21 FISCAL AND QuASIFISCAL PUBLIC SECTOR DEFICITS. 1965.1990 Income "ublic Sector Central lank Total Inflation Velocity Deficit / Losse 61 Deficit of Period of Broad ---------e r c**** (Percent oT GDP) --.************ (percent) Money gl 1987 6.1 4.9 11.0 114.5 8.2 1 1.7 4.3 6.0 18.5 It 4.3 3.4 7.7 18.2 111 6 .4 4.4 10.8a 22.7 IV 9.2 6.8 16.0 24.8 1988 6.1 6.6 12.7 1,722.3 15.9 1 0.2 5.4 5.6 54.6 1 1.2 7.1 a.3 9.2 UI 7.3 6.2 13.5 2;1.1 1V 7.4 6.8 14.2 148.2 1959 4.9 2.7 7.6 2.775.3 24.4 1 1.9 2.6 4.7 198.1 i1 3.0 2.3 5.3 135.2 III 4.9 1.6 6.5 97.8 IV 5.6 3.2 8.8 107.5 1990 7.649.6 41.7 I 5.6 1.6 7.2 124.6 t 6.9 0.2 6.7 160.0 111 n.e . . n.1. 623. IV n.a. a.a. n.&. 43.6 at Mon-financial public Sector. 1l Quasi-ftacael deficit. I 1acludes dollarndeoinoatcd deposits. Sources Central bank. 4. The Inherited Economy. When the Fujimori Administration took office in July 1990, inflation was running at 70 percent per month, real wages had fallen to less than half the level of five years earlier, real consumption per capita of the poorer half of Peru's population had declined by 50 percent and real GDP had plunged 25 percent since 1987. The country's infrastructure had deteriorated severely because of inappropriate investment and inadequate maintenance. The country's fiscal base had almost vanished--in 1989 tax revenu3 totaled 4 percent of GDP--most public sector prices and tariffs were approaching zero in real terms, disposable international reserves had been exhausted and more than two-thirds of the foreign debt was in arrears. CHAPTER I - TOWARDS A NEW DEVELOPMENT STRATEGY A. The Strategy 1.1 Four major problems have been at the root of Peru's growing macroeconomic instability and hAve hindered its economic development: (a) an oversized and bureaucratic state; (b) excessive regulations and interventions generating costly market distortions and favoring the shift towards the informal sector of the economy; (c) paternalistic institutions, such as de Jure labor stability and agrarian reform, which are hurting most those whom they are intended to benefit; and (d) social turmoil and subversive uprisings that in part can be attributed to the poor development record of the last two decades. 1.2 To break the pattern of macroeconomic crises and lay the basis for a working economic system , the state needs to terminate or reduce its role in many areas and strengthen its activity in others. Four areas of change are crucial: (a) Budget Constraints ari Size of the State. The overall size of the state, as measured by the employment of labor and other resources, must be reduced to match the state's appropriate functions and the resources raised by taxation. This strategy requires that the state adopt taxes that minimize distortions in production, encourage savings and improve income distribution. (b) Infrastructure and Human Development. The state must concentrate on providing a basic infrastructure, as well as non-tangible benefits such as well-defined and enforceable property rights, a stable- valued currency, and adequate protection of its citizens. It must make greater efforts to develop the country's human resources by providing improved basic education and health services to all Peruvians. (c) Deregulation. Liberalization of the economy's main markets-- financial, foreign trade, agriculture and labor--and abolition of public monopolies are needed to promote the most dynamic sectors of the economy through an efficient allocation of scarce resources. This involves eliminating excessive red tape and detrimental regulations and barrisrs to entry, and removing or phasing out many subsidies and special protection. (d) State Enterprise Sector. If the state wants to perform its core functions effectively, it needs to stop diverting its scarce managerial and financial resources into, production that the private sector can handle more efficiently. To end this drain, the state should privatize virtually all production and marketing activities. 1.3 The Fujimori Administration has successfully exploited the window of opportunity provided by popular support for the belief that maintaining the inherited institutions, legal framework and economic incentive 3tructure would continue to lead at best to economic stagnation and a fragile macroeconomic performance, and at wors. to recurrent hyperinflations, economic retrogression and social upheaval. - 2 - 1.4 This report summarizes what the Administration has achieved since August 1990 and -outlines additional measures that may prove necessary for the next stage--both short-term macrQeconomic management and structural reforms for sustainability and efficiency. These structural reforms fall into four main areas: restructuring the state's economic activities; solidifying price stabilization and improving allocative efficiency; establishing the foundati,ns for growth by redefining sectoral policies, includi g reduced public participation in production, and renewing Peru's participation in international trade; and ensuring that the basic needs of the poorest and most vulnerable groups in society are met in nvtrItion, health and education. B. The Macroecoi. ic Proaram of August 8 1990 1.5 Obiectives. Although the wide measures adopted in the stabilization program launched on August 8, 1990, had the immediate aim ot controlling ongoing hyperinflation, some were also intended to introduce the structural reforms necessary for increasing productivity, alleviating the butden of the crisis on the poor and ending Peru's international financial isolat,on. 1.6 Stabilization Measures. Balancing the public sector's cash budget was the most important step in stsbilization. A cash committee was given control of spending and Central Bank financing to the Government was stopped. Budget balance was achieved with tight control over public sector wages and salaries-- which hyperinflation had eroded severely in real terms--with drastic increases in all public-sector prices--the price of gasoline was increased 32-fold--with reductions of subsidies and exemptions to tariffs and sales taxes, and with emergency taxes on wealth and exports. A summary of the main measures is presented in Table 3. The expansion of the domestic real money demand--which always occurs once hyperinflation is stopped--was met almost exclusively through Central Bank purchases of foreign exchange in the open market. From August to November 1990, the Central Bank made these purchases with a view to maintaining a floor nominal exchange rate; a completely free float would have resulted in additional real appreciation of an already uncompetitive exchange rate. Since December 1990, the Central Bank is placing more emphasis on meeting monthly growth targets of base money. At times, however, the intervention in the foreign exchange market has switched back to an exchange rate target. The counterpart of Central Bank foreign exchange purchases has been the accumulation of about US$0.6 billion in international reserves to achieve a net reserve position of about US$0.5 billion by late March 1991. Table 3: MAIN STABILIZATION MEASURES OF AUGUST-SEPTEMBER 1990 Exchange Rate Fiscal Policy Monetary Policy Wage Policy and Foreign Trade - Abolition of - Drastic increases - Zero Central Bank - 1002 wage bonus to multiple exchange in public sector credit to the absorb the shock of rates prices and tariffs public sector public price adjustments - Establishment of a - Abolition of many - Remonetization floating exchange tax exemptions exclusively - Moderate adjustment rate regime under sales tax, through Central to minimum wages selective excises Bank purchase of - Elimination of and tariffs foreign exchange - Abolition of import licensing backward-looking - Esta.ishment of - Progressive indexation of vages - New tariff emergency taxes: reduction of for public structure with * If! on exports mar&inal legal enterprise rates of 152, 252 * ' , on property reserve employees and 50% * &t on insured requirements property * Central Government - Liberalization of wages within the - Creation of a interest rates constraints of Central Treasury's revenues Government cash committee - Creation of social emergency program 1.7 Efficiency Measures. The Government has lifted most price controls, the exchange rate has been unified and allowed to float and interest rates de facto have been liberalized because the Central Bank has set very high, non- binding ceilings. These measures have not only removed many distortions in relative prices but also enhanced the credibility of stabilization by signaling that the Government would not resort to heterodox measures but rather to market mechanisms. In Septmber 1990, the Government eliminated quantitative restrictions on imports and greatly simplified the tariff structure, replacing nearly 20 tariff rates with three at 5,15 and 25 percent. 1.8 Ware and Social Policy. In August 1990, the Government ordered a one- time bonus for workers and later announced a minimum wage at the Inti equivalent of US$36 per month--the average wage prevailing in June-July 1990. Public sector wages were adjusted in line with the Treasury's budgetary constraints. In addition, the Government decreed the abolition of backward-looking indexation of wages of public enterprise employees. The minimum wage was increased again in September to make the August bonus part of the regular wage, which was still about one-third of the real level prevailing in 1985 and one-fourth of that in 1987 (Chart 1). In August 1990, the Government also announced the creation of a social emergency program, which consisted of transfers from the Treasury to the network of some 500 Peruvian NGOs that provide food and medical assistance. C. The Structural Reforms of March - April 1991 1.9 Following the initial phase of adjustment, the Government in March 1991 announced a series of drastic structural adjustment reforms aimed at promoting domestic and external competitiveness, private sector development and deregulation of economic activity. The most important are summarized below. - - 1.10 Foreian Trade. The three-tier tariff schedule established in Sept-mber 1990 was reduced to a two-tier system with tariffs at 15 percent and 25 percent, the average tariff. ,declining from 26 percent to 17 percent. In addition, some QRs--such as local integration coefficients for the automobile industry, licenses for imports of agricultural products, and phytosanitary, health and bureau of standards restrictions--were abolished. The main remaining QR is t:.ade in petroleum products, which continues to be a PETROPERU monopoly. Two other trade measures adopted were the extension of the temporary admission of imports by exporters ana the creation of a duty-drawback of indirect domestic taxes paid by exporters. 1.11 Customs. Many of the responsibilities previously entrusted to the Customs Service, such as the assessment and recovery of tariffs, have now been delegated to private agents who can retrieve imported items from customs warehouses within 24 hours. In addition, the Government has decreed the restructuring of the Customs Service to include the upgrading of its staff and the streamlining of its procedures. The Government monopoly in operating customs warehouses has also been abolished. 1.12 Ports. With the elimination of the Controlling Commission of Maritime Labor, which monopolized most loading/unloading activities and reaped high profits, the cost of these services has been reduced from US$12 to US$5 a ton. 1.13 Restrictions on Mobility of Capital. Foreign exchange surrender by exporters has been abolished and foreign currency deposits abroad are no longer illegal. 1.14 Foreian Investment. Foreign investors are now permitted to repatriate their entire net profits and royalties and to invest under any corporate form or joint venture. Also, they are allowed to freely purchase stock from residents and to invest in any sectors except those reserved for nationals. 1.15 Tax Policy and Administration. Several loopholes in the sales tax have been eliminated and strong penalties for tax evaders have been decreed. In addition, the Revenue Service (SUNAT) is being restructured. 1.16 Privatization. Procedures for the privatization of public enterprises have been defined and 23 small enterprises have been put up for sale. 1.17 Land Reform. Private ownership of land has been broadened and strengthened. Agrarian cooperatives can now legally become private estates. Moreover, land has been made freely transferable and can now be used as collateral for credit. 1.18 Monopolies and Deregulation. Monopoly rights of 12 public firms have been abolished (including grain marketing, imports of fertilizers, gold trading and reinsurance). 1.19 Banking Law. A new banking law increases the capital requirements of banks, strengthens prudential and credit concentration ratios, promotes universal banking and opens new Peru's commercial banking to foreign investment. In addition, the insurance business has been partially deregulated by freeing premiums and abolishing some 1overnment monopolies. 1.20 Labor Market. Labor stability in Peru is a constitutional right conferred on workers after a three-month probationary period. They can then be laid off only for "just cause." The law further restricts dismissals by -5- requiring that the Ministry of Labor verify the tirm's claim of "just cause," which the employer must prove to the Ministry 'of Labor. Labor contracts are legally precarious and easily cqqtestee in thq labor tribunal courts, which are autonomous and have been strongly influenced by the Ministry, which requires firms to seek approval to suspend or dismise. The Administration has taken at %i to strip the labor courts of autonomy by making them part of the regular judiciary system. -6- CHAPTER II MACROECONOMIC PERFR1.ANCE UNDER THE STABILIZATION PROGRAM A. The Initial Results and the Assessment 2.1 The Results. The emer.-ency economic program has succeeded thus far in halting hyperinflation. The monthly inflation rate fell from 63.2 percent in July 1990 to 5.9 percent in November 1990 (after having reached a historic high of 397 percent in August 1990, the month in which the public price and tariff adjustments were effected). Chart 5 shows that the nominal exchange rate experienced an upward trend during August and September (as a result of Central Bank intervention) and stabilized in October and November. Chart 5 also shows that the economy registered a deflation for over a month following the announcement of the program. The initial effect of stabilization on output was a drop ia economic activity in August-September 1990--which added to the 20 percent fall ir. real GDF experienced in 1988-89--but the economy recovered in October-December although to a level of activity lower than that prevailing before the announcement of the program (Chart 7). 2.2 Expectations waned somewhat in late November and early December because the actual revenue from the emergency tax meajures turned out to be lower than anticipated. This prompted doubts about the Government's ability to abide by its promise to balance the budget and led to a run against the Inti which resulted in a 20 percent depreciation in the exchange rate. The Government reacted quickly by increasing gasoline prices by 50 percent and announcing the measures in the first stage of the Tax Reform. The aftermath of this mini-crisis was that inflation rebounded to a monthly rate of 23 percent in December 1990 and 18 percent in January 1991, and so did interest rates on Inti deposits (Table 4). In January, the Government had to yield to a minimum wage adjustment, thus validating the price-cost jump. With the announcement of structural adjustment measures in March, inflation started to recede and reached 5.8 percent in April. Table 4& PERFORMANCE INDICATORS OF THE HACR0ECONCtKC PROGRAM 1989....90.199-------1.;; 0ct-Dec Jan-JeI July August Sept-How Dec Jan Feb March April .ation late Moth) 27.3 34.2 63.2 397.0 9.7 23.7 17.8 9.4 7.7 5.4 &I GDP AOdes 1965 * 100) 63.1 98.5 101.6 63.0 80.0 68.8 87.4 65.7 65.1 a.e. asuge &ate 11 Uts per VS$T 8.369.0 30.506.0 122.390.0 373.023.0 438.958.0 $23.939.0 560.000.0 $55,000.0 565.000.0 705,000.00 F.schange Rate? es July 65 - 100) rease ian depreciation) 69.1 36.5 63.7 39.4 36.4 35.2 30.9 29.4 26.9 31.4 al Broad Money 31 Was Dec 65 - 10) 30.5 22.0 17.6 11.6 17.4 18.9 17.0 17.0 17.8 21.3 &I Intl@ Money 6/ Liez Dec 65- 100) 33.5 23.6 16.8 7.4 14.3 14.3 11.2 11.2 12.8 14.1 at lasteel l Rate (2) 24.6 41.7 54.6 61.5 20.4 12.0 18.7 24.6 24.4 24.8 i Rate (2) 19.9 25.2 35.6 35.6 11.2 7.3 5.5 6.0 6.5 8.4 arces Central baok. of period. rate effective trade weighted escbange rate relative to Peru's seven largest trade partners. les aollar accounte in financial intermediaries. Judes dollar accounte to financial Intermediaries. - 7 - 2.3 The Shortcomings. Despite the clear achievements of the short-term macroeconomic program, the current stabilization is still fragile as demonstrated by the mini-crisis of December.-January. There are four main problem areas. First, the fiscal balance attained is precarious. The revenue side depends on a narrow tax base and on public sector prices, in particular the price of gpioline, which is eroded in real terms Sy the incidence of inflation. Tax revenues during the first quarter of 1991 have been about 3 percent of GDP lower than the 11 percent targeted for the 1991 fiscal program. The spending side of :he fiscal balance relies heavily on reducing expenditures to unrealistic levels. This is particularly true of the current attenuated wage structure for public employees, whose salaries secount for close to half of Central Government expenditures. Likewise, public investment and social emergency program transfers have been curtailed to the minimum levels. The second problem is that financial intermediation in local currency is to weak that even a small public sector cash imbalance in absolute terms, compounded by a likely massive rush on the dollar, could easily lead to another hyperinflationary outburst. Thirdly, wage restraints and moderation will continue to be critical through this first stage of stabilization. And fourthly, there is sZrong pressure for the Central Bank to continue to provide significant credit for the Agrarian Bank to finance crops. Central Bank lending to the Agrarian Bank, virtually a transfer, was one of the main forces behind hyperinflation. 