Peru - Public investment program 1966-1967 (Vol. 1 of 7) : Main report

RETURN TO REPORTS DESK RESTRICTED WITHIN WH155 ONE WEEK Vol. 1 This report was prepared for use within the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. The report may not be published nor may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION AN APPRAISAL OF THE 1966-1967 PUBLIC INVESTMENT PROGRAM OF PERU (in seven volumes) VOLUME I MAIN REPORT December 28, 1965 Western Hemisphere Department  CURRENCY EQUIVALENTS 1 US $ = 26.82 Soles 1 Sol (S/.) = 3.7 US cents. 1 million Soles = US $37, 286  THE MI SSION Hubert F. Havlik ................ Chief of the Itission Paul Craig-Hartin . . ........ General Adviser to the Mission H. Michael Sapir . ........... Investment Program Adviser Hans Wyss ................. Chief Economist Oktay Yenal ,.,. . . , Public Finance Economist Alberto J. Favilla . . . General Economist Sei-Young Parlc . . . Transportation Economist Segurd Heien . . . ....... Port Adviser Alf Bergan . ..........,.,., Highway Adviser 1ichael E'alein ....,,......... Transport Economist Antonio Copello ...... ...,.. Transport Economist R. Vaughan Sear . ............. Power Adviser Robert E. Van Geuns . . ............. Industry and Private Investment Adviser M. LeBosquet . ..............W.,... Water Supply and Sanitation Adviser Mullath Vasudevan . . .............. Education Adviser Nathan Gil . ................,... Agricultural Production Expert Kenneth E. Snelson . . ............. Irrigation Adviser ,Jalter E. Chryst ............... Agricultural Economist Gerald Desmond ................... Housing Economist Carlos L. Acevedo ............ Housing Adviser Mrs. Joan Hardy . . ........... Secretary  TABLE OF CONTENTS Page No. BASIC DATA ....... ......................................... i - ii SSUMMARY AND CONCLUSIONS ...................................... i - v INTRODUCTION .. ............................................... 1 PART ONE - GENERAL REPORT' CHAPT_R I - RECENT CrROWTH EXPERIENCE ................. 2 A. Economic Growth, Investment and Savings . .............. 2 B. Prices and Monet;ary Policies ......................... 4 C. Balance of Payments . ................................. 5 D. Conclusion ......................... 5 CHAPTER II - DEVELOPMENT POLICIES AND THE PUBLIC INVESTMENT PROGRAM .................................. 7 A. Development Goals, Strategy and Policy .... ........... 7 B. Level and Composition of Public Investment Program: 1966 and 1967 ... ........................... 8 C. The 1966 Budget Investment Program and Adjustments Suggested by the Mission ..... ............ 12 CHAPTER III - THE FINANCIAL SITUATION AND OUTLOOK ........ 1l A. Introduction ........................................ 1 B. Public Finances ...................................... 1 C. Private Finances ............... .................... 25 D. Credit, M4oney, Prices and Wages ................... .. 25 CHAPTER IV - BALANCE OF PAYMENTS PROSPECTS AND EXTERNAL DEBT SERVICE CAPACITY ...................... 28 A. Exchange and Trade Policies: Medium-Term Current Account Prospects .... ..................... .. 28 B. New External Borrowing and Debt Service Capacity ..................... .... *.................. 30 CHAPTER V - TiE FOREIGN BORROWING PROGRAM ..... .......... 34 PART TWO - REVIEW OF THE SECTOR PROGRAMS Agriculture ............................................. b1 Transport ............................................. .. 45 Electric Power ........................................... 48 Industry and Mlining .. .. ... .. ...... 51  -2- Page No. Housing .......................... . 53 Education ................................ *, ....* .... 51 Public Health and Sanitation ........................... 55 APPENDIX A - Export Projections, 1965-1975 APPENDIX B - Adjustments Suggested by Mission in 1966 Budget Public Investment Program STATISTICAL APPENDIX Map  BASIC DATA Area: 482,300 square miles Population (1964): 11.3 million Rate of growth: 2.8 percent p.a. Density: 23 per square mile Gross National Product (1964): 85.2 billion soles Rate of growth (199`F94): 6.5 percent p.a. Rate of growth (1964): 5.4 percent Per capita (1964): 280 US $ Gross Domestic Product (1964, at market prices): 86.9 billion soles of which, as a percentage of total Agriculture, Fishing 21 Mining 8 Manufacturing, Construction 24 Transport, Communications 5 Commerce 18 Other services 2h Average Percent of GDP at Market Prices: 196h 1959-1964 Gross domestic investment 22.1 20.6 Gross national savings 22.4 20.2 Balance of payments current account surplus/deficit +0.3 -0.4 Investment income paynents abroad (net) 2.0 2.2 Public sector current resources 19.8 16.7 Resource gap/surplus (derived from current Average account balance of paYments) as percent of 1964 1959-1964 investment: +1. -2.0 Money and Credit: 196h Average annual (billions of rate of change soles, end of during year figures 1959-196h Total money supply 11.1 14.4% Time and savings deposits 7.5 19.9%o Commercial bank credit to private sector 12.0 14.2% State development banks credit to private sector h.7 15.9% Rate of change in prices (rate of change mid-1964 through mid-1965) 19% 8.6%  Average annual rate of change Public sector operations: 1964 1959-1964 (billions of soles) (based on curren.t price data) Public sector current resources 17.2 21 % Public sector current expenditure 1505 21 a Surplus 1.7 22p Public investment