2.4 The current stabilization program is thus an emergency measure that can buy several months of precious time while the needed structural reforms are implemented to reduce the size of the public sector and provide sustainable financing of it through a full-fledged tax revision. Only these reforms can provide a long-term cure for inflation and lay the grounds for economic recovery. They are discussed in detail in Chapters III, IV and V. 2.5 Short-term monetary and exchange rate managpment also plays an important role in preserving the current stabilization effort. Sustaining the program during the remainder of 1991 and in 1992 will require, above all, a firm reduction in inflation. The Government set a target of about 2 percent per month by late 1991. This compares with a 5.8 percent increase in prices in April. B. Fiscal, Monetary and Erchange Rate Policies 2.6 To achieve the inflation target of 2 percent monthly by the end of 1991, the Government basically has two instruments: control of Central Bank domestic credit and exchange rate/international reserve policy. Clearly the most important element in the program will be the consolidation of the fiscal balance (including the remaining quasi-fiscal losses of the BCRP and any credit to the Agrarian Bank) so as to avoid expansion of domestic credit to the Government. As noted above, given the current small monetary base, Central Bank financing of any fiscal imbalance will most probably produce a resurgence of hyperinflation. The fragility of the fiscal balance, attained so far by resort to delays in payments of authorized expenditures, will require the Government to proceed firmly with the tax and tax administration reform initiated in December 1990. Preliminary fiscal targets for 1991 (Table 5), embodied in the budget presented to Congress, imply a fiscal balance and should be followed closely. As mentioned before, however, actual revenues are lower than projected. -8 - Table S& TARGET FISCAL INDICATORS (Percent of GP) 4 4 Historical Targeted 1985 1986 1967 1988 1989 1990 1991 1992 1993 1994 1995 Central Govt. Revenues 15.0 12.6 8.9 9.1 5.5 6.4 11.0 13.2 14.0 14.4 15.0 Central Govt. Sapanditures 16.2 16.9 15.5 14.4 11.1 11.3 13.4 15.9 16.7 17.0 17.3 of which; Accrued gat. Interest a1 4.2 2.8 1.9 3.9 2.5 3.4 3.7 4.1 4.2 4.2 4.2 Central Govt. Deficit 3.2 4.4 6.6 5.3 5.7 4.9 2.4 2.7 2.7 2.6 2.3 Public Enterprise and Rest of UPPS b--10A SOP 0.4 1.5 1.0 4.7 1.8 0.7 1.1 1.0 0.8 0.7 0.9 Central Bank Losses 2.0 1.9 3.6 4.4 0.3 0.0 0.2 0.2 0.1 0.1 0.1 Credit to 5eaco Agratio 0.3 1.5 1.6 1.6 2.3 1.0 0.5 0.2 0.1 0.0 0.0 Public Sector lorronn Reuireaments 5.9 9.3 13.0 16.0 10 1 6.6 4.2 4.1 3.7 3.4 3 Esserual insscing k/ 5.2 3.5 2.4 4.3 2.9 3.6 4.7 3.8 3.9 3.6 4.1 Domotic Finaciag 0.7 5.8 10.6 11.7 7.2 3.0 .0.5 0.3 *0.2 .0.2 *0.8 / Includes all interest accrued on total stock of ezternal debt (including arrears and interest on arreare). b1 Includes financing of total accrued enternal Interest paymense. Sources Central Bank and Ministry of Economy preliminary targets. 2.7 Exchange rate/international reserve policy is the other available instrument. Here the Central Bank should clearly define a management policy that conserves convertibility at a unified rate and is consistent with the reserve and domestic credit targets. 2.8 If these measures are pursued along with fiscal balance and structural reform, inflation will steadily decline and the demand for real Inti balances will increase. Although it is difficult to determine the desirable level of real money growth, given the structural changes that have taken place in recent years and the unsettled nature of expectations, the best that can be said is that the demand for the stock of broad money surely will remain below the levels of the first half of the 1980s but might increase by one or two percentage points of GDP if these policies are continued. Such remonetization implies that ex-post nominal growth of the monetary base will be in excess of inflation. 2.9 One way for the Government to signal its intention to slow inflation would be to set a nominal target of expansion for the monetary base, say, an average annual rate of 40 to 50 percent for the remainder of 1991, to be attained through reserve accumulation. If this target increased the pressure on the current real appreciation of the exchange rate, the Government would have at least three options: (a) continue to accumulate reserves beyond the target, at the cost of higher-than-targeted growth in the money base and money and, thus, a slower decline in inflation; (b) adhere to the target and the corresponding increase in money by allowing the exchange rate to appreciate, i.e., maintain the monetary rule. Such an appreciation would slow the rate of inflation by reducing the increase in the cost of imported goods and by tightening the pressure of international arb-itrage, but also would slow the growth of exports and possibly output; - 9 - (c) allow some growth in broad money by permitting banks to increase credit, to the private sector through a'decline in reserve requirements rather than an increaqe in international reserves. This policy would lead to lower interest rates, reduce commercial banks' spreads, increase private sector credit and enable the Central Bank to gradually reduce the remuneration of required reserves. Of course, this reduction in reserve requirements would have to be cautious and dependent on the expansion of the real demand for money. It would have the beneficial effect of reducing the Central Bank's quasi-fiscal deficit. The choice among these three options would depend on the degree to which the targets for inflation and reserves were being fulfilled. But, in principle, the best course would be a combination of the two latter options. C. The Problem of Exchange Rate Real Appreciation 2.10 A concern since the start of the stabilization program has been the appreciation of the real exchange rate. At present, this rate--calculated by comparing external and domestic price indices--is less than half the average value for 1985-89 (Table 6). In turn, the real exchange rate calculated by comparing external and domestic cost indices is also uncompetitive, although more competitive than the former indicator because part of the real appreciation has been absorbed as lower real wages. It cannot be claimed, however, that the real exchange rate is being kept artificially low, because it has been under a managed float where the Central Bank's intervention has consisted of significant net purchases of dollars in the open market (except in late March 1991). Table 6s EAL EXCHANGE SATE INDEX a/ (July 1965 * 100) Average19*.1 **9* * --- 1990 1991 ------- 1985*1989 Jan-Mar Apr-Jun Aug. Sept Dc. Nov. Dec. Jan. Feb. March April Price Index a/ 6 37 50 39 42 38 36 35 31 29 27 31 Cost ldex h7 94 54 51 67 79 80 77 67 63 63 62 66 a/ Computed using the effective exchange rate and the combined price index of Peru's seven largest trade partners. An increase in the index means real depreciation. k/ Calculated using the cost index of a typical exporting firm. Sources Central Reserve bank 2.11 The Causes. The explanation of the overvaluation of the exchange rate is as follows. The dollar and the Inti are both financial assets. The real supply of Intis was basically written down by the 397 percent inflation of August 1990. The significant reduction in inflation since then, together with the liberalization of interest rates, has tended to increase the public demand for Intis. Since the Central Bank is not creating Intis to finance the public sector, the private sector must obtain Intis by either running an external current account surplus or else drawing down its dollar holdings (selling dollars to the Central Bank). The latter takes the form of repatriation of external funds and reduction in dollar hoards. To the extent that the Central Bank does not demand all this excess supply of dollars, because of its concern about the growth of base money, this process tends to appreciate the nominal (and real) exchange rate. - 10 - 2.12 An increased trade surplus has contributed to the pressure to appreciate the exchange rate. At present, the flow damand for dollars resulting from imports is artificially loy,because the current level of real GDP is also low (about 30 percent lower than in 1987). Exports, by contrast, have been expanding because of the moderately reasonable (dollar) prices of traditional exports and the fact that some manufacturers have had to switch to the export market to survive while the domestic market is in crisis. Thus, the excess supply of dollar3 from the flow of trade has compounded the excess supply of dollars arising from liquid portfolios. 2.13 The Solutions. Defining policies that correct the overvaluation in a sustained non-inflationary manner is not an easy task. The real exchange rate is an endogenous variable that changes only in response to other real variables of the economy. Nominal exchange rate depreciation, prompted by a faster accumulation of international reserves by the Central Bank, would increase domestic inflation and thus would not depreciate the real exchange rate unless it is complemented by the following measures: (a) A fast and sustained liberalization of foreign trade that was initiated in September 1990 and strengthened in March 1991. This policy can be expected to increase soon the demand for imports--and thus for foreign exchange--and, at the same time, to reduce the prices of commodities produced by the import substitution sector. These trends will depreciate the nominal and real exchange rates. (b) A public sector fiscal surplus that would enable the Treasury to buy dollars without additional growth of the money base, that is, without additional issuance of Intis. The increased fiscal tightness would depress the prices of non-tradables (i.e., the sectors not subject to international arbitrage), while the net purchase of dollars would put upward pressure on the exchange rate and thus on the prices of tradables. 2.14 A relatively low ieal exchange rate is inevitable with the permanent increase in the real demand for money or remonetization of the economy that comes with the success of a stabilization program. This adverse trend can be altered by the two measures outlined above and is usually corrected at the pace the portfolio adjustment is being completed and the economy attains more normal activity levels. Once capital inflows slow down and GDP and imports increase, the real exchange rate can be expected to depreciate from current levels. 2.15 A drastic policy to correct overvaluation would be to abolish the national currency and establish a foreign reserve currency as Peru's only legal tender. Considering the stock of dollars--dollar notes, external deposits and domestic dollar deposits--held by Peruvians is probably seven or eight times the current stock of Intis, the abolition of the national currency, and thus of the exchange rate, would complete the portfolio adjustment immediately. - 11 - CHAPTER III RESTRUCTURING THE STATE'S ECONOMIC ACTIVITY AND ITS FINANCING 3.1 By attempting to get involved in practically every aspect of economic life, the Peruvian public sector has become oversized, inefficient and unable to perform its legitimate duties. In recent years these trends have worsened. The number of employees in the public sector--excluding the military--increased from 604,000 in 1982 to 935,000 in 1990, a 50 percent increase. Overstaffing has been accompanied by a drastic reduction in wages (1990 real salaries are less than one-fourth of their 1985 level). The public sector owns 181 enterprises, employing around 200,000 workers, in a wide range of economic activities. 3.2 Inflationary financing of this oversized sector generated a two-year- long hyperinflation. The continuing inability to ctilect enough taxes is both an expression of society's unwillingness to pay for an oversized and inefficient public sector and proof in itself of an inefficient public administration.2/ Sustaining stabilization and restoring growth require both reducing the size of the sector--and improving its efficiency--and collecting the tax revenues to pay for it. A. Tax Reform 3.3 Recent Developments. Tax revenues amounted to only 4 percent of GDP in the 12 months before the current Government took office, down from 14 percent in 1985. On August 8, 1990, the Government imposed emergency tax measures--on exports, gasoline and property--and established a cash committee. The new measures, effective in 1991, fell short of a full-fledged tax reform, in part because the Government only amended the previous tax laws. 3.4 The new measures simplified taxation by reducing the numerous current taxes to five: income (firms and individuals), wealth (firms and individuals), general sales (IGV), selective consumption (ISC) and import tariffs. The emergency tax on insured assets and the 10 percent export subsidy to non- traditional exports were abolished. For 1991 only, the emergency tax on debits (turnover of bank deposits) and the 10 percent tax on exports (no tax for non- traditional and 5 percent for the rest, except for large mines, which still pay a 10 percent rate) were retained at reduced rates. 3.5 The new tax measures also followed the desirable rules of reducing dispersion of rates and expanding the tax base. Selective consumption tax rates- -excluding gasoline taxes and a few services--were reduced to three, with a maximum of 50 percent; the income tax rate on firms was reduced from 35 percent to 30 percent and exemptions were scaled back; and the net-worth tax rate for firms was unified at 2 percent and all exemptions were eliminated. The two latter taxes will be based on a more refined adjustment to inflation beginning in 1992. For individuals, the maximum income tax rate was reduced from 45 percent to 37 percent and the personal property tax is now computed based on the inflation-adjusted value of a list of taxable assets (at the rate of 1.5 percent). The coverage of the general sales tax was extended by reducing exemptions. 2/ The drastic fall in tax revenues during 1988-90 was also a result of the hyperinflation itself. - 12 - 3.6 At the time the tax measuren were introduced, the fiscal revenues for 1991 were estimated at 9.3 to 11.0 percent of bDP, depending on the degree of improvement in tax administratiqn (Table 7). Assuming continued improvements in tax administration and further reform of the tax system, tax revenues have been projected at 14-15 percent of GDP by 1995. Table 7i TAAGETED FISCAL REVENUES IN 1991 (1 GDP) Before Tea Emergency Tas Inflt. auption Reactiv. After Tas Atual eform easure Elimn. Etfect Reductioo Other riscalts.* Reform kt Jan4tarch 91 1. Income 0.5 0.7 0.3 1.5 0.6 2. Wealth 0.6 -0.3 0.1 0.2 0.2 0.8 0.6 Firms 0.3 0.1 0.2 0.4 Persoasl 0.0 0.2 0.2 Ztraordinary 0.3 -0.3 0.0 3. Importa 1.2 0.3 0.6* 1.5*2.1 0.7 4. s.ports 0.9 .0.4 0.5 0.2 3. Productiealcoaumption 3.6 -0.1 0.6 0.3 1.1* 4.2.5.3 4.5 General Sales (Interswl) 0.6 0.4 0.8* 1.0-1.5 1.1 Selective (Gasoline) 2.2 2.2 2.3 Selective (Other) 0.8 -0.1 Z.3 0.3* 1.0.1.3 1.1 6. Other tames 0.9 .0.1 0.8 1.3 Debits 0.5 0.5 Insurase 0.1 *0.1 0.0 Other 0.3 0.3 Total . 0.6 *0.1 0.8 0.9 0.8 9.311.0 7.9 Upper 11imt a tax adalistration improvements. ll Revenue projected under tax regime prevailing before measures. k/ Projected revenue in 1991 after measures. 3.7 However, actual tax revenues during the first quarter of 1991-- running at 7.9 percent of GDP--have fallen considerably short of the 11 percent of GDP embodied in the 1991 budget presented by the Ministry of Finance to Congress. Since this represents a major risk for sustaining stabilization, it is advisable to: (a) maintain the cash committee and improve the expenditure authorization system to avoid further generation of domestic and/or external arrears. If Central Government expenditures cannot be cut sufficiently, a fraction of public enterprise revenues should be withheld to supplement the Treasury's revenues in the short run; (b) increase the revenue potential of the tax system as soon as possible by: * replacing the net-worth tax for firms by a gross asset tax at the rate of at least 2.5 percent as a minimum payment on account of the income tax. The basis of this would be the value of a firm's assets periodically adjusted for inflation. This new tax was successfully implemented in Mexico in 1989 and is more difficult to evade than the current net-worth tax because it utilizes a higher and not previously used fiscal proxy. A rate of 2.5 percent is recommended to ensure sufficient revenue; and * limiting interest deductions in the firms' income tax (the benefit from deduction of interest payments exceeds the effect of the current tax on interest paid); (c) give priority to improving collection of the IGV; and - 13- (d) quickly implement the recommendations to restructure the tax and customs administration presented in section B of this chapter. 3.8 Peru's taxation system should aim at stability, simplicity, neutrality and equity, relying on a few simple, broadly based universal taxes with moderate rates and an effective tax administration able to deter evasion. The tax measures of November 1990 were a step in the right direction but additional changes are desirable. For example, Table 8 shows that Peru's tax effort is half as successful as that of comparable developing countries and that the tax system is relatively regressive because of the much lower proportion of direct to indirect taxes. Table St TAX REVENUESs PERU VERSUS OTHER COUNTRIES (Percent of GDP) PERU INTERNATIONAL s/ STANDARD - 1980.1985 1966*1987 1988 1969 1990 Total Tax Revenues 12.6 9.8 8.6 5.2 6.4 17.0 Direct Cases 3.7 2.8 2.5 1.3 1.1 6.3 Indirect taxes 1 9.2 7.0 6.1 3.9 5.3 10.7 I/ Average tax revenue for a sample of developing countries with per capita GDP siailar to Peru. Sources PerusCentral Reserve Bank and World lask Estimates. International Standards Vito Tanti "Quantitative Characteristics of the Tax Systems of Developing Countries," in Neubery and Stert, editors. The Theory of Taxation for Developing Coutris. Oxfore University Press, July 1967. 3.9 As soon as other revenues permit, highly distortionary taxes such as the one on debits--turnover of bank deposits--and exports should be phased out. Exemptions under all taxes should be further reduced. The general sales tax should evolve to a comprehensive value-added tax on all consumption, and the personal income tax should be revitalized by means of effective withholdings on salary, other income and interest. It i- also advisable that double taxation of enterprises be eliminated by combining a minimum tax on gross assets with the tax on business profits suggested above. Discriminatory taxation, like the 10 percent tax on exports of large mines when the rate is 5 percent for other traditional exports, should be avoided. Likewise, for the sake of the openness and universality of taxes, no agreement of tax stability should be made or extended in future (at present 193 firms have contracts of fiscal stability with the Treasury). B. Reform of Central Government Administration 3.10 The proliferation of public institutions over the last two decades has been accompanied by a sustained increase in public employment. Table 9 reveals that today the public sector employs around 1.3 million people--including the military--representing almost half of the non-agricultural formal labor force. For every 100 inhabitants of Peru, 4.5 work for the public sector, whereas the average for OECD and developing countries is about half of that. Sustained growth of public employment together with fiscal collapse has led to a ratio of 2.1:1 between the maximum and minimum remuneration of public sector employees (November 1990), compared with a ratio of 8:1 in countries of similar development. -14 Table 9: TRENDS IN PUBLIC SECTOR EMPLOYMENT (in thousands) 1982 1985 1988 1990 1. General Government a/ 496 615 713 730 (of which) Central Government 386 513 559 561 2. State Enterprises 108 143 172 205 3. Total 604 758 885 935 Memorandum items Central Government Payroll/GDP 4% 4% 3.3% 2.6% Index of average real earnings of civil servants 100 107 100 48 j/ Excludes armed forces and police which were estimated at 300,000 in 1990. Source: 1982-88, INAP; 1990 MEF. The Basic Approach 3.11 The reform of the Central Government requires a revision of the tasks performed by each agency. The key will be to phase out unnecessary operations and regulations of competitive markets, to privatize functions that can be performed more efficiently by the private sector and to improve the quality of genuine public goods. This requires that the Government shrink as regulator and gradually increase the quality and remuneration of a smaller number of civil servants. Salary reform will not be easy, because tight budget constraints limit the possibility of improving the salary scale until savings are realized by scaling down some dependencies, including staffing, and until taxes increase beyond the levels currently planned. The results of a policy of voluntary resignations launched in late 1990 have been encouraging; in the Lima Metropolitan area alone 12,000 out of 67,500 employees working in a sample of Central Government agencies had resigned by March 1991. One drawback of the program is the aforementioned financial constraint; another is that the staff reduction, in general, has not been carried out in parallel with a comprehensive functional review of Government entities. Although the Government has reduced the number of ministerial departments (of director general level and above) from 276 in 1989 to 238 at present, a more comprehensive and systematic approach to redefining Central Government administration is required. - 15 - 3.12 The redefinition of functions and the reduction in the number of public employees, as well as the rapid elimination of unnecessary operations, should continue to be based on voluntary decisions. 3.13 The methodology suggested is to follow a two-pronged approach. On the one hand, quick action should be taken on a case-by-case basis to phase out, close or merge agencies now decentralized and some departments of ministries. On the other hand, a system should be devised for the gradual reform of the rest of the Central Government and should include a broad restructuring of the Civil Service. In particular, redefinition and/or abolition of functions and related reductions of staffing should be accompanied by a gradual decompression of the salary scale. A proposal to scale back the number of ministerial dependencies from 238 to 69, and of decentralized agencies from 109 to 76, would permit a reduction in staffing of about 30 percent (Table 10). Table 10: POSSIBLE REDUCTIONS IN STAFF OF PUBLIC ADMINISTRATION I/ (in thousands) Possible Reduction Present -------------------------------------------------------------------- Final Staffing Restructuring h/ Privatization Liquidation Regionalization Staffing 1. Ministries, 478 140 - 1 - 337 Legislative & Judicial 2. Decentralized Agencies 29 10 1 2 2 14 3. Autonomous Agencies 80 20 - - * 60 4. Total 587 170 1 3 2 411 &/ Includes national institutions only and excludes the military. b/ Includes mergers. 3.14 In selecting agencies for reform, the first priority should be the tax administration office (SUNAT) and the customs office (SUNAD). because stabilization critically depends on the Government's increased ability to collect taxes and tariffs on imports. Some lines of reform for SUNAT and SUNAD are provided below. Reforming Tax Administration (SUNAT) 3.15 SUNAT's performance has been very poor. Tax collection dropped from 14 percent of GDP in the mid-80s to 4 percent in 1989. Even though this indicator was affected by economic conditions and lags in collection due to hyperinflation, administrative inefficiencies and overstaffing were contributory factors. Available data show that the number of taxpayers decreased from 416,717 in 1988 to 283,024 in 1989 and revenue comes mostly from a few big taxpayers-- 1,200 taxpayers account for three-fourths of total revenues. There is only one taxpayer for every 70 inhabitants, while in the U.S.A. this ratio is 1:3 and in Spain it is 1:4. In addition to the close monitoring of big taxpayers, a focus on the following areas is required: (a) unified system of taxpayer identification - 16 - and record-keeping; (b) improved collection, accounting and follow-up procedures for all taxes and taxpayers; (c) database system for fiscalization purposes, including cross-checking of different taxes; (d) improved planning and execution of fiscalization; and (e) effective internal auditing. 3.16 These improvements will be difficult to implement without a broad institutional reform of SUNAT. There appear to be three main reasons for administrative deficiencies: management instability, personnel quality and low salaries. 3.17 The superintendent of SUNAT must have reasonable job permanence to be accountable to the nation and public opinion for the performance of the agency. This has not been possible because of the rapid turnover of Ministers of Finance and the consequent turnover of superintendents of SUNAT (there have been 13 over the last 10 years). In addition, SUNAT should be staffed by civil servants of high caliber and moral integrity who would be adequately remunerated. (As of November 1990, the maximum salary in SUNAT was US$100 per month. The compression of the salary scale provides no incentives for outstanding performance and encourages dishonesty.) 3.18 It is proposed that a new decentralized institution with its own budget be created outside the Ministry of Finance. To ensure stability on the job, the superintendent could be nominated by the President but would have to report to the Minister of Finance. The institution would not deal with tax policy issues, which would continue to be handled by the Ministry of Finance, but would establish its own recruitment standards and procedures and would offer salaries comparable with those for similar jobs in the private sector. SUNAT should be phased out. Reforming Customs Administration (SUNAD) 3.19 SUNAD has evolved into a rigid, overstaffed and complex structure. Its staff is double that of Chile's but handles less than half the trade. Normative, administrative and operational reforms are needed. With the measures adopted in March 1990, the Government has started to move--in line with the Kyoto recommendations--towards simplifying and rationalizing administrative procedures, allowing importers to assess and pay duty (with spot checks and severe penalties for underassessment) and delegating some functions to private customs agents and private warehouses. 3.20 SUNAD faces the same organizational problems as SUNAT: untrained personnel, low salaries and management instability. Professional personnel constitute only 6 percent of overall staffing. Salaries are subject to ths general Government scales, and as of November 1990, the maximum was about US$100 per month. The turnover of superintendents has been very high; latterly they have averaged six months in office. The same institutional arrangement proposed for SUNAT is applicable to SUNAD. - 17 - Case Study: Reforming IPSS 3.21 Assessment. The social security system, which comprises both health insurance and retirement pensions, is a public autonomous entity, the revenues for which are raised by an 18 percent levy on wages. Administrative expenses reached 21 percent of total outlays in 1989, but the quality of health coverage provided was so bad that 20 percent of the workers had a second (private) insurance. From 1985 to 1990, the population covered by the IPSS tripled because health benefits were extended to the dependents of workers. There was no corresponding increase in contributions. Real revenues were cut by half, while the number of employees increased from 28,000 to 44,000. In addition, IPSS generally procures its inputs at excessive costs; often subcontracts services from private institutions when its own hospitals have a 30 percent to 40 percent slack capacity; and spends more per medical visit than private practitioners charge. To balance the budget, pensions were reduced by 77 percent in real terms between 1985 and 1989 (Table 11). Table 11: PERUVIAN SOCIAL SECURITY SYSTEM 1985 1989 Average Pension in Real Terns 1985 w 100 100 23 Number of Beneficiaries 1984 a 100 188 263 Total Real Revenues of IPSS 1985 a 100 100 56 Administrative Expenses as 2 of Total Outlay 14 21 Number of Employees 28600 41000 3.22 Although the Administration has taken some very positive actions to improve the financial health of the IPSS, including some reduction in staffing, the system continues to be intrinsically flawed. It encourages evasion because pensions are based not on capitalized contributions made during an individual's working life, but on the average nominal wages received for the last 12 months. Moreover, anyone with five years of service is eligible for a pension. Although the ratio of contributing workers to pensioners is 12:1, the growth trends are worrisome because the number of pensioners is increasing at an annual rate of 9 percent compared with a rate of 4 percent for enrolled private sector workers. 3.23 Recommendations. The monopoly of the IPSS should be abolished and each worker should be allowed to choose any health and pension institution, public or private (the current Chilean system). The transition to this optional system could be immediate for health insurance, but might entail some cash-flow complications for the pension fund because younger workers would be the most likely to switch to the private system, thus causing a cash deficit for IPSS. Long-term external financing would probably be required to bridge the gap. In any case, the IPSS pension system should be changed to a fund system that ensures that pensions will be related to the capitalized amounts contributed by each worker. Likewise, health insurance should cover only a fraction of health costs, say 80 percent, and not the present 100 percent, to avoid abuse of the system. Also, health insurance premiums should be proportional to the number of dependents. - 18 - Case Study: the Housing Sector 3.24 Assessment. The housing program (FONAVI) is based upon an earmarked contribution, equal to 6 percent of wages, which accounted for 0.5 percent of the GDP in 1985 and only 0.2 percent in 1990. Revenues are distributed among different institutions, which survive only because of this transfer. FONAVI loans are highly subsidized, and understandably only a small fraction of contributing workers ever receives a FONAVI mortgage loan. From 1979 to 1989, the recovery of loans was only 10 percent of total revenue (this ratio dropped to less than 2 percent in 1990). The Government is heavily involved in housing (through one ministry, two public banks, one public enterprise and several other agencies). 3.25 Recommendations. Public involvement in housing should be scaled down significantly and ideally phased out. The Government could still provide for low-income housing by either compensating private banks for the difference between the market interest rate and a reasonably subsidized rate oz. loans or giving an outright cash ouboidy to targeted beneficiaries. Government agencies in the sector could be either abolished or scaled back in a way consistent with the new approach. It is estimated that the number of public employees in the sector could be reduced to one-tenth. The tax on wages that funds FONAVI is inequitable because it is levied on all formal sector workers and benefits only a few. By raising the cost of labor, it deters formal employment and drives workers to the informal sector. It should be phased out or at least reduced. Reforming Covernment Ministries 3.26 A full-fledged functional review is required to identify desirable reductions in public institutions and employment. Following are several general criteria that could be followed: (a) abolish those agencies that: (i) administer a regulation that has disappeared (e.g., the seven offices in charge of price controls); (ii) are in poor financial condition (most public banks); or (iii) are redundant (e.g., 18 legal offices when there are only 14 ministries'; (b) divest agencies that can be administered by the private sector (e.g., the public zoo, all training agencies for private sector workers); (c) merge agencies that perform similar activities (e.g., there are several public programs (PAD, ONAA, COOPOP) channelling subsidies to the poor, and more than one office in charge of project evaluation); (d) merge some of the ministries (e.g., establish a production ministry that would consolidate the Ministries of Industry, Fisheries and Transportation). - 19 - C. Reforminz the Public Enterprise Sector 3.27 The reform of the large public enterprise sector a major cause of Peru's disappointing economic and financial performance, should concentrate, first and foremost, on privatizing public enterprises and encouraging private sector participation, and then, on reforming retained public enterprises by increasing managerial and financial autonomy and accountability--as soon as stabilization is consolidated. The present desirable tight control over all public sector revenues and expenditures can be relaxed thereafter. 3.28 Size of the Sector. The number of public enterprises was 40 in 1968, rose to a high of over 180 in the late 1970s, and today is 133 (if financial public enterprises were included the total would be 181). The expansion came about without a clearly defined role for the public enterprise sector. Some indication of this can be found in the mechanism used to create public enterprises. About 33 percent of existing public enterprises were directly created by the state, 25 percent were converted from decentralized public organizations to public enterprises and the rest were taken over from the private sector, including 12 percent from foreign companies, 8 percent from Peruvians and 11 percent as bankrupt private firms. 3.29 The net result has been that the public enterprise sector plays a dominant role in the economy. It produces about 15 percent of GDP and accounts for 28 percent of exports, 26 percent of imports and 30 percent of public sector investment (Table 12) Public enterprises are involved in the production of electricity, water, fertilizers, steel, rail, telecommunications, paper and cement, and dominate production in petroleum and gas, fish processing, mining and banking. Although foreign companies collaborate with PETROPERU in the extraction/production of crude, it controls domestic sales and foreign trade. A number of public enterprises--marketing boards--are heavily involved in mining and basic foodstuffs. Table 12: PUBLIC ENTERPRISE: KEY 1NDICATORS (in Z) 1981 1985 1989 Exports/total exports 46.2 36.9 28.1 Imports/total imports 25.8 26.1 26.2 Investment/GDP 3.3 3.2 1.5 Investment/total 76.8 49.4 32.2 public investment Employment 100 97 205 (in thousands) Source: CONADE - 20 - 4, Scope for Divestiture 3.30 In March 1991, the Government offered 23 smaller public enterprises for sale--a positive first stcp that should demonstrate the feasibility of privatization. 3.31 Divestiture and reliance on the private sector to undertake a number of major investments are major elements in Peru's public sector reform. Quick action is needed to enhance Government revenues and particularly to demonstrate the determination to reduce the state's economic role so it can concentrate on providing genuine public goods. 3.32 Divestiture should be open and should maximize the Treasury's revenues. A minimum target of about US$200 million of revenues from sales of enterprises could be set for the next 12 months. The Government could move rapidly in several of these areas: (a) Oil and Gas. Tha Government now controls 50 percent of the production of crude and all refining and distribution. In 1988, Peru again became a net importer of oil (in value terms), a situation that will get worse unless there is broader private sector involvement, because the public sector lacks the resources for investments in the foreseeable future. New exploration contracts and new concessions are needed to revive production, and as much private sector participation as possible is necessary to provide sufficient finance and efficiency. Action should be taken to settle existing disputes and revive stalled projects such as Camisea. (b) Mining. The public sector controls about 40 percent of production. Given the easily separable activities and mines of public sector firms, the Government could proceed to sell the mines and facilities of CENTROMIN, HIERROPERU, MINEROPERU and TINTAYA. Substantial private participation is necessary because of the deterioration of the facilities. (c) Fisheries. Government intervention in the sector since the early 1970s--the public sector now controls about 35 percent of total domestic production--has proven counterproductive as evidenced by the drop of fishmeal output from 2 million tons in 1969 to about 1 million tons at present. Rapid total or partial disengagement from the production/marketing actiities of PESCAPERU and FLOPESCA is needed. The Government should also divest its controlling interest in COPES. There appear to be potential local buyers for several individual plants and outlets of these firms. (d) Banking. As discussed below, it will be easiest to privatize the public commercial banks now that financial intermediation is still small and the existing volume of non-performing assets probably can be absorbed more easily. The Government has already started the process by offering Banco Popular for sale. Banco Continental, - 21 - Interbank and several "financieras" could follow before portfolios deteriorate. In turn, public development. banks should be wound up (e.g., Banco Minero) or severely limited in operation (e.g., Banco Agrario to farmers in Sierra and Selva, and Banco Industrial to small borrowers), with any subsidy provided by the budget strictly limited and unconcealed. (e) Transportation. AEROPERU is an excellent candidate for privatization. It is in a highly competitive sector and enjoys highly saleable assets in the form of its routes, particularly now that an open-air policy has been agreed upon among the Andean Pact countries. The experience of privatizing other airlines in the recent past (British Airways, Mexicana, Aerolineas Argentinas) offers valuable lessons that could be replicated easily. - 22 - CHAPTER IV REFORMING THE ECONOMY'S KEY MARKETS 4.1 Peru's key markets--financial, foreign trade, labor and agri- cultural--traditionally have been encumbered with regulations, restrictions and direct Government participation. Solidifying fiscal stabilization requires the phasing out of direct Government involvement in the financial sector and agricultural marketing, which have been a chronic burden for the Treasury and the Central Bank. In turn, improving resource allocation to reach normal levels of economic activity and then resuming growth call for deregulation and liberalization of all these markets. The Government has taken bold steps in passing the new Banking Law, liberalizing foreign trade, abolishing public monopolies in grain trading and other activities, reforming land tenure and relaxing several labor market restrictions. A. Financial Sector Reform Backxround and General Lines of Reform 4.2 Experience in many countries has shown that financial sector and macroeconomic reforms must be closely coordinated. A stable macroeconomic environment and a price/incentive framework are essential to the financial system's solvency and performance. At the same time, economic development requires a dynamic financial system to mobilize resources and allocate them in a decentralized fashion at a low cost of intermediation. 