expenditure (excluding development credits to private sector) 4.0 around 30 % External assistance to public sector (gross)2.4 n.a. External public debt (repayable in foreign 1958 1961 1964 currency) (Tillions of US $) Total debt 215 325 578 Annual debt service (based on projections) 27 42 71 Debt service ratio (debt service as a percentage of merchandise exports) 9.5 8.5 10,7 Average annual rate of change Balance of_payments: 1964 1959-1964 (millions of US$) Total exports (f.o.b.) 678 16.0 % Total imports (f.o.b.) -521 13.7 d Net invisibles -144 10.4 0 Net current account balance +13 n.a. Average 1959-1964 1.964 Commodity concentration (commodities as % exports) Iqain commodity (fishmeal) 15 23 Two main commodities (fishmeal, cotton) 32 37 Three main commodities (fishmeal, cotton, copper) 48 52 Four main commodities (fishmeal, cotton, copper, sugar) 59 62 Average (Sept0 3) Official gold and foreign exchange 1959-1964 1965 reserves (millions of US$) 100 197 or 2-1/2 months or 4 months of imports of imports  SUMMARY AND CONCLUSIONS 1. Over the past decade, econmic growth in Peru has been rapid, well above the high rate of population growth, and in this process the production capacity of the economy has been broadened and strengthened. However, overall large discrepancies among economic groups, particularly between the prosperous coastal areas and the poverty-stricken highlands, have become, if anything, more striking than before. Nevertheless, recent growth provides a better base from which the Government may effectively confront the country's development problems. Prospects that an effective attack will gradually overcome these problems will depend largely on success in maintaining the momentum of economic growth during the next few years, when some main factors of recent strength, particularly sharply rising export earnings, may not be maintained. 2. The National PlanLning Institute (INP), established in Oc-tober 1962, produced a program for public investment for 1964-1965, and pre- pared a new program for 1966 earlier this year, which provided a basis for the mission's study in March-April 1965. Modifications in this program were made in the Government's proposals for the 1966 Budget in August of 1965; these reduced considerably the overall size of the INP program and, to a relatively minor extent, changed the emphasis on various sectors of investment. During a visit to Peru by mission members early in September 1965 the mission reviewed, in a general way, the 1966 Budget proposals and their investment content. The financial implications of the 1966 Budget proposals were further discussed with the Government in October ]965. 3. The Government development programs, as reflected in the 1966 public investment plan and also in the 1966 Budget proposals, appear in general to be well designed to achieve the Government's principal aims: a satisfactory rate of economic growth, a significant expansion of public welfare, and a more even distribution of the benefits of economic growth among various regions and economic groups, especially so that levels of living in the Sierra and among agrarian workers may be substantially improved. The programs include an extension of previous efforts to provide the country with a more adequate system of transportation, especially highways. They seek to promote agricultural development, through new irrigation schemes and improvement of existing works both on the coast and in the highlands, agrarian settlement of existing and new lands, opening new areas to development, and extension of agricul- tural credit. They seek to complete industrial projects already started and to provide medium and longer-term credit for private industry. The programs also set ambitious goals in housing and health, provide for local community development on a wide variety of lines, and would carry on with an important education effort at all levels. The Government's programs, as planned, must overcome serious obstacles in a number of sectors, such as the general lack of skilled manpower, organizational problems, and need for technical and economic studies of projects. The present efforts of the Government to take measures to deal with these problems cannot be expected to be fully effective immediately and it was, therefore, unavoidable that the  - ii - investment program proposed by the INP for 1966 should be substantially reduced. Efforts of the Government now to strengthen its program execu- tion for 1966 would strengthen its capacity to carry forward somewhat rising levels of capital outlays in succeeding years. On another level, and possibly more important in its implications for the immediate future, is the shortage of internal financial resources required to compleanent the prospective external assistance. 