4.3 The Government's program--reduction of inflation, liberalization of interest rates and reduction of the public sector's demands for credit-- could set the stage for better financial sector performance. The repeal of the Bank Nationalization Law and its replacement by the new Banking and Insurance Law--that inter alia promotes universal banking, removes restrictions on foreign participation in the sector and liberalizes operations and interest rates--represent important steps in establishing a more efficient financial system. At this point, reforms are needed in three key areas: (a) strengthening the solvency of the system; (b) reducing the role of the state through divestiture and reform of public banks; and (c) improving further the financial system's efficiency. Strengthening the Solvency of the System 4.4 For a country that has experienced as many severe macroeconomic troubles as Peru, the quality of the system's loan portfolio is not bad by Latin American standards. This is partly due to the fact that hyperinflation reduced drastically the real indebtedness of firms. On the other hand, the high reserve requirements that have prevailed in recent years limited loans to the private sector that could have become non-performing. Of course, the portfolios of the development banks and the public commercial banks are much worse than the average and in most cases are in a critical state. 4.5 The system's solvency could nonetheless deteriorate substantially as the economy remonetizes, particularly because the concentration of lending is high and ex-post real interest rates on Inti-denominated deposits are very - 23 - high and are likely to remain high. Successful macroeconomic stabilization typically leads to high ex-Post real interest rates for three reasons: the public often underestimates the odds for successful stabilization and thus demands high nominal returns on domestic currency deposits; intermediation costs typically are high relative to the initial size of total deposits/lending in the system, making the spread larger than in normal times; and there is substantial demand for distress financing. From the third week of August 1990 to the fourth week of April 1991, the average was 17 percent. In contrast, monthly lending nominal interest rates on dollar loans over the same period have been less than 2 percent. The high rates on Inti loans, measured both in real terms and in dollars, reflect the extent of devaluation expectations and represent a "tax" on stabilization by economic agents skeptical of the program's success. Despite the lower interest rates, however, foreign exchange lending bears the risk of sharp exchange rate fluctuations (like those that occurred in early December and May). This is a problem particularly with the portfolios of borrowers of domestic market orientation. 4.6 To withstand possible post-stabilization shocks and improve the health of the system, financial institutions need to be protected by tighter regulations that limit lending concentration and strengthen loan collaterals, capital requirements and reserves for bad debts. Considering the financial condition of banks is generally worse than what their statements show, reserves for bad debts should be given particular attention. All these measures will reduce the Central Bank's potential liabilities and the potential disruptions that may arise in a situation of distressed borrowing, high real interest rates, exchange rate depreciation and large shifts in relative prices. 4.7 Measures to improve solvency could include: (a) strengthening the authority of the Superintendency of Banking and Insurance (SBS) to force intermediaries to deal head-on with solvency and profitability problems; (b) establishing a more effective legal/regulatory framework like that initiated with the new Banking Law (amendments to the SBS and BCR laws may also be required); (c) improving the mechanisms for managing and resolving banking crises; and (d) encouraging higher intermediation levels and facilitating labor mobility in the financial sector to reduce the high unit cost of deposits. Reform and Divestiture of Public Banks 4.8 State-owned financial institutions hold half of the deposits and nearly two-thirds of the credits in the financial system (Table 13). Many public banks are in poor financial condition and several are bankrupt. The Government could take forceful action in two main areas: (a) canceling or strictly limiting the regionalization of the banking system--that was decreed at the end of the previous Administration--and especially preventing the transfer of control of public banks to regional governments (regional control of state banks has led to a loss of monetary control in some countries, e.g., Argentina); and (b) reducing the scope of public sector intermediation by privatizing public commercial banks and liquidating the more troubled development banks and restricting the operations of those that remain. - 24 - Table 13a STRUCTURE OF THE FINA CAL STSTRM (October 1990) go. of Ho. of Staff Growth Total Share of Film. Ssm 2) Institutions Staff 86.90 Offices DOetEs8 Ce1 State Banks 3 10364 52 477 34.91 59.24 of vbicb Sace Bacton 1 7407 02 454 36.69 53.96 Developaent Banks 5 12283 242 338 3.69 10.74 Public Commercial Banks 7 12997 N.A 429 19.27 12.95 Private Commercial Banks 13 12266 N.A $47 29.49 14.95 SavingelCoop lanks 2 2223 292 205 2.06 0.53 Public ?Ienae Coop. 3 594 N.A 21 2.69 0.65 Private Finance Cop. 4 See *.A 20 5.86 1.57 4.9 The Government owns several commercial banks, some managed better than others, but all perceived by the market as less efficient than private banks and all plagued by dwindling resources and inferior management capabilities. The Government should consider privatizing these institutions while their losses are still small in absolute terms and can be absorbed easily. 4.10 The Government operates Banco de la Nacion and COFIDE as financial agents of the public sector. Both are oversized in relation to the financial market and need a redefinition of functions. Banco de la Nacion has the monopoly of public sector deposits and credits, controlling 37 percent of deposits and 54 percent of credits in the system (Table 13). An alternative would be to allow COFIDE to concentrate on second-tier lending and to phase out its direct lending activities. 4.11 The Government also owns five development banks (Banco Hipotecario, Banco Industrial, Banco Agrario, Banco Minero and Banco de la Vivienda), whose inefficient operations require large subsidies to their respective sectors and contribute to the loss of monetary control. Most are in a weak financial condition as a result of poor lending practices, poor management and overstaffing. As a first remedial step, development banks should not have access to Central Bank funding and should not be allowed to operate as commercial banks. A major downsizing of these institutions is necessary since they have over 12,000 employees, well in excess of what they need for the size of their operations. The Banco Minero is in the worst shape. With a negative net worth and almost all its loans in default, it is a clear candidate for liquidation since it is virtually impossible to make it financially viable. Banco Industrial also is in bad condition and could be considered for either liquidation or a major downsizing that would permit it to lend at market rates only to small and micro entrepreneurs. Banco Agrario, oversized and in critical financial condition, should be limited to serving peasants in the Sierra and Selva, with interest rate subsidies, if any, coming from the Treasury (not the Central Bank) and strictly limited. Monetary/Fiscal Policy and Financial Sector Development 4.12 To achieve financial sector efficiency, monetary policy should be applied with the least distortions. As explained above, during the first stage of stabilization the public sector should make no demands for Central Bank financing. The practice of consolidating the Government debt to the Central Bank as a zero interest loan at 100 years should be terminated. Growth targets of the money base should be met exclusively by purchases of - 25 - foreign exchange reserves. As monetary targets permit, the Central Bank should continue to lower reserve requirements to levels consistent with greater allocations of credit to the private sector. At the same time, interest payments on reserve requirements should be reduced so as to eventually reach the technical, non-remunerated, low-reserve requirement ratios established by the new Banking Law. Improving the Financial System's Efficiency 4.13 The efficiency of Peru's financial system has been undermined by macroeconomic instability, inefficient Government involvement, restrictions on the operations of commercial banks and non-neutral taxation of financial institutions, assets and income. Redressing these conditions will establish an environment conducive to a more efficient and resilient financial sector. Reduced macroeconomic uncertainty will help remonetization and lengthen the average maturity of financial instruments. 4.14 To strengthen competition, the Government has provided a clear signal of interest rate liberalization by setting non-binding ceilings on Inti rates and by reducing the supply of subsidized credit. This signal could be strengthened by linking interest rates on currently subsidized credit to market rates (however small the amount of that credit may remain) and abolishing mandatory credit allocations to areas outside Lima and to agriculture. Strengthening property rights and marketability of land and informal property would improve collaterals and thus the access of the affected sectors to private financial resources. The Government should continue to examine land tenure in the context of easing property restrictions, particularly after the recent decree enlarging private sector participation in agriculture. 4.15 The financial system should contribute to fiscal revenues with a more neutral tax that is not directly levied on intermediation itself. The 0.75 percent tax when deposits turn over and the 15 percent tax on interest income on loans discourage financial intermediation and invite financial institutions to resort to all kinds of tax evasion. However, given the need for fiscal restraint, current taxes on financial intermediation should be phased out only as new tax revenues replace them. B. Foreign Trade Reform Background 4.16 The present Government has accompanied its short-term stabilization program with a wide-ranging effort to liberalize trade. Peru's last attempt to reform foreign trade policies occurred in 1979-81 when most nin-tariff barriers were lifted, a 60 percent tariff ceiling was established and export subsidies were trimmed. That process was reversed in the last two years of the Belaunde regime, and the APRA Administration that followed introduced further restrictions. By 1988, all of the 5,266 tariff categories were subject to QRs and other restrictions (Table 14). - 26 - Lable , CERCZeIS orCS Of TARIFF AND fOUAL NON-TArff s&RAIS (percent) ..... ------ December ------- Set. March 1981 1985 1988 1989 190 1991 1. Siaple AversRe a/ 32.0 63.0 70.0 66.0 26.0 17.0 jl 2. Standard Deviatlon b/ 16.0 24.0 20.0 25.2 13.0 a.a. 3. Nazism Tariff Cum Turcbarge 60.0 137.0 108.0 110.0 50.0 25.0 d/ 4. Zffective Tariff Collection latio 11 16.0 25.0 23.0 17.0 n.a. a.a. S. Nuaber of Restricted Tariff Categories (as 2 of total) 2.2 10.3 100.0 20.4 0.0 a1 0.0 a/ at Simple average Iacluding tariff surcharges. V/ Eacludes surcharge. TI During the indicated year. l Zacluding wheat. flour. powdered milk and seven other products aubject to additional specific levies. - For inatance. wheat is subject to an taport levy of 0S550 per ton in addition to the ariff. ll It does nt consider the *zLetence of several Government monopoltes. the sain one being that of PITROPERO. Sources SaP Recent Developments 4.17 By March 1991, the new Administration had made substantial progress in liberalizing trade. Most formal non-tariff barriers--including registration requirements and phytosanitary restrictions--have been dismantled and the complex tariff schedule has been reduced to two rates: 15 percent and 25 percent. (Exceptions to this rule, shown in Table 15, are wheat and nine other agricultural products, which are subject to additional levies, and imports by SIDERPERU, which pay a 5 percent tariff.) Several Government monopolies remain, the most important being PETROPERU's in petroleum products. CERTEX, the export subsidy for non-traditional exports, has been abolished, together with the emergency export tax of 10 percent. The tax on traditional exports has been lowered to 5 percent, except for large mining, which still pays 10 percent. Foreign exchange surrender requirements for exporters have been abolished and, in general, capital account transactions have been liberalized. The Government also has extended the Temporary Admission System of imports for exports by broadening eligibility and has introduced a duty- drawback system for exporters. Table 15: EXCEPTIONS TO THE TWO*TIER TARIFF REGIME (USS/ton, April 1991) -****Powdered Milk-*** Yellow SIDERPERU's Item Type I Type II Type III Wheat Flour Maize Rice Sorghum Sugar Pasta Inports Additional Levy 408 540 378 50 75 5 40 5 40 100 Subject only to a special tariff of 5 percent. 4.18 The simplification of trade taxation and barriers needs to be accompanied by a reform of the Customs Service to ensure effective revenue collection in support of macroeconomic stabilization. Customs should be responsible for the collection of at least one-fourth of total Government tax revenues in addition to the value-added and excise taxes collected on imports. This is especially important in view of the recent elimination of most of the cumbersome duty exemptions. Customs reform should be given priority in the restructuring of the administration. - 27 - Reforms Needed to Improve Allocative Efficiency 4.19 The present tariff schedule should be reduced to a uniform rate to guarantee effective protection to all import-substituting activities. In addition, the levies on wheat, flour and other agricultural commodities should conform to those for import-competing activities. If there are good reasons to protect these sectors, efficient resource allocation would require this to be done by direct production subsidies. 4.20 With the removal of CERTEX, exporters can be expected to show greater willingness to use the new liberal Temporary Admission mechanism, under which exports entitle them to duty-free imports. Under CERTEX, the value of these imports was deducted from the FOB base to calculate the export subsidy. Moreover, the previous Temporary Admission system, although well conceived, was slow and inefficient. Safeguard Mechanisms 4.21 Close attention should be given to the possible reemergence of protective measures in the form of regulatory trade restrictions, such as sanitary controls and technical norms. Reforms should also guard against resort to minimum reference prices (Precios de aforo minimo) for imports to counteract alleged dumping practices. In this regard, it is important to support the liberalization process with the creation of a safeguard mechanism that, whenever tariff changes or other trade measures are under consideration, would ensure adequate and equitable Protection for the interests of all those affected by the decision--domestic producers, exporters and consumers. Also essential is a mechanism by which those groups interested in a more open trade arrangement can voice their views vis a vis the interests of the import- substitution sectors, and by which, aside from tariffs, the panoply of regulatory protection instruments, in particular reference prices and other trade barriers, can be dealt with. 4.22 One way for Peru to strengthen its commitment to trade liberalization would be to negotiate adherence to the GATT codes of subsidies and countervailing duties. Such international agreements would protect Peru's access to foreign markets by allowing its exports the benefit of the injury test. (Peru should elso sign a tariff-binding commitment with GATT to ensure that no tariff is ra.sed over current levels.) The codes would also protect the Government from the constant demand of pressure groups for the adoption of subsidies. C. Agricultural Credit and Marketing Background 4.23 The agrarian reform laws and other well-meaning measures of the early 1970s aimed at protecting small farmers retarded agricultural sector growth. They introduced uncertainty in land tenure when collective plots were parceled out, and severely restricted land marketability, including the possibility of using land as collateral. On the other hand, the import- substitution strategy pursued since the 1960s contributed to the persistent deterioration of the agricultural sector's terms of trade as a result of high - 28 - trade barriers-for industrial products, chronic overvaluation of the currency and sporadic multiple exchange rates that discriminated against agriculture. 4.24 In an attempt to offset these disadvantages, the Government provided massive subsidies to agriculture through Peru's two grain trading agencies, ENCI (grain marketing and fertilizers) and ECASA (rice marketing), and through subsidized lending by the Banco Agrario (BAP). In 1989, the. Central Bank gave BAP US$696 million, equivalent to about one-third of fiscal revenues, to finance agricultural producers at significantly negative real interest rates, and contributed US$295 million indirectly through exchange rate subsidies to ENCI and ECASA, which suffered a combined US$24 million trading loss. 4.25 Employment in these institutions grew significantly during the period 1985-90. It tripled in ENCI, increased two and a half times in ECASA, and grew by a quarter in the Banco Agrario (Table 16). As a result, operating expenses were high: in 1989, ENCI spent US$10 million and Banco Agrario spent US$25 million. Tabte 16: EMPLOYMENT AND TRADING VOLUME OF ENCI AND ECASA 1984 1985 1986 1987 1988 1989 ENCI Nunber of workers 1108 1132 1694 2884 2849 3042 Tons marketed per worker empLoyed 2.650 2.485 2.763 1.804 1.675 883 ECASA Number of workers 1655 1834 2412 3269 4125 4612 Tons marketed per worker emptoyed 684 726 608 567 411 187 4.26 In a decisive turnaround of agricultural policy, the Government issued two decrees in April 1991 which, if ratified by Congress, will set the stage for efficient agricultural development. These decrees promote the role of the private sector in land ownership, provide incentives for collective farms to become private estates and abolish restrictions on land marketability and its use as collateral. Reforms Needed to Solidify Stabilization 4.27 The strategy of offsetting distortions in the agricultural sector by Government subsidies, followed over the last two decades, could undermine stabilization, fiscal balance and monetary stability. It has also failed to promote agricultural growth. From 1970 to 1990, the agricultural sector grew at half the rate of population. Peru has now started to confront the real problems of agriculture (land tenure, marketability of land, reduction of protection to industry and a floating exchange rate) and to move away from massive inefficient subsidies. To the extent that the Government sees a continuing need for involvement, it should concentrate exclusively on the Sierra and Selva, where income distribution considerations and emergency conditions warrant this intervention. Producers on the Coast--the area that - 29 - traditionally has received the bulk of subsidies--are relatively more capitalized and have or could hakre access to private suppliers of inputs and to non-public sources of-credit. 4.28 ECASA. The Government has taken a positive step in liquidating ECASA. In Selva, the transport and marketing of rice, which competes with the coca crops and would be uneconomical under private operation because of high transport costs, has been transferred to ENCI. The Government should make sure that the entire assets of ECASA are sold to the private sector and that its staff is given adequate compensation so that ENCI does not inherit responsibility for ECASA's functions, assets and staff. 4.29 The Role of ENCI. Another decisive step has been the abolishing of ENCI's monopoly in grain trading, without which ENCI would become a deficit institution and therefore a major fiscal problem. Therefore, ENCI should consider withdrawing from the Coast and concentrating its promotional work--in fertilizer and inputs provision and limited marketing of grains--in the Selva and Sierra, excluding the areas in which private traders already operate. ENCI would require a transfer from the Treasury to market at most 200,000 tons in those areas (including the purchase of rice from Selva previously made by ECASA). Consequently, the best approach would be to grant ENi a non- adjustable transfer for it to decide the most convenient lines of operation. Its personnel could be reduced to no more than one-fifth, largely located in the Sierra and Selva. 4.30 The Role of Banco Agrario. Subsidized lending by Banco Agrario disguised the real problems of agriculture by delaying needed solutions to land tenure and to the use of land as collateral for lending. Moreover, its right of first call on guarantees--recently abolished by the Government-- almost eliminated private financial lending to agriculture. ENCI and Banco Agrario have to a large extent duplicated the Government's infrastructure in granting subsidies to farmers. Indeed, in many areas Banco Agrario provides the farmer with subsidized credit to buy subsidized fertilizer or seed from ENCI. Duplication could be avoided by having either ENCI provide the inputs on credit or Banco Agrario provide the credit and the private sector supply the inputs. It is important to emphasize that lending by Banco Agrario was one of the maior factors contributing to the 1989 hyperinflation. As shown in Table 17, Central Bank transfers to Banco Agrario accounted for 43 percent of total Central Bank domestic credit or monetary flow. - 30 - Table 17: RELATION BETWEEN LENDING BY BANCO ACRARIO AND MONETARY FLOW ( (USS millions) 1985 1986 1987 1988 1989 -- - ------ --- - - -- - - - - -- - - - - - - - - Total flow of lending by Banco 502 815 652 379 842 Agrario Financed by: - Central Bank transfers 73 245 288 233 696 - Own resources and other 429 570 364 146 146 sources Memorandum Item Central Bank transfers to Banco Agrario (as a perc.tage of total Central 13.8 23.9 19.6 9.8 42.6 Domestic credit) 4.31 Banco Agrario should terminate its operations on the Coast and cut its staffing (at present 5,500) by at least three-quarters. Its infrastructure could be divested to existing or potential agricultural savings and credit cooperatives, commercial banks or similar institutions. To the extent that there is duplication between the networks of BAP and commercial banks in some areas of the Selva and Sierra (32 percent of commercial bank branches are in those regions), selected closures of BAP offices in these areas should also be considered. If a reasonable and limited subsidy to farmers is deemed necessary, this should be given directly by the Treasury (not the Central Bank) through the commercial banks. Reforms Needed to Improve Market Efficiency 4.32 Current measures to ensure security of land tenure and marketability of land and to promote titling should be strengthened and public intervention in agricultural markets should be reduced (Table 18). Most agricultural products are traded in commodity markets, where prices will dictate the most suitable crop patterns if a competitive environment is allowed to prevail. When the price of a specific crop in the emergency areas drops significantly, ENCI could decide whether to use part of its budget to establish a precio de refueio. Otherwise, it should refrain as much as possible from setting guarantee prices and storing grains. Table 18: LAND TENURE BY REGION Land Tenure Regime (%) Extension in Ha. With Title Without Title Unclear Coast 572,093 61 30 9 Sierra 9,747,967 65 30 5 Selva 4,373,276 30 64 6 Source: ENAHR, December 1986 - 31 - D. *Labor Market Reform Backzround 4.33 Most of the regulations introduced in the labor market in the early 1970s were aimed at protecting workers' employment and improving their incomes. However, the results have been quite the opposite. The formal labor market (the portion that fully complies with the labor stability regulations) has shrunk significantly and real wages have fallen systematically over the last 20 years. Aware that without an increase in labor mobility the benefits from the new incentive framework will be limited, the Government has recently broadened some of the layoff provisions of the labcr stability law so as to make the labor market more flexible. Leral Framework 4.34 The general principle of Peru's labor legislation over the last 20 years has been that workers in the formal sector are entitled to stability, which they acquire after three months' probation. A worker who is laid off can seek legal redress and, if successful, can choose either to be reinstated or receive severance pay (for example, workers with more than three years of seniority are entitled to a year's salary). The very narrow definition in the law has made it difficult to prove "fair cause" in the courts. The overall effect of stability has been to reduce the responsiveness of firms in the formal sector to changes in market conditions, to turn labor costs into fixed costs and to raise the effective cost of labor. In addition, the regulations are believed to be responsible for lowering labor productivity. 4.35 In March 1991, the Government issued several decrees to restrict the applicability of labor stability by: (a) enlarging the provisions of "fair cause" for layoffs to include low productivity of workers and "exceptional economic or technical situations" of firms; and (b) simplifying procedures for proving "fair cause." Although these measures undoubtedly make Peru's labor market more flexible, it is still relatively rigid compared with most other developing countries. 4.36 Like labor stability, legislated fringe benefits have significantly increased labor costs and deterred increased employment without improving workers' incomes. Most of these benefits have had the effect of depressing take-home wages and reducing the demand for labor. Regulated fringe benefits and labor stability have raised the cost of labor by at least 70 percent of formal sector take-home wages (Table 19). - 32 - Table 19: RIGIDITIES IN THE FORMAL LABOR MARKET: WAGES VERSUS COST OF LABOR Wages and Percent Items Over Wages Comments Take-Home Waxe 100.0 Additional Costs of Labor a. To Waies: Minimum Wage ? Not possible to evaluate quantitatively but restriction affects the level and variance of cost of labor. Indexation Idem Social Security and 21.00 other Contributions Retirement 6.00 Health 6.00 Accidents 3.00 FONAVI 5.00 SENATI 1.00 Vacations 9.72 Bonuses 19.44 Two bonuses a year that, although not required by law, are common. Labor Community i/ 3.75 1. Profit. 1.50 A 152 net profit rate is assumed. 2. Ownership 2.25 Idem 3. Management ? Increases factor risk. b. To Employment: Compensation for Years of Service 8.33 Labor Stability , Not possible to quantify, but increases labor costs by reducing productivity. Massive Layoffs Increases factor risk. Severance Payment 8.33 This percentage is a rough estimate. - --------------------------------------- .......... ..----------- .......................... Total Cost of Labor 170.57 Labor participation in ownership, profits and management results from the "labor community" instituted in the early 1970s. However, new firms have ways of avoiding it. Employment Trends and Real Waite Evolution 4.37 The evidence suggests that these laws and mandatory benefits have been devastating for workers, systematically reducing real wages and job opportunities in the formal market. Table 20 shows the dramatic decline in real wages over the last 20 years, and Table 21 estimates that only 778,000 workers, or about 10 percent of the labor supply, are wholly protected by the laws. Limited formal sector employment reflects the higher cost of labor, which not only has encouraged the substitution of capital for labor, but has reduced the competitiveness of formal sector firms and prompted their shift into the informal sector (Table 22). (This process, of course, has contributed to a shrinking tax base.) Table 20: EVOLUTION OF REAL WAGES (Index 1963/75o100, average of the period) 1963/75 1976/84 1985 1989 minimum Wage 100 77 45 22 Average Salary 100 71 55 36 Average Wage 100 83 63 42 Source: Cuanto S.A. 1990 - 33 - Table 21: ESTIMATED COMPOSITION OF PERUVAN POPULATIOd IN 1990 (Thousands of inhabitants) 4 Total Population 22,322 Labor Supply (PEA) 1.661 Unemployed 766 Employed 6.895 Independent 4,137 Wage labor 2.758 Public sector 1,280 Private 1.478 Without labor stability 700 With labor stability 778 Source: National Institute of Planning Table 22: COMPOSITION OF LABOR SUPPLY (Percent) Group 1961 1981 1988 Peasants 32 24 22 Agricultural Producers (small and medium) 2 6 8 Independent Urban Workers (informal sector) 15 19 22 Wage Labor 49 50 47 Workers and Employees 43 46 44 Public Sector 7 17 19 Private Sector 36 29 25 Domestic Employees 6 4 3 Employers 2 1 1 Total 100 100 100 Source: National Planning Institute 4.38 Four regulations permitting temporary employment have been enacted to circumvent the detrimental effects of the labor stability laws on new employment. These are: Emergency Employment Program (PROEM), Fixed-Term Contracts Decree (DL 18138), Employment Contracts in Free Industrial and Exceptional Treatment Zones (Law 25100) and Employment in Non-Traditional Exporting Firms. Labor Market and Structural Adiustment 4.39 Labor market rigidity could reduce the speed and success of foreign trade reform, financial sector liberalization and other improvements. Firms competing with the import sector will find it difficult to adjust to the abolition of QRs and tariff reductions unless labor laws are made more flexible. Likewise, debtor firms will be less likely to honor debts at the - 34 - high ex-post real interest rates of the early phase of stabilization if they cannot adjust their labor costs. The engine of growth under the new, less distorted incentive framework will be existing or new firms and investments in the sectors in which Peru has real comparative advantage. Investment and employment in the required new export sectors will be greatly deterred by labor restrictions and rigid labor laws. 4.40 Reforming the labor market has a flow and a stock dimension. The market can be reformed "in the flow"--i.e., for incremental or new employment- -by lengthening probation and by broadening the scope of the four laws regulating temporary employment. Dealing with the stock problem--i.e., the universe of workers now covered by stability--would require the abolition of labor stability. The Government has taken a sensible initial step in this direction by broadening the interpretation of "fair cause" to include low productivity, declining terms of trade for the employer and other economic reasons. 4.41 In order to encourage expanding firms to employ labor more efficiently, two policy changes are needed at a minimum: (a) the total elimination, or at least the extension to several years, of the probationary period; and (b) the enactment of laws with more general applicability and permanence than the current temporary contract laws. 4.42 These changes, however, would only be second best to abolishing labor stability and most fringe benefits altogether and allowing freer negotiation of non-wage labor costs. The coexistence of two groups of workers with large differences in employment stability could become a temptation to extend the labor stability regulations to workers under temporary employment programs, thereby increasing labor market rigidities. In addition to widening the definition of "fair cause" for dismissal, suggested changes might include: (a) allowing a voluntary trade-off of non-wage benefits for a higher wage so that workers can either receive a higher take-home pay or be required to invest part of the higher wage in private funds. (In this connection, the Government has recently decreed that the 8.3 percent deduction from salaries for the "compensation for years of service" to be paid in bulk at lay-off or retirement will now be deposited at financial institutions instead of being capitalized in the firm); (b) allowing employers to buy out the right to labor stability from workers, thus restoring a more even bargaining position between employer and employee. 4.43 Overall, these reforms can be expected to improve the welfare of all workers by increasing wages and the demand for labor, instead of protecting the interest of a limited number of workers in the formal sector. - 35 - CHAPTER V REFORMING SECTORAL POLICIES 5.1 Barriers to entry into private sector activity, inefficient public sector involvement in productive activity and excessive regulation have contributed to decapitalization of Peru's infrastructure and further delay in growth. This chapter analyzes the regulatory framework and -he direct participation of the state in the sectors of transportation, power, water supply, oil and gas, mining and fisheries and recommends the main lines of reform. A. The Transportation Sector Institutional Framework 5.2 With the exception of transport in the Lima Metropolitan Area, which is managed by the metropolitan area government (MLM), the Ministry of Transportation and Communications (MTC) has overall responsibility for planning, coordination and regulation in the sector. MTC has four general directorates: DGC for roads; DGTT for land transport services; DGWT for water transport; and DGTA for air transport. There are five public companies for operations: ENAFER (railways), CPV (shipping), ENAPU (ports), CORPAC (airports) and ENATRU (for a portion of metropolitan transport). Both the Transport Tariff Regulatory Commission (CRETT) and the Sectoral Budgeting and Planning Office (OSPP), charged with transport planning and budget programming, fall under MTC. Recently the Committee for Coordination of Transport and Communications (CCTC) was created to consolidate and coordinate modal policies, plans, programs and budgets within the sector. Under the coordinating umbrella of OSPP and CCTC, the general directorates develop policies and oversee budget allocations for their respective programs which are implemented by the modal agencies. 5.3 Peru's transportation sector will not be able to support sustainable economic recovery, not because of a lack of physical capacity, but because of operational inefficiency, inadequate maintenance and inefficient allocation of funds, all traceable to the policies and neglect of the 1980s. These problems are common to all the subsectors examined in this report -- roads, ports, urban transport and railways -- and are discussed below. The Problem of the Subsectors and the Lines of Action 5.4 Roads. Very little has been done for the maintenance and rehabilitation of roads for the last five years and the network is disintegrating, about half of it classified as in bad condition. Although this is partially due to lack of funding and inefficient expenditure allocation, it is also a reflection of DGC's administrative shortcomings. A primary cause is the inability of DGC to hire and retain high-caliber professionals because of very low salary levels. Semi-autonomous agencies responsible for planning, procarement and supervision could be established (with adequate salary levels possibly financed by bilateral donors) to manage the various maintenance and rehabilitation functions through the private sector, including micro-enterprises that could carry out routine maintenance. The process of regionalization appears to have modified the role of DGC. Avpropriate measures should be taken to assure adequate maintenance in the - 36 - 4* regions, with possible oversight by DGC. Nevertheless, the National Highway Network should remain the responsibility of DGC. A reliable source of funding should be established for maintehance to enable effective planning, encourage participation of the private sector and preserve costly infrastructure investment. 5.5 Ports. High port tariffs in Callao and Matarani, both per unit and in comparison with break-bulk tariffs, appear to be inhibiting trade .and the development of containerization. This affects export competitiveness and also port traffic, at least in the case of Matarani, because shippers are choosing to use ports in Chile instead. In March 1991, the Government abolished the "Comision Controladora de Trabajos Maritimos," a state-run monopoly that controlled stevedoring and imposed unrealistic labor requirements for unloading/loading. Container operations for which three people were sufficient were required to have 28 in conformance with old break- bulk practice. The Government can now move towards progressive privatization of other port services. 