5. The mission felt that the INP program for direct public invest- ment for 1966 as initiall;y formulated (amounting to 7.3 billion soles) could be reduced for the satne year by about one fifth (to abolit 5.6 billion soles), mainly on grounds of operative capacity and expected delays; it cLlso suggested some changes in emphasis. Suggestions by the mission were cdiscussed with the INP and public agencies, and in many instances were already being considered. The investment level implied in the proposed 1966 Budget (nearly 6.0 billion soles), although reduced below original plans, represents an increase of about 20 percent over preliminary estimate outlays on direct investment in 1965; in real terms this increase would be substantially less unless current rapid price increases are checked. The level of clirect investment implied in the Government's budget submission would probably exceed operative capacity in some cases. More serious, the mrission believes that it is out of joint with the financial plans for 1966, reflected in Budget estimaxtes, which imply excessive reliance on net f'inancing by the domestic banking system. The mission, therefore, on f'inancial and to some extent operative grounds outlined a reduction in the level of the 1966 Budget direct investment program amounting to about 1.0 billion soles (or almost 17 percent), mainly in locally financed ex- penditures. Even such a cut assumed an increased effort to obtain impor- tant tax revenues, and to mobilize non-inflationary internal resources, or to reduce current expenditures. 6. The financing problems of the Government are not of new origin. The Government increased :its revenues in the last five years from 15.5 percent to 20 percent of Gross National Product (GNP). However, its current expenditures rose even more rapidly. In consequence, public sector savings declined from four percent of GNP in 1961/62 to about two percent in 1964 and about 1.5 percent in 1965. Despite substantial re- coveries f'rom sale of capital goods (mainly housing and land) and repay- ments of development bank credits, the Government relied increasingly on domestic borrowing in 1964 (mainly from the Central Bank) and on short- term borrowing from foreign banks in 1965. 7. The Government's budget proposals for 1966, implied that public savings, after taking account of prospective receipts from external sources, would fall short of financing needs by even larger margins than in 1964 and 1965, and that the Government would face a large gap in f'inancing investment of about 2.6 billion soles in 1966. For 1967, the mission would estimate a gap of close to 3.0 billion soles. If these deficits were to be covered wholly by net new internal credits to the  - iii - public sector - whether from new credits or from drawings on existing public sector deposits - notes in the hands of the public and new liabil- ities of the banking system to the private sector would be increased by close to eleven percent, even without any increase in credit to the private sector. But if credit to the private sector were allowed to increase by ten to eleven percent annually in 1966 and 1967, in order to permit GDP to grow at an annual rate of five percent in real terms while assuming that prices would increase at a rate of about 5.5 percent annual- ly, and if financing of a 2.6 billion soles Government budget deficit took place entirely through the banking system, the prospects would be that a major reduction in foreign exchange reserves would occur. To avoid such ar impact from domestic bank financing of the indicated public sector deficit, drastic action would have to be taken to restrict new credits to the private sector. This would have a major impact on the growth prospects for the dynamic private sector which would certainly run counter to the development objectives of the Peruvian Government. Furthermore, such financing of the 1966 Budget would weaken the position of Peru in establish- ing levels of public sector savings necessary to maintain even present pub- lic investment levels during 1967 and the following years. 8. For these reasons, immediate steps are needed to bring about real balance between income and expenditure in the public sector. The mission, in this report, suggests a combination of selected tax increases and cuts in investment expenditures in order to reduce the public sector's reliance on the banking system to financially and economically justifiable proportions. The Government is aware of the dangers of inflationary finan- cing and is considering what practical steps should be taken to cover the gap, such as increasing tac revenues, reducing expenditures, maximizing disbursements on foreign loans, and obtaining domestic funds outside the banking system; it aims thereby to reduce net recourse to the banking system in 1966 to limits consistent with financial stability. Moreover, it is making tax studies in order to enable it to introduce next year modifications of the tax structure so as to increase public revenues to help finance the 1967 budget. 9. The rate of increase in prices has accelerated in recent months. During the year ending in Harch 1965, the cost of living index rose by :17 percent as compared with eleven percent in 1964 and about 5.5 percent annually in the growth years 1961-1963. These increases emphasize the urgency of finding non-inflationary resources for balancing the 1966 Budget. If not checked, these inflationary pressures will multiply Peru's difficulties in carrying out the public investment programs and the economy would become subject to sharp adjustments which could eventually undermine sound growth. Since Peru is primarily a private-enterprise economy, largely free of controls, it will be necessary for the success of the public invest- ment program and for continued vigorous growth to assure that confidence in the economy both at home and abroad is maintained. Non-inflationary financing of the public investment program will need to be accompanied by  - iv - restraints on wages and by moderate rates of credit expansion to the private sector. Wage increases - over which the Government has consid- erable influence - should be limited in line with improvements in productivity. 