5.6 Urban Transport. The quality of urban transport in the Lima Metropolitan area is poor. Buses are scarce, overcrowded, in bad condition, uncomfortable and undependable. The proposal to build a "tren electrico" will not change this. It will require another US$450 million-US$600 million and an annual operating subsidy of US$10 million-USS18 million, excluding depreciation, to keep it running. Even at this cost, the "tren" will s3rve only about 5 percent of the travel demand and will have very little impact on the public. The other Central Government operation in urban transport, ENATRU, also has minimal impact on the total travel demand and at high cost. ENATRU receives direct and indirect subsidies of US$3 million-US$7 million per year, excluding capital expenditures. ENATRU's capital expenditures have totaled over US$60 million during the past five years and are projected to reach US$128 million during the next four. ENATRU serves only about 10 percent of total travel demand. The Central Government should stop construction of the "tren" and divest ENATRU to a cooperative of employees or other private entity. The government of the Lima Metropolitan area (MLM) should be encouraged to develop a regulatory function within its "Secretaria Municipal de Transporte Urbano" to coordinate the private sector provision of urban transport services. With its own funds and generated financing, the MLM should complete the proposed busway system. On the other hand, the recent removal of QRs on imports of transport equipment will have the positive effect of renewing Peru's aging fleet of buses and automobiles. 5.7 Railways. Operation of the railway by ENAFER is plagued by low utilization of equipment, overstaffing, poor track maintenance and uneconomic services. The lack of a cost-accounting system adversely affects its pricing policy. In addition, its unfavorable commercial relationship with CENTROMIN- -a public mining firm which is a major user--reduces the return on its cars when they are in CENTROMIN control. Rehabilitation of some equipment and infrastructure is necessary, but the primary issue is the need for improved operational efficiency, including greater autonomy for ENAFER. Certain passenger services, less-than-carload freight, parcel service and door-to-door service are examples of uneconomical activities that should either be turned over to the private sector or self-financed through adequate pricing. - 37 - Transportation Sector Investment Strategy 5.8 Investment in the transportation sector for the next two years should concentrate on maintaining and rehabilitating equipment and infrastructure and improving operational efficiency. Additional capacity does not appear to be necessary to support the Government's restructuring efforts. The primary need for investment will be in the highway subsector, which is in great disrepair. All investment in the Lima Metropolitan Area should become the responsibility of MLM. The recommended investment for the next two years totals US$330 million, 90 percent of which is in the roads subsector. B. The Power Sector Institutional Framework 5.9 The Ministry of Energy and Mines (MEM) is in charge of sector policy and strategy formulation and supervision of the state-owned ELECTROPERU (EP), which is responsible for sector planning and construction/ operation of the bulk of the generation facilities, the entire interconnected grid, some of the distribution networks and rural electrification. MEM also supervises the regional utilities, for which EP acts as a holding company for their shares and in which it is the major shareholder. The 10 regional utilities, whose establishment as regional agencies has not yet been completed, are responsible mainly for power distribution; however, some of the EP subsidiaries operate power-generating facilities. In addition, the Electricity Tariffs Commission (TC) created in 1982 regulates electricity tariffs for the whole sector but has no autonomy to set these tariffs. Diaanosis of the Sector 5.10 The power sector faces a deep crisis, reflected in the low level of service, the inefficiency of the public utilities and the sector's financial difficulties. Frequent and lengthy service interruptions, poor reliability and a high level of losses are characteristic. Power restrictions in 1989 reached up to 20 percent of demand. The installed capacity is not sufficient to cover demand; new generation added in the period 1980-1989 was only 736 MW to meet an increased demand of about 1,000 MW. An aggregate generating capacity of 213 MW is out of service because of disrepair. Transmission and distribution networks are generally in bad shape. The overall efficiency of the utilities is poor. The employee-to-customer ratio is 90 (it is 150-200 for efficient utilities in Latin America and over 400 in developed countries) and the ratio of administrative to technical staff is close to 3:1. Since 1985 the sector has registered annual net losses, which reached US$560-million in 1989. A negative result is also expected for the current year. Legal and Regulatory Framework 5.11 To a great extent the current problems of the power sector are linked to its organizational and legal framework, which are responsible for monopolistic and centralized operations, pricing policies inconsistent with economic principles and the lack of an independent regulatory body. Moreover, political interference has resulted in non-competitive employment conditions, the inability to retain qualified personnel and the absence of continuity at management levels. - 38 - 5.12 Objective. The overall policy objective should be to ensure an adequate and reliable power supply at marginal cost and to reduce the negative impact of the sector on fiscallresources. To implement such a policy, the following measures should be adopted: (a) redefinition of the role of the state in the power sector, clearly separating its policy/regulatory role from its role as owner of public utilities; (b) recognition that the power business should be profitable, that private sector involvement should be encouraged, and that government-owned utilities should be transformed into commercially oriented enterprises; and (c) recognition that electricity prices should reflect economic costs. In recent legislation, the Government has granted the private sector limited access to electricity generation and distribution, a development that should be followed by easing overly restrictive regulations on tariffs and by establishing conditions for the private sector consistent with those prevailing for state/regional utilities. 5.13 Pricing Policy. Pricing regulation should be the responsibility of an independent technical body whose recommendations the Government should be fully committed to support without political considerations. First, the basis for setting tariffs should be changed from accounting to economic principles and tariff equalization should be replaced by a recognition of the cost differences for providing service in different regions. Second, as a consequence of this, the Generation Compensation Fund (GCF) should be abolished. Third, the average tariff level and the existing distortions-- among categories and within each category--should be corrected. Peru is one of the few countries where residential (high-cost) users are charged a lower tariff than industrial (low-cost) users. 5.14 Institutional Measures. Improvement of sector institutions covers both managerial and financial aspects. On the managerial aspects, the recommendations are: (a) to complete the regionalization process in an orderly manner, ensuring that the country's interests are safeguarded by maintaining transmission and major generation units under central control; (b) to treat the power utilities as commercial enterprises, freeing them from interference in their day-to-day operations but establishing clear managerial objectives; and (c) to liberate the power sector from the highly bureaucratic procurement and contracting procedures and restrictions imposed by labor legislation. On the financial aspects, it is recommended that: (a) the average tariff be brought in line with long-run marginal cost, estimated at about US$100/MWh (the avorage tariff for April was US$56/Mwh); (b) the sector consolidate and formalize its long-term debt with the Government; and (c) the level of collection from Government agencies be improved. With these measures, the sector could start repaying its debts and financing part of its expansion without Government support (other than the retention of electricity taxes). Rehabilitation Requirements 5.15 Investments to rehabilitate electric systems are required to ensure that lack of energy is not an obstacle to economic recovery and growth. The se%ere deterioration of facilities necessitates an emergency plan to avoid further shortages. The first priority should be a short-term, low-cost rehabilitation program. Even assuming that all emergency works to guarantee a minimum of supply are completed on time, the Central-North Interconnected System and the South System will need generation works in the short term, as well as some transmission works, to supply expected demand increases beyond 1992. Investment requirements of the sector for the next two years amount to about US$425 million-US$198 million fo,- tH- emergency plan and US$227 million - 39 - for a supplemental plan to restore the system's reliability within the limits of financial constraints. *4 C. The Water Supply and Sanitation Sector Diagnosis of the Sector 5.16 Of a total population of 22 million, about 9 million people in Peru do not have connections to a safe public water supply system and 12 million do not have access to safe sanitation. In Lima, water pressure in 70 percent of the districts is below the recommendod minimum. A 1989 survey by SENAPA, the National Water Service, revealed that 30 percent of the urban population in all but the three major cities had water service less that 10 hours a day. The quality of water in small and medium-size cities suffers for lack of chemicals and quality control laboratories. 5.17 To compound the problem, maintenance levels of existing facilities are well below those required. In Lima, for instance, about 3 km/year of water pipes were replaced from 1987 to 1989 in a system with over 6,200 km of pipes, or less than 2 percent of what is considered good practice. The situation in the rest of the country is even worse. 5.18 The low coverage, reliability and quality of service have an adverse effect on the health of the population. Morbidity from water-borne diseases has reached peak levels as manifested by the rapid spread of the current cholera epidemic. Unreliable service has forced many industries and households to build expensive storage reservoirs and pumping facilities without benefit of economies of scale. Institutional Problems 5.19 Deficiencies in the nanagement of sector institutions and ill- conceived tariff policies have been responsible for the unsatisfactory development of the sector. Excessive Government controls have reduced the accountability of managers at all levels. Sector agencies have also suffered a high turnover of upper-level staff that has affected institutional continuity and weakened the ability to formulate long-term plans and the strategies to implement them. 5.20 The regionalization underway and the corresponding changes in sector organization assign all operational responsibilities to regional and local governments. In general, this is a desirable trend as it brings the level of responsibility closer to the users, but it poses a great challenge to these governments to create the institutions necessary to respond effectively to local needs. The management of services in more than 400 urban centers of fewer than 100,000 inhabitants is of particular concern. The new institutions will need substantial technical assistance to build up their planning, operating, financial and project implementation capacities. Assistance will also be required to build up the regulatory_framework at the regional level to ensure that services are efficient and that the rates reflect the real cost of service. In the next two to three years, it is likely that the response capacity of the new system will be even worse than it is today as the fledgling institutions gain the experience they require. 5.21 Emergency Investments. Average annual sector investments from 1985 to 1989 represented about 0.15 percent of GDP, one of the lowest in Latin - 40 - America. No internal cash generation has been available to maintain the existing infrastructure. Investments have been financed to a large extent by Government grants and highly concessionary funds from Fondo Nacional de Vivienda (FONAVI) which, in turn, raises resources from a tax on wages. Most investments have not been cost affective. Investments have been directed to expand production, while meager allocations have been made to reduce the level of losses which, on average, exceed 50 percent of production. Investments have not been equitably distributed, leaving the urban and rural poor with highly inadequate service and the obligation to pay 20 and more times the cost, on a unit basis, to procure a few liters of water. 5.22 The challenge ahead is awesome. It is necessary to serve not only the present population that today has inadequate water/sanitation services but 6 million more that population growth will add within this decade. To maintain present coverage on a percentage basis would require an investment during this decade of about US$190 million per year, equivalent to 0.75 percent of GDP. To provide the entire population with domestic service would require about US$570 million per year, or 2 percent of GDP. The recommended aggregate sector emergency plan of US$90 million for 1991-1992 is modest in comparison with needs. However, these are hard economic times and it is necessary, first, to improve efficiency and to develop the implementation capacity that the sector lacks at present. This plan has the following objectives: (a) to rehabilitate the existing infrastructure; (b) to reduce waste and losses by means of an extensive metering program and tariffs that fully recover costs; and (c) to expand services to low-income areas through low-cost options. Private Sector Participation 5.23 The Government should consider awarding private sector concessions for service in the large cities or contracting out the provision of specific services or functions. This process could be quickly initiated in Lima using the experience gained in othar cities. Most service contracts require investments that the private sector could make. D. The Oil and Gas Sector 5.24 The oil and gas sector is in a critical situation after several years of insufficient investments in exploration and production and lack of financial resources to carry out normal maintenance operations in all of PETROPERU's areas of activity. For practical purposes, PETROPERU has lost its equity and so has PETROMAR. The reserves and production now represent 50 percent and 65 percent, respectively, of their highest level in 1982. Flawed petroleum pricing policies and contentions with international oil companies are the main explanations for this situation. Restoring Foreien Participation 5.25 Important actions that Peru could take to attract international petroleum firms are: (a) agree to international arbitration in new exploration agreements; (b) include a broad stability clause in new exploration agreements; (c) demonstrate that stalled projects, such as Camisea, are being revived; (d) resolve the PETROPERU/AIG/Belco indemnification issue--Belco was expropriated by the previous government without compensation--in a way that provides for private sector participation in further development of production in Northwest offshore Talara; and (e) negotiate with Oxy the conditions for a - 41 - 4 & rapid increase of production from reserves that are not attractive under the present contract but will make economic sense under the current international oil prices. Pricing of Petroleum Products and Deregulation of the Market 5.26 Another problem facing the sector is the absence of efficient pricing and of explicit procedures for determinating the prices, taxes and subsidies of crude and petroleum products. Deregulation could be introduced in two phases. The first phase would: (a) reform the price structure, clearly identifying all taxes over border prices; and (b) establish ex-refinery, pre- tax prices equal to international parity prices. Applicable indirect taxes would be charged over border prices and the rent component of PETROPERU, equal to the difference between production costs and border prices, would be captured through a surtax. The second phase would be glolal deregulation of refining, imports, exports, wholesale and retail transportation and distribution of petroleum products through freely established prices and free entry to those markets. Targets for Privatization 5.27 The immediate objectives should be the award to the private sector of risk exploration and production contracts in marginal areas and secondary recovery areas, following the example of Argentina, and negotiations for private sector investments in Camisea and Aguaytia. PETROPERU's shipping company could also be privatized to compete with the two existing private shipping companies. In addition, PETROPERU's marine terminal and storage facilities for bulk petroleum products should be transferred to an independent company that would operate them as a regulated service (initially) for a fee. 5.28 Once prices have been deregulated and an open market prevails, PETROPERU's LPG distribution company, its transportation fleet and the company in charge of marine terminals and storage facilities could be privatized. 5.29 Finally, if PETROPERU's cost-effectiveness improves, it could be given managerial and financial autonomy-cum-accountability. Most auxiliary services now performed internally or by its subsidiaries could be privatized. For example, it would be counterproductive if PETROPERU could not negotiate drilling contracts quickly and economically under accepted petroleum industry standards of procurement. Privatization would cover Serpetro drilling services, the seismic computing center and other engineering services, as well as mechanical and maintenance services. At that time, private participation could be sought in refining and in petrochemicals and lubricants in light of the company's strategic plan in the sector. Camisea Field Development 5.30 Peru is likely to become a net oil importer once the economy recovers, unless the Camisea field can rapidly increase production of hydrocarbons or substantial reserves are found. Thus, Camisea offers the most important investment opportunity in the near term. 5.31 The rate of return varies between 16 percent and 29 percent on the basis of international oil prices of US$15 to US$25 per barrel. The project has important implications for the energy sector and the economy. It will provide a low-cost fuel for power generation (this is likely to be the least- - 42 - cost solution for the power sector) and will replace fuel oil now used in industry that can then be either exported or cracked further to make gasolines and other fuels. Furthermore, gas production will be accompanied by the production of high-value.condensates and LPG that are easily exported if in surplus. Camisea will not only save Peru from importing petroleum products but will provide the Treasury with additional revenues from petroleum taxation. The payout of the project will be about 4 years, after which annual positive cash flow would average US$300-US$600 million for 20 years, assuming a market price of US$20/BBL (US$ 1988). 5.32 Peru should encourage maximum private sector participation, given the huge investments required. A modified version of the Mobil exploration and production contract could serve as a model for negotiations, since it covers the oil price risk for the investor and guarantees the Government a larger share of revenues if Camisea's reserves are actually larger than estimated. 5.33 PETROPERU should go ahead with the project as defined in its latest study and start immediate negotiations. The project should focus on the development (wells, gathering lines and surface installations) of the Camisea field and the construction of the two pipelines (gas and liquids) to Lima, and should be carried out as an integrated task by an experienced operator so that the different components are implemented in time and within budget. An excellent example is the Oxy-ECOPETROL association for the development of the giant field of Canon Limon in Colombia (partially financed by the Bank) where Oxy was in charge of the execution. The Cuzco project could be a separate subproject, carried out either with or after the Camisea project, but with an arm's length arrangement (market price for gas and liquids) to prevent delays in negotiations on the Camisea project. Subsidies, if any, to the Cuzco region should be explicit and provided directly by the Central Government, not through subsidization of prices of gas or liquids. E. The Mining Sector Diaenosis of the Sector 5.34 Peru has a significant and diverse mineral resource base and is a major producer of copper, silver, zinc, lead and other minerals. Overall, mining accounts for 10 percent of GDP, 44 percent of exports and 4 percent of formal employment. 5.35 Mining has performed poorly in recent years. Production declined by about 25 percent during the second half of the 1980s, investment in expansion of production and in exploration has been low and investment for replacement of equipment has been insufficient to maintain productive capacity. The financial condition of mining companies has deteriorated, forcing them to increase their financial leverage because of profit margins depressed by increased costs and unfavorable exchange rates. 5.36 The four large state-owned enterprises (SOEs), CENTROMIN, MINERO PERU, HIERRO PERU AND TINTAYA, together account for about 40 percent of sector output, but their operations are running at about 75 percent of installed capacity and output has been decreasing by about 10-15 percent per year. Meanwhile personnel have increased and production costs have risen substantially. Without immediate restructuring and rehabilitation, these companies will require subsidization during 1991 and 1992, when world market - 43 - prices are expected to drop. SOEs and INGEMMET (Instituto Geologico Minero y Metalurgico) have privileged access to mineral resources through their right to reserve areas, pay no land rentals and do not have to comply with work requirements. This has led to an overuse of rights in idle mines that could have been exploited by the private sector. Areas reserved for SOEs total more than 9.5 million ha. 5.37 Some of the major shortcomings of the mining sector are: (a) a deficient cadastral system; (b) regulations that allow the use of obsolete surveying equipment and methods; (c) red tape and inadequate systems that prolong the processing of requests for exploration and mining rights and hinder the transfer of mining rights; and (d) an unclear distinction between the roles of Government agencies and mining enterprises. The correction of the first three deficiencies will require streamlining the Direccion General de Minas (DGM) and amending regulations of the mining law. The correction of the last deficiency will require the restructuring of INGEMMET. Emergency Investment and Divestiture 5.38 The Government should embark on new investments only within the context of a broad restructuring plan that would include the divestiture of SOEs and release of mining rights to the private sector. An emergency program would require investments of US$99 million in 1991 and US$75 million in 1992 (to be increased to US$124 million and US$110 million, respectively, if financial constraints permit) to stem the further decline of production and to utilize a portion of the currently idle capacity. These investments would yield increased production estimated at US$50 million in 1991 and US$180 million in 1992. The EIP would provide equipment and spare parts to replace worn-out machinery and would eliminate production bottlenecks. The bulk of the proposed investments would be for CENTROMIN, which has the best potential for improvement in the short term and is in a position to finance part of the investments from its own cash flow. 5.39 The emergency investment program would maintain the short-term viability of mining enterprises, but medium- and long-term solutions of complex structural issues can best be addressed by new private management. Steps should be taken to transfer the ownership of mining SOEs to the private sector. In this context, the recently expressed interest of foreign investors in CENTROMIN is encouraging. Alternatively, if it is not privatized entirely, CENTROMIN should consider which minerals and mines it should concentrate on and which operations it should cut down, sell, open to joint ventures or rent. One approach could be for CENTROMIN to offer several of its mines to private investors and concentrate its operations on mines requiring only a moderate degree of rehabilitation. 5.40 HIERRO PERU and MINERO PERU are in much poorer condition than CENTROMIN in terms of physical facilities, personnel and management, and would be extremely difficult to rehabilitate. The Government should immediately invite foreign and local investors to take over these companies or to participate in joint ventures. TINTAYA, the fourth mining SOE, is planning to implement the Coroccohuaico and Chabucas projects to ensure the continuity of operations beyond 1997. Neither the Central Government nor the Inca Region, which now owns TINTAYA, should spend resources on these projects. Immediate steps should be taken to attract private investors. - 44 - Legal and Reaulatory Framework 5.41 The institutional pblicy framework requires the following changes: (a) The Direcci6n General de Minas (DGM) should function mainly as the administrator of mineral rights and regard the modernization of the cadastral system as its most important task. INGEMMET should become the Geological Survey Institute of the country, taking responsibility for basic development and moving away from detailed exploration. (b) The vast areas that INGEMET and the SOEs maintain as reserves for future exploration and exploitation by the state should be released to the private sector. Recent steps in this direction should continue. (c) The Ley General de Mineria (1981), which needlessly divides mining producers into three categories by size and assigns a predominant role to the SOEs, should be amended. The differentiated fiscal treatment favoring small and medium over large mining companies encourages suboptimal decisions to avoid a change of category. (d) Legislation covering labor stability, strikes and collective bargaining should be changed to allow mining enterprises to reduce their labor force or close a mine in response to unfavorable economic developments. This is important since mining is subject to the depletion of deposits and to fluctuations in metal prices. (e) The structure of taxation of the mining industry, which presently emphasizes indirect taxes over direct taxes and is detrimental to efficient mining, should be modified. F. The Fisheries Sector Prognosis of the Sector 5.42 Peru is endowed with some of the richest marine resources in the world. In 1989, fisheries represented 16 percent of total commodity exports and provided 6 percent of total formal sector employment. The main activity of the sector is fishmeal production from anchoveta, a variety particularly abundant in Peru. Between 6-8 million tons per year can be harvested with proper management. 5.43 In the early 1960s, through private initiative, Peru's fishmeal industry jumped from a negligible position in world statistics to the top. In 1973, the Government expropriated it and since then it has deteriorated progressively because of inappropriate legislation, the conflicting roles of Government as owner and regulator and poor management by SOEs. The net result has been a sharp decline in fishmeal production from close to 2 million tons in 1970 to I million at present, of which the private sector contributes 65 percent. Four public enterprises operate in the sector: PESCAPERU, EPSEP, FLOPESCA and COPES. If the right policy environment is created, the private sector appears willing to expand its participation. - 45 - Privatization 5.44 Since Government production/marketing of fish products is less efficient than that of private industry (Table 23), the Government should consider divesting the whole sector. Instal3 capacity now roughly matchee fishing resources, and it would thus be wise . usa this capacity more efficiently through privatization before new pr vate investments are undertaken. PESCAPERU, the largest of the public enterprises, should be easy to sell. Nationals have shown an interest in purchasing several of its 20 operating plants. Table 23: RELATIVE EFFICIENCY RATIOS OF PUBLIC VERSUS PRIVATE FIRMS IN FISHMEAL (1989) Output/ Output/ Capacity a/ Employment b/ PESCAPERU (Public) 122 135 Private Firms 398 149 p/ Tons per hour. b/ Tons per worker. 5.45 FLOPESCA, which operates a fishing fleet in deplorable state and is a burden to the Treasury, should be liquidated as soon as possible and its assets sold. EPSEP, which supplies low-cost animal protein to the low-income population, should downsize its activities and limit its role to wholesale distribution. Most of its ancillary facilities, including its fishing vessels and up to 90 percent of its road transport fleet, should be disposed of. Its fish depots could be leased to traders or cooperatives and its retail outlets could be sold to qualified individuals. EPSEP recently has canceled the unfavorable policy contract with the Soviet firm, Sevriva. Regulatory Framework 5.46 The efficient management of fish resources requires a reliable technical research institution to provide vital data for decision making. IMARPE (Instituto del Mar del Peru) should be brought up to the required level of excellence by adequate investment in scientific equipment and staff training. 5.47 The Ministry of Fisheries is burdened by overstaffing and cumbersome regulations and is not noted for the expeditious processing of licenses and other applications. It should undergo a comprehensive staffing and administrative review to differentiate its roles of regulator and owner. 5.48 A critical issue is the regionalization that would fragment the Coast into six resource management areas--an absurd arrangement, given the common-property nature of fish resources and their deployment along the coast. - 46 - This process could have unpredictable negative effects on the rational utilization of fish resources and should therefore be reversed. 44 5.49 The current legal framework is a major obstacle to enhanced private investment. Modifications needed to the Fisheries Law are: (Art. 73), which gives PESCAPERU exclusive rights to produce fishmeal and allows private firms to produce fishmeal only if their main line is other fish consumer products; (Art. 74), which restricts foreign investment; (Art. 52), which may lead to Government monopoly of the export trade; and (Art. 63), which requires that operations of foreign fishing fleets have to be based on a previous government-to-government agreement. Within the overall context of fiscal reform, export taxes should be phased out as other revenues permit. Labor legislation, which ignores the seasonal nature of the industry by not allowing seasonal hiring of workers, should also be modified. Likewise, the arrangement whereby fishing vessel crews must receive 40 percent of the value of the catch deters the development of a national fishing fleet and should be abolished. 5.50 The environmental impact of external pollution (e.g., mine tailings) and internal pollution (fish processing wastes) requires prompt assessment for the framing of appropriate policies. 5.51 The fisheries sector does not require much medium-range public investment other than what is needed to ensure a smooth transition to the private sector and to strengthen the Government's regulatory role. The recommended public sector investments for 1991 and 1992 are US$18.3 million and US$24.4 million, respectively. All major new investments--except for infrastructure and research and training--should be made by the private sector. G. Public Investment Program The Investment Program 5.52 The sectors reviewed by the 1990 World Bank public investment mission (transport, power, water, oil and gas, mining and fisheries) account for 75 percent of total public sector investment. Within these sectors, recommended investments total US$633 million in 1991 and US$901 million in 1992 (Table 24). Financing for these investments would be possible in 1991 only if the official target for Central Government revenues of 11 percent of GDP is realized. In the event of a revenue shortfall--likely from tax revenue trends in the first half of 1991--a core program of US$516 million in 1991 and US$511 million in 1992 is suggested. - 47 - Table 24: SECTORAL DISTRIBUTION OF RECOMMENDED PUBLIC INVESTMENTS 1991-1992 (US$ millions) 1991 1992 Transportation 147 181 Power 138 287 Water and Sanitation 43 47 Hydrocarbons 163 252 Mining 124 110 Fisheries 18 24 Subtotals of Sectors under Review 633 901 Other Sectors: (Health, Education, Agriculture) 327 573 Total 960 1474 Z of GDP 2.8% 4.2% Investment Decision-Making Process 5.53 The present system is not efficient. Investment proposals neither consider the country's resource restrictions nor rank investments according to their economic rates of return to ensure intra-sectoral and resource consistency. 5.54 In terms of the institutional framework, a reform of the functions and hierarchies of different institutions is required. The revival of the InterMinisterial Committee as a forum for discussing public investment priorities is recommended. Project feasibility studies and rate of return calculations should be required for all investments and examined by the sector ministries. The role of the National Institute of Planning should be limited to verifying that appropriate techniques and assumptions are used in project evaluation. The Ministry of Economy and Finance should ensure resource availability and consistency. 5.55 For investment execution, rolling multi-annual investment programs and budgets are required, with adequate leeway for operational and maintenance expenditure. A specific expenditure management strategy, rather than the adjustment of investments by a uniform scale factor, is needed to smooth out the response to income-expenditure fluctuations. - 48 - CHAPTER VI POLICIES FOR POVERTY ALLEVIATION AND SOCIAL EMERGENCY A. The Social Situation in August 1990 6.1 Peru's chronic poverty, which affects large segments of the formal and informal working classes, marginal urban sectors and,rural communities, has been compounded by the economic collapse that reached crisis proportions starting in 1988. While GDP has fallen by about 30 percent since then, real wages have plunged to less than one-third of their previous levels. Hyperinflation has hurt the poor most, since they are the ones least able to protect their incomes against inflation tax and declining employment. 6.2 Recent information indicates that in 1990 the average household in Lima spent half of its income on food (the poorest 30 percent spent at least 60 percent). Despite this high expenditure, 51 percent of Lima households consumed inadequate diets. As Table 25 reveals, the monthly per capita expenditure on food declined by half from US$70 in 1985-86 to US$35 in 1990. Moreover, the decline was particularly acute for the poorest 10 percent, whose food expenditure fell by 58 percent. Current statistics also indicate that primary school attendance in Peru has decreased from 1990 to 1991 for the first time in recent history. Vaccination rates for infants also experienced a decline in 1989-1990. Illnesses such as tuberculosis and malaria are on the rise. The current cholera epidemic demonstrates the extreme vulnerability of the populace because of underlying poverty and poor living standards. Table 25: CHANGES IN PER CAPITA FOOD CONSUMPTION IN LIMA, 1985-86, 1990 (measured in constant US$ of June 1, 1990) Poor **************************** *---------------Rich Decite 1 2 3 4 5 6 7-10 ALl Monthly Food Consumption per Capita in 1985-86 24.4 33.1 42.2 47.7 52.7 61.9 103.6 69.6 Monthly Food Consumption per Capita in 1990 10.3 47.5 21.0 23.5 26.5 30.7 55.8 35.1 Change 1990/1985-86 -58% -47% -50% -51% -50% -51% -49% -50% Source: Peru Living Standard Measurement Survey 1985-86 and 1990. World Bank and Cuanto S.A. 6.3 The roots of social regression can be found in: (a) chronic macroeconomic mismanagement; (b) an oversized and bankrupt state that has partially relinquished its responsibilities (including health, education and targeted subsidies to the poor) to move into other areas in which it has proven unproductive; and (c) market distortions and paternalistic legal institutions that preponderantly have hurt the interests of peasants and workers. 6.4 With the advance of poverty and a state withdrawing from its social duties, non governmental institutions have emerged to fill some of the gaps in social assistance. Thus, at present Peru benefits from the acti,vities - 49 - of over 500 NGOs (Caritas, PEMTEC, Accion Comunitaria, Alternativa, etc.) and many community organizations (mothers' clubs, "vaso de leche" committees, "comedores", PTA9, etc.). B. Measures Since August 1990 6.5 The new Government has taken several preliminary strides in its efforts to reduce poverty through direct intervention. In trying to help the poor, the Government set up the social emergency program for the period August-December 1990, which disbursed US$67.7 million of Treasury funds directly to NGOs or community organizations. The program planned to disburse US$415 million but failed to attract external support and confronted several drawbacks, including: (a) insufficient Treasury funds; (b) limited capacity to program large levels of funding; (c) disagreements about the role of NGOs and the type of assistance to be provided; and (d) changes in the program's leadership. 6.6 The 1991 national budget has authorized the creation of the National System for Social Compensation and Development to be "the force behind a policy of protecting vulnerable groups with targeted programs of feeding and nutrition, medicine, health and employment." This institution is the official depository of the US$266 million in Treasury resources to be applied to social compensation and development programs in 1991. 