10. Restraint on credit and wages will be all the more necessary in view of the outlook for Peru's exports and balance of payrments. With declining prices for Peruts principal export commodities on world markets, export earnings through 1970 are likely to increase by barely two percent per annum. Thereafter, in the first-half of tlhe 1970ts, with both improved prices and increased export production, they would rise more rapidly, by about four percent per year. These developments would represent a con- siderable slow-down from the extraordinary export growth of recent years. Nevertheless, the export sector will remain basically strong, provided that measures are taken to avoid increases in internal costs and that the present Government follows the policy of permitting exchange rate adjust- ments to take place should this be necessary to maintain a balance-of- payments equilibrium. With rising imports, tlle large trade surplus of 1964 may fall to modest proportions by 1967, and with increasing dividend and interest out-payments, current account surpluses would give way to increasing and substantial deficits in the late sixties. These, together with increasing repayments on private and public external debt, indicate that the balancing of Peru's external accounts will depend on substantially higher inflows of foreign capital, both on public and private account. 11. External borrowing in the order of US $500 million (some US $425 million for the public sector plus a margin for private sector loans with a Government guarantee) would be needed from mid 1965 to the end of 1967, in order to assure that Peru could maintain substantial investment efforts in 1966 and 1967 and in following years. As a general average, the amount of commitments would constitute about 60 percent of the cost of projects suitable for foreign financing from mid 1965 to 1967. Nlajor efforts will be required to realize such a borrowing program. Preparation of projects and programs will have to be completed so that they may be presented op- portunely to the external financing agencies, The organizations respon- sible for the execution of the projects will need to be able to utilize the foreign credits without delay. The Government will need to be in a position to provide the necessary amounts of complementary domestic financing on a non-inflationary basis, when needed. 12. If these efforts are successful, and provided the projects in preparation prove suitable for financing upon appraisal by external agencies, thie mission estimates that the utilization of external loans could be in the order of $122 million in 1965, $96 in 1966 (including proceeds of a general purpose loan of $15 million on the private market), and $124 million in 1967. To achieve these levels, however, it will be necessary for foreign agencies to be prepared to finance, in some cases, an important share of the local costs of the projects proposed for foreign financing. Disbursements in the amounts indicated above would cover some 40 percent of total public investment outlays (including development bank credits) in 1966 and about 44 percent in 1967. The  - v - mission considers that if Peru succeeds in her efforts to provide the necessary internal resources for the public sector in 1966 and 1967, such foreign financing would not constitute an excessive share of the cost of the investment program. 13. Fxternal borrowing in the magnitudes indicated above would generate higher levels of public capital inflows in the late 1960's; 4,hese are desirable to help balance Peru's external accounts during a period in which exports are likely to grow slowly. However, the total of such new borrowing through 1967 would be close to 90 percent of public external debt - repayable in foreign currencies - outstanding at the end of 196h; this was some US $578 million, to which US $46 million were added during the first semester of 1965. The average maturity of Peru's debt had been reduced in the early 1960's as a result of Peru contracting sorme large suppliers' credits as well as sizeable foreign bank loans; by 1965 the average repayment period on the entire outstanding debt was slightly less than ten years. Thus in order to avoid an excessive burden on exchange earnings, it will be essential that in contracting the above large scale borrowing program, Peru raises the average length of amortiza- tion of its external debt from about ten to not less than fifteen years. Such an average can be achieved if the terms of lending now in use by international lending agencies were applied to all major projects. With such improvements in terms, debt service payments on present and new debt which may be contracted through 1970, would reach 16 percent of projected export earnings. Without such improvement, the ratio would reach 20 per- cent, a heavy, if not excessive, burden, which would raise questions about the possibilities of Peru's borrowing the amounts mentioned. 