6.7 Its potential to fulfill its intended role will depend on its success in achieving the following key objectives: (a) a clear definition of its role and its relation to existing Government institutions, including sectoral ministries; (b) the allocation of funds to well-targeted population groups with cost-effective criteria; (c) the development of a management structure which hires technically qualified staff; and (d) sufficient management leadership to convene domestic NGOs and elicit foreign grants. C. Social Sector Policies Education 6.8 Peru's educational problems include an 11.0 percent adult illiteracy rate, pressure on educational facilities from population growth, poorly qualified teachers and grossly inadequate resources. With a 1991 budget of US$249 million and 7.5 million students, Peru's Ministry of Education has about US$30/student/year to run all its programs. 6.9 The Government's six priorities for 1991 are to: (a) increase educational coverage, particularly for 6-14-year-olds, and reduce illiteracy; (b) rehabilitate the educational infrastructure, particularly sanitary facilities; (c) improve the quality and effectiveness of the educational system, with an emphasis on education as preparation for employment; (d) improve in-service training and the welfare of teachers, particularly in border and relatively underdeveloped areas; (e) strengthen the National System for University Planning; and (f) improve and expand the services of public decentralized agencies within the education sector. 6.10 These priorities are sound but too ambitious. The most immediate concerns should be to reduce attrition among primary school students, rehabilitate the existing infrastructure using simple, low-cost technologies - 50 - to bring classrooms up to minimal standards, reallocate resources to the primary level and to the less-served areas of the country, and provide pre- primary and primary students with a strong nutritional component. An ambitious overhaul of educational curricula and new strategies to make education more responsive to the job market are of secondary importance at present. Mechanisms to train and retain qualified teachers and collaborative arrangements with the private sector should be explored. Health 6.11 Peru's health indicators are among the lowest iii the region. Infant mortality and child mortality rates are 84 and 119, respectively, per 1,000 live births. The average life expectancy is 63 years. These figures mask even worse conditions among the rural Andean and Selva populations. Service indicators are also quite low. Many Peruvians have no effective access to health care, despite a public health system where most services theoretically ave free. With coverage of at least 10 million Peruvians, the Ministry of Health's US$186 million budget for 1991 allows a per capita outlay of US$18.60 for all services. Since early February, the Ministry has had to combat a cholera epidemic through public information and direct treatment. At least 70,000 patients have been treated in hospitals, where rehydration supplies alone for an average three-day stay cost US$150 per patient. 6.12 The Ministry's objectives for 1991 are to: (a) reduce morbidity and mortality from cholera and other prevalent diseases, particularly in the rural and marginal-urban areas of the country; (b) expand health service coverage in high poverty areas; (c) rehabilitate the infrastructure and equipment of health facilities (hospitals, centers, posts); and (d) re- establish professional standards and adequate working conditions for health personnel. 6.13 The accomplishment of these objectives will depend on improved planning and management at the central level and the capacity at all levels to carry out successful decentralization of health services. The health sector must provide basic care in underserved areas and explore collaborative arrangements with the private sector. An incentive system to retain health personnel is crucial to the sector's ability to deliver services. As seen in Chapter III, the ratio of support to professional staff, currently 3:1, needs to be improved by downsizing support staff. Medium-term objectives should be to improve the division of health services between the Ministry and the Social Security Institute and to expand cost-recovery mechanisms for health services where feasible. - 51 - CHAPTER VII THE INTEGRATION OF PERU INTO THE INTERNATIONAL FINANCIAL COMMUNITY A. The Default 7.1 In July 1985, the previous Government announced a cap of 10 percent of exports on foreign debt payments, thereby breaking with the arrears-cum-best-effort-to-pay tenet of the last two Belaunde years. It attempted to convince some creditors that new debt commitments would be fully serviced while old debt would, as a rule, be serviced only when creditors provided a positive net transfer to Peru. What actually happened from July 1985 to July 1986 was that Peru's debt payments reached 25 percent of exports and the negative net transfer was almost as high as it had been in the last two Belaunde years. The assumption that Peru could selectively default with some creditors and obtain financing from others proved erroneous. It was not until 1988 that total debt service dropped to the 10 percent limit. 7.2 Unlike most other Latin American debtors that went into default, Peru extended the moratorium to multilateral credit institutions and also banned external debt service payments by private debtors. In August 1986, Peru was declared ineligible for IMF lending and one year later was placed on non-accrual status by the World Bank. In early 1989, the Inter-American Development Bank also took the step of classifying Peru as a non-accrual country. 7.3 Although it is beyond the scope of this report to assess the costs of the default, suffice it to say that these were significant in terms of paralyzed development projects, arrested foreign investments, trade restrictions by creditor countries, reduced aid flows, and above all, a major macroeconomic collapse. When President Fujimori was sworn in, about two- thirds of Peru's US$22 billion external debt were in arrears and Peruvian commercial debt traded at 5 cents on the dollar in the secondary market. B. Steps To-4ard Reintegration 7.4 The new Government announced that the reintegration of Peru into the international financial community was a central policy objective. Consistent with this, it resumed payments of current obligations falling due to the World Bank in October 1990 and the IDB one month later, thus freezing arrears at the level of October 1990. (The previous Administration had resumed debt service payments to the IMf in September 1989, following a warning that Peru could lose IMF membership.) Debt service payments of about US$45 million per month, or one-sixth of fiscal revenues, to the three multilaterils represent a sincere effort by Peru considering its unfulfilled social denands and current low ability to pay. Some delays in payments have occurred since March 1991. 7.5 The new Government is committed to a growth-oriented three-stage debt work-out. In the first stage it will clear arrears with multilateral creditors; in the second stage it will reschedule its bilateral debts with the Paris Club; and in the final stage it will negotiate a solution to its debt overhang with commercial banks. - 52 - C. The Debt Work-Out 7.6 Multilaterals. Arrears with the three multilaterals now total US$2.2 billion (Table 26). Under a financing plan already agreed upon, arrears with the World Bank and the IMF were to be cleared by December 1992 and with the Inter-American Development Bank by September 1991. Payments will be financed by a combination of: required resources from a support group .of creditor countries; bridge loans against front-loaded post-clearance disbursements by multilaterals; and Peru's own balance of payments. Table 26: PERU'S EXTERNAL DEBT AND ARREARS (as of December 1990) (in US$ millions) Total (Of which Debt a1 Arrears) I. Medium- and Long-Term 21,464 13,976 A. Public Sector 19,986 13,976 (i) Multilateral Creditors 3,709 2,149 o World Bank 1,560 927 o IMF 988 875 o IDB 1,068 347 o Other 93 - (ii) Bilaterals and Suppliers 9,406 6,319 (iii) Eastern European Countries 1,223 192 (iv) Other 5,648 5,316 B. Private Sector 1,478 n.a. II. Short-Term 1,377 116 Total 22,841 14,092 b/ A/ Includes outstanding principal, principal in arrears, interest arrears and accrued interest on arrears. h/ Excluding arrears of private sector debt. Source: Central Bank-IMF-MEF 7.7 The four conditions for the success of the financing plan are that: (a) Peru comply with the fiscal-monetary targets under an IMF program and implement structural reforms agreed upon with the World Bank and the Inter-American Development Bank; (b) the support group fill the two-year financing gap of US$1.3 billion; (c) Peru continue to discharge current debt service obligations to multilaterals without interruption; and (d) Peru obtain - 53 - sufficiently favorable terms in the forthcoming rescheduling of Paris Club debts. 7.8 In 1990, the IMF established a new policy to deal with countries in arrears. Under this policy, termed the Rights Accumulation Program (RAP), a country can build up rights towards a large new disbursement following the clearance of arrears and the satisfactory attainment of set macroeconomic targets. At the end of the program, remaining arrears can be cleared with a short-term bridge against IMF post-clearance disbursements. Peru's 18-month RAP was expected to be approved by the IMF Board by July 1991 after the required support group contribution had been raised. The program will continue until December 1992. 7.9 In 1991, the World Bank also established a new approach to dealing with countries whose arrears were large but who were implementing strong adjustment policies. Under this approach, the Bank can develop and process adjustment and investment loans during a performance period in which the country would build a track record. Although these loan requests can be presented to the World Bank's Board, loan signing and disbursements do not take place until all arrears have been cleared. At the end of the performance period, the country can arrange a bridge loan to clear its arrears and this clearance triggers the disbursement of the accumulated requests. Under conditions (a), (b) and (c) of para. 7.7, Peru could avail itself of such adjustment loans. 7.10 Bilaterals. The bulk of Peru's external debt (48 percent) is with bilaterals and suppliers, most of them Paris Club creditors. The Government had planned to seek a comprehensive rescheduling of Paris Club debt shortly after the 18-month Rights Accumulation Program was approved. The Paris Club does not allow rescheduling of post-cutoff debts. (Peru's cutoff date, January 1, 1983, was established in a previous rescheduling.) Likewise, the Club does not generally grant debt reduction, the only exceptions being the so-called Toronto terms for sub-Saharan African countries and the "exceptional terms" recently given to Poland and Egypt. These two restrictions are a major handicap for Peru to attain medium-run balance of payments viability. Short of exceptional treatment, Peru would have to receive best terms given to any middle-income country, including rescheduling and deferment of moratorium interest and deferment of post-cutoff date arrears. 7.11 Commercial Creditors. Peru's debt with commercial banks totals US$5.6 billion, more than 90 percent of which is in arrears. The uncooperative approach of the previous Administration generated a series of lawsuits in 1989-90. In contrast, the conciliatory approach of the new Government, together with the implementation of sound economic policies, quickly prompted a withdrawal of legal action by commercial banks. However, Peru's current and foreseeable financial burdens do not offer the promise of debt service payments to commercial creditors at any time in the near future. In the context of continued structural adjustment, Peru will be a suitable candidate for trading policy reforms for debt and debt service reduction schemes (i.e., buyback schemes and/or outright reduction with enhancements). Unfortunately, unlike the case with Argentina, Brazil and Mexico, Peru's debt with commercial creditors is only one-quarter of its total external debt. 7.12 The Financing Plan of the Debt Work-Out. Under the assumptions outlined above, the obligations for Peru to resume full financial relations with multilaterals and bilaterals are about US$4 billion for the two-year period 1990-1992 (Table 27). Of this total, US$0.4 would be provided by the - 54 - Andean Reserve Fund, US$1.3 billion by the support group, and US$2.3 billion by renewed post-clearance disbursements of multilaterals. Table 27: DEBT WORK-OUT, 1991-92 (in US$ millions) 1991 1992 1991-92 Recuirements 1242 2757 3999 Accumulation of Reserves 146 225 371 Debt Service to Multilaterals 522 546 1068 Debt Service to Bilateral Creditors to be Paid in Cash b/ 249 786 1035 Clearance of Multilateral Arrears a/ 357 1802 2159 Net Other Excluded Balance of Payments Items -32 -602 -634 Financing Plan Andean Reserve Fund 370 - 370 Multilateral Disbursements to be Bridged - 1790 1790 Multilateral Disbursements 350 185 535 Support Group Contributions 522 782 1304 A/ Assumes clearance of World Bank and IMF arrears in December 1992 and Inter-American Development Bank arrears in September 1991. b/ Paris Club rescheduling assumes the best terms offered to any middle- income country other than Poland and Egypt. More specifically, it assumes that the Paris Club creditors would: (i) reschedule 100 percent of Peru's arrears on pre-cutoff and previously rescheduled debt (including an estimated US$0.9 billion in late interest); (ii) reschedule 100 percent of current maturities on pre-cutoff and previously rescheduled debt; (iii) reschedule a substantial proportion (70 percent in the first year and 50 percent in the second year) of moratorium interest; (iv) defer until the second year the payment of that part of moratorium interest that was not rescheduled in the first year; (v) defer clearance of Peru's post-cutoff arrears beyond the end of the IMF's RAP (this assumption goe3 beyond the precedent for other countries); and (vi) defer into the second year the payment of interest accruing on the deferred post-cutoff arrears. Source: IMF 7.13 The Support Group was officially formed on June 7, 1991, under the co-leadership of the U.S. and Japan, and included Spain, France, Germany, Canada and Italy. On this day, firm commitments by member countries totaled US$850 million. The remainder was expected to be raised within a month. - 55 - D. The Medium-Term Outlook of the Peruvian Economy 7.14 The policies so far .implemented by the Fujimori Administration, if continued and strengthened, can reverse Peru's economic retrogression and decline in social standards. In the short run, the most urgent priority should be to consolidate the courageous but still very fragile fiscal stabilization. This requires restructuring of the state--including large- scale downsizing of public institutions, divestiture of public enterprises and civil service reform--and a solid tax reform. Unless stabilization succeeds, the chances for survival of recently liberalized key markets (foreign trade, floating exchange rate, free interest rates and prices) are minimal. Thus, only sustained stabilization will give Peru the opportunity of furthering the process of structural reforms and of resuming growth. 7.15 The debt work-out outlined in Table 27 is critical to ending Peru's financial isolation from its creditors, many of whom also are its trading partners. Needless to say, fiscal and monetary stability is the key for the debt work-out to succeed. 7.16 If the Government manages to consolidate stabilization and maintain the current pace of structural reform, Peru's economy will indeed recover from the present slump and will gradually start to earn creditworthiness. As is always the case, the timing and intensity of these two key variables are hard to predict. Other countries that have recently come out of hyperinflation, like Argentina and Bolivia, are not finding an easy path to resuming growth. It is true, however, that they have not suffered a 30 percent cumulative fall of real GDP during hyperinflation nor undergone such a severe recession. In the case of Peru, a partial early recovery of real aggregate demand from the collapse of 1988-90 should not be completely ruled out. 7.17 Table 28 projects an optimistic outlook for a recovery in 1991-93 and a sustained 5 percent real growth rate thereafter. To attain this, Peru's economy would have to endure the hardship of marginal saving ratios of just over 50 percent until 1996 and improve significantly its efficiency in the use of capital (a reduction of at least one-third in the hist3rical ICOR). Under this scenario, by the turn of the century Peru will merely have reached the level of real per capita consumption of 1988 and managed to reduce its external debt-to-exports ratio from 5.2 to 4.3 (which is still 65 percent higher than the present average for Latin America). If anything, this dramatizes how costly past misguided policies have been to Peru and confirms that without significant external assistance, including debt reduction, Peru's solvency will not be restored at any time in the foreseeable future. For the current policy reforms to succeed, Peru cannot do without the cooperation of its creditors. 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indicators of Intensity of Adjustment 1. Reat GDP Growth -11.5% -4.3% 2.8% 4.0% 4.5% 4.72 5.0% 5.0% 4.82 4.8% 4.9% 2. Inflation Rate (Dec./Dec.) 2775.3% 7639.5% 1402 50% 30% 20% 12% 12% 12% 122 122 3. Real Per Capita Consumption Growth -14.0% -6.8% 0.3% 1.6% 2.1% 2.3% 2.7% 2.7% 2.6% 2.6% 2.72 4. Reat Per Capita Consumption Level (1988=100) 86 80 80 82 83 85 88 90 92 95 97 5. Marginal Savings Ratio -26.6% 249.1% 208.5% 59.4% 61.7% 54.2% 58.6% 65.9% 27.8% 28.62 29.4% 6. Resource Account/GDP 3.1% -0.7% -0.6% -0.6% -0.9% -1.1% -0.8% 0.2% 0.2% 0.3% 0.3%, Indicators of Creditworthiness 7. External Debt (USS million) 19,816 21.707 23,298 24,898 26,527 28,239 29.953 31.629 33.390 35,325 37,443 8. External Debt/Exports GNFS 432% 503% 519% 527% 527% 520% 503% 472% 455% 439% 425% 9. Interest Accrued/Exports GNFS 36% 36% 39% 39% 39% 38% 37% 35% 36% 37% 36% 10. Inplicit Capitalization of Interest Ratio b/ 90 87 84 83 78 72 66 66 66 Fiscal Adjustment Indicators (% of GDP) 11. Public Sector Borrowing Requirements (PSBR) 7.7 6.0 2.9 2.1 2.8 3.1 3.7 3.5 3.5 3.5 3.6 External Financing 5.2 3.4 2.9 2.1 2.3 2.1 2.2 2.0 2.0 2.0 2.1 Domestic Financing 2.6 2.6 0.0 0.0 0.5 1.0 1.5 1.5 1.5 1.5 1.5 1 12. Broad Money/CDP S/ (as of Dec. of each year) 16.5 15.6 9.3 12.2 15.1 20.2 22.8 22.8 22.8 22.8 22.8 af Assumes no debt reduction. b/ This is an illustrative index which measures how much of accrued external Interest would have to be financed by new net disbursements. c/ Note that the ratio overstates actual financial intermediation because stocks of broad money are in Inti as of December whereas GDP is in Intf for months during the year.