11l. External borrowinig of US $500 million from mid-l965 through 1967 could be realistically envisaged only provided the Government effectively implements sound public finance, monetary, trade, exchange and re'lated economic policies. The public authorities in Peru intend to continue their efforts to contain inflationary pressures and to reconsti- tute public savings, and in addition, intend to contract external debt on prudent terms, since they are aware that these measures are an essential underpinning for a large foreign borrowing program. Even with these measures, the prospects that service on public external debt may reach 16 percent of exports within the next five years is far less than com- fortable for Peru, all the more so in view of the increasing rigidity of import demand and the likelihood of larger swings in export earnings. But with a successful effort by the Government on the lines summarized above, this debt burden, while high, would not be excessive.  INTRODUCTION 1. Peru's economy has grown rapidly in recent years, and the balance of payments position has been strong. The Belaunde Administration has been making and carrying out plans, particularly for public investments, intended to assure continued growth and to meet pressing economic and social develop- ment needs. In doing so, however, it faces rising inflationary pressures of serious proportions with which it has begun to deal. Limitations wilich are likely to arise from a much slower growth of exports in the next several years than in the recent past are beginning to be recognized. 2. Against this background, a Bank mission visited Peru in March- May 1965 to appraise Peru's public investment program for the years 1966 and 1967 in the context of the Government's overall development efforts. When the mission arrived in Peru, the 1966 investment program was being f'ormulated by the National Planning Institute (INP) as part of the process of preparation of the Government Budget for 1966. Preliminary work on preparation of a program for 1967-1970 had only recently begun. Invest- ment programs of individual ministries and agencies for 1966 were being reviewed by INP, and the possibilities of finding the necessary financial resources were still being studied. The mission discussed these programs and their financing with officials of INP, the ministries and agencies con- cerned, including many of the observations and suggestions presented in this report. In early September, members of the mission visited Peru to review a draft of the missionts main report with officials of the Govern- ment and to obtain information on the Government's budget proposals for 1966, just submitted to Congress. Another visit by a mission in mid- October led to clarification of the Government's views conIcerning its intention to develop further measures to finance its requirements in 1966 in a manner which would not contribute to inflationary pressures, and also to prepare modifications of the tax structure which would contribute additional internal resources for expenditures in 1967. This report presents the results of the mission's work, beginning with a brief review of recent economic developments as background.  PART ONE C H A P T E R I RECENT GROWTH EXPERIENCE A. Economic Growth, Investment and Savings 3. Peru achieved a rate of expansion during the 1950's, in terms of GDP, of more than four percent per annum. After balance of payments difficulties during 1958 and 1959, GDP growth accelerated to an annual rate of around 6.5 percent between 1959 and 196h. The latter period included a year of slackened economic growth, 1963, when exports leveled off and the political uncertainties of an election year disturbed domestic production. Peru's growth performance during the past 15 years compares very favorably with other Latin American countries. Despite some fluctua- tions in expansion, mainly connected with developments in the balance of payments, occasional slowdowns have not led to any serious recessions. With a population growth of about 2.8 percent per annum, per capita income has increased by over 40 percent since 1950 and by 25 percent since 1959. 4. This improvement in the nation's economic well-being has not been shared evenly among regions and pcpulation groups. Production has grown mainly in the coastal area, but little, if at all, in the high- lands. Redistribution of income through changes in the property struc- ture or through fiscal measures has not been substantial, although a middle-class appears to be emerging in Lima and also in other centers. Migration has only in small part offset regional differences in per capita income. Nevertheless, migration from the Sierra into coastal areas has been sufficient to lead to some major social problems in many coastal cities, particularly related to housing and employment. 5. Economic developments during the 1950's and in the early 1960's have been accentuated by changes in the country's terms of trade. The deterioration in the balance of payments in the late 1950's was, to a major extent, related to sharp price declines in Peru's export products. Increased export prices since 1959 have helped to accelerate growth and to improve the balance of payments; in 1964 export prices were more than one-fourth above their low 1959 level. 6. The key sectors of expansion during the 1950's were export- oriented agriculture and minerals. Since the late 1950's, Peru has developed into the world's biggest volume producer of fish products. Other industries have also growqn, though not as rapidly as fish meal, and industry has provided the main impetus to accelerated economic ex- pansion although minerals have continued to play a dynamic role. In con- trast to the export-oriented fish meal industry, other new industries established for supplying the domestic market often have had the benefit of newly built tariff walls. While industry and mining have led overall  3- expansion, they have also contributed to the fluctuations of Peru's national product. In contrast, traditional agriculture - much of it in the highlands (Sierra) - producing for self consumption and the domestic market has stagnated. Techniques in agriculture of the Sierra have remained virtually unchanged and the more enter- prising people from these areas appear to have moved increasingly into other activities. In contrast, agriculture in the coastal area, mostly cotton and sugar, has substantially improved in efficiency. 7. Expansion of the economy has been associated with a high and increasing rate of investment. Since the mid-fifties some 20 percent to 22 percent of the gross national product has been invested annually in fixed capital, except during the balance of payments adjustment period 1959/1960. The destination of these large investment outlays is not known precisely. ilowever, it is estimated that throughout most of the last fifteen years, relatively little has been invested in housing activities, while investments in mining, power and transportation have been substantial and industries have increasingly participated in the capital outlays. Investments in agriculture on the other hand appear to have been concentrated on irrigation works and farm development in the coastal areas. As measured by the realized rate of growth in GDP, past investments seem to have been directed, in general, into sectors with a substantial rate of economic returns. 8. Data on savings are very inadequate. Nevertheless, avail- able indirect evidence derived from investment and balance of payments data indicates that the development of savings has been associated with changes in the country's terms of trade, and its financial policies. Thus savings rose quickly in the early 1950's with increased incomes resulting from favorable export prices, but declined from 1954 to 1958 when export prices dropped from the exceptional levels attained during the Korean War. Substantial tightening of public expenditures and a change in the price struc- ture related to an exchange rate adjustment under the 1958 stabili- zation program resulted in a marked increase in savings rates between 1958 and 1960. Income gains resulting from better terms of trade have made for a continuously high national savings rate (some 20 - 23 percent of GNP during 1960 - 1964) in spite of domestic cost increases and higher public outlays in recent years. Net reliance on external resources has been small, except during 1955 through 1958. During 1960 through 1961 and again in 1964 in fact the national savings exceeded domestic investment. 9. Within the country's overall savings, public savings have played a relatively minor role; in 1964 about one-tenth of total savings (or two percent of GNP) was generated by the public sector. While public sector revenues increased from 15.5 percent of GNP in 1960 to 20 percent in 1964 (and 1965), current public outlays rose  - 4 - even more rapidly, i.e. from 12 percent of GNP to 18 percent of GNP in 1964 and 1965. Iluch of these increased current expendi- tures have been directed toward economic and social services, principally agriculture, education, and public health. However, these higher outlays often have not been accompanied by required improvements in the quality of these services. 10. Little is known about private savings in spite of their apparent high level. The bulk of private savings appears to have been generated in the foreign trade sector and, in recent years, in manufacturing. Although an increasing flow of private savings has in recent years been channeled through commercial banks, insurance companies and through the rapidly growing savings and loan associations, progress toward an effective capital market has been slow. Most of the savings in the private sector still remain within the company or group of companies which generate surpluses. Many of the industrial and commercial companies are linked to lead- ing commercial banks which in effect act as distributing agents for investible funds among the "group". B. Prices and Monetary Policies 11. During the 1950's and into the early 1960's, Peru pursued, over extended periods, conservative financial policies which put the country in an intermediate group of Latin American economies in terms of price movements. Intermittent reliance on excessive credit expansion as a source of financing both for public and private expenditures resulted in balance of payments problems in 1953 and again in 1958/1959. During the 1950's domestic prices rose at an annual rate of some eight; percent; from 1959 to 1963 prices in- creased at an annual rate of six percent to seven percent. Subse- quently, the rate of increase accelerated; in 196h, prices rose by 12 percent, and in the first half of 1965 at an annual rate of 19 percent. Under prevailirng monetary and fiscal policies, rising wages and substantial increases in turnover taxes contributed to higher price levels. In addition, public sector outlays have been substantially stepped up with increasing reliance since 1963 on financing from the banking system. Since mid-1964 the Government's non-inflationary resources have in fact fallen behind its increased outlays and in late 1964, a substantial recourse to the Central Reserve Bank took place. This, together with increases in exchange reserves during a year of exceptional export performance, has greatly increased the liquidity of the banking system. In May 1965 in accord with -the 114F Stand-by Arrangement of April 1965, the Government took measures intended to reduce its reliance on central bank financing; later, in June, monetary authorities took measures to increase the reserve ratio of commercial banks in order to reduce liquidity. The Government also made use of drawings on a $40 million bank cre- dit abroad.  5 C. Balance of Payments 12. Since 1959, Peru's exports have more than doubled while shifting towards commodities more income-elastic in world markets. With rising prosperity in industrialized countries, demand for fish meal and minerals has greatly increased, and output in Peru has responded vigorously. Their share in exports has grown at the expense of the traditional agricultural lines, cotton and sugar. In 1964, exports provided around 24 percent of GDP as compared to 20 percent by 1957/1958. Peru has moved among the South American countries from sixth to fourth largest exporter. Imports have advanced at similar rates from the depressed 1959 levels. Quick adjustments in imports to possible export drops have become more difficult as there has been increasing reliance on consumer goods imports, particularly in foodstuffs, because national production of the latter has failed to rise in line with domestic demand. The substitution of formerly imported manufactured goods by newly developed domestic products has resulted in a higher proportion of imports of intermediate products and thus reduced the possibilities for temporary downward adjustments of imports. Capital goods im- ports have maintained a substantial weight (over 40 percent) in overall imports. 13. The exchange market has been free throughout the 1950's and since 1959 the exchange rate has been stable. The strength of the exchange rate and of the balance of payments can be clearly traced to the favorable development of the export industries which have proved to be highly productive. Under the impact of this development, the net reliance on external borrowing has remained relatively small although gross capital inflows had an important part in some sectors; imports, including practically all services, have been paid out of the proceeds of exports in every year since 1959 with the exceptions of 1962 and 1963, when small current ac- count deficits emerged. 14. These favorable developments in the balance of payments have generated increased confidence in Peru by foreign lenders permitting Peru to borrow abroad substantial amounts recently, par- ticularly for the public sector. Whether such a reliance on exter- nal financing could continue depends on prospective developments of the balance of payments discussed in Chapter IV of this report. D. Conclusion 15. To sum up, Peru has greatly widened and strengthened the basis of its economy during the past decade. The benefits of growth, however, have not been evenly distributed throughout the community. In fact, the gap between the rich coastal areas, mainly  -6- metropolitan Lima, and the poverty-stricken highlands has become more pronounced. Nevertheless, the rapid economic progress, particularly the greatly increased import capacity of recent years, has provided a stronger basis from which the country can effectively attack its basic development problems. The means of gradually overcoming these problems - discussed in the following chapters - will be contingent largely on the success of the Government's efforts in maintaining the momentum of eco- nomic growth during the next few years, when prospects are that some of the main recent factors of strength, primarily the export performance, are unlikely to be mainta:ined.  C H A P T E R II DEVELOPIMENT POLICIES AND THE PUBLIC INVESTMENT PROGRAM A. Development Goals, Strategy and Policy 16. The continued rapid expansion of the economy in the past five or six years, confronted by growing scarcity of cultivated lands on the coast, difficult transportation problems and a rapid urbanization, have made it increasingly necessary for the Peruvian Government to formulate adequate development policiesand to expand public investment in infra- structure and allied facilities required to provide a foundation for further growth. The Belaunde Administration considers it urgent that the pace of economic growth in Peru be maintained. A major objective of the 196h/65 plan was to achieve an average annual rate of growth over the next few years of seven percent gross domestic product, a rate signific- antly higher than in the recent past; for 1966 the target appears to be 5 to 5.5 percent. The Government firmly believes that the benefits of growth should be more evenly distributed among various economic and social groups, and particularly that the levels of living in the Sierra and among agrarian workers should be substantially improved. The Government sees itself as a leading agent in transforming the country into a modern integ- rated society; this will require that future economic expansion on the coast be counter-balanced by a substantial betterment of life in the Sierra and accelerated settlement and development of the eastern slopes of the Andes and the tropical forest (Selva). These changes are also envisaged as a means of integrating the society and expanding the internal market, itself at present a barrier to growth. 17. The Administration has expressed its broad objectives in terms which catch the imagination and raise the expectations of wide segments of the population. Thus the goal of increasing agricultural output and relieving population pressure is expressed in terms of improving the "land-man ratio" by bringing into cultivation a "million hectares" of new lands, through new irrigation works on the coast and in the Sierra, and through settlement of new lands in the Selva, to be opened up by building new roads into that region. President Belaunde has taken the lead in pro- moting a new highway - known as the "lVarginal de la Selvall - running along the upper edge of the Selva in Peru and continuing through Ecuador and Colombia on the north and Bolivia on the south. Agrarian Reform, under a new law, and a broad cooperative program of self-help - "Cooperacion Popular" - in building roads, houses and cornmunity works, are being pushed to help meet the hopes and stimulate the active participation in economic improvement of large low-income masses. In addition, the Administration lays heavy emphasis on expansion of education, health and water supply facilities, and raising the rate of housing construction. 18. As an instrument for achieving its broad developmental objectives, the Belaunde Government places considerable reliance on an increased and improved investment effort, particularly in the public sector, with the aid of plarning techniques. The new lIational Planning Institute (INP),  - 8 - established in 1962, produced a first program for public investment in June, 1964, covering the years 1964/65, within the general framework of economic projections to 1970. In May 1965, INP, with the assistance of sectorial planning groups representing the various public agencies mlaking investments in the sector, prepared a program of public investments for 1966 as part of the budget making process for that year. It had also begun preliminary work on a comprehensive development plan for 1967-70 including plans of the private sector. The mission believes that it is urgent for the ITP to push forward with the task of elaborating an in- vestment and development program for 1967-70, particularly in the public sector. A number of important large projects are being prepared by various agencies of the Government, with a view to starting them as soon as possible. However, the full implications of these projects as regards the possible size and composition of the public investment program in future years and the possibilities of financing them at home and abroad are frequently not fully realized in Government circles, including the individual public agencies. The mission considers it important that the Government, through the I1FT, prepare a thoroughanalysis of the 1967-70 public sector program and in so doing, enlarge its review of the various sector development programs and their relation to each other. The planning- process in Peru is relatively new. W^hile it has already achieved signif- icant progress, it will need to be strengthened in personnel in order to continue to improve the quality of the programs produced and their imple- mentation. B. Level and Composition of Public Investment Program: 1966 and 1967 19. A public investment program centered on only one or two years is too narrow a basis for giving expression to the Government's development objectives or for measuring the impact of its policies for implementation, especially its efforts to mobilize the necessary resources, and for assur- ing proper balance within the program. However, starting with a review of the investmnent program proposed for 1966 by DIP in May 1965, the mission suggested changes in the composition and level of that program and it also outlined an investment program for 1967, taking account of available plans in some sectors, which varied considerably in completeness. 20. In its review, the mission examined the general objectives in each sector, the policies and measures proposed to meet these objectives, the relative economic priority of the projects proposed, the state of readiness of projects for external financing and for executing, the exist- ing commitments to complete on-going projects or programs, and the oper- ative capacity of the agency responsible for carrying out the project or program. lWlhile the aim of the mission was to maximize the economic impact of the investment expenditures, it was keenly conscious also of the scarcity of financial resources and in suggesting adjustments in proposed expendi- tures, it generally excluded expenditures of apparent lower priority or doubtful justification. The mission did not attempt to tailor the size of its suggested program for 1966 and 1967 purely to eliminate a possible  budgetary financing gap; it considered that should Peru be unable to gen- erate the required internal resources by non-inflationary measures, and to arrange the external financing required by the program, further read- justments in the program of investment outlays would be necessary. 21. The public investment level in the INP program for 1966 was con- siderably higher than that programmed for 1965 and even more above that wqhich probably will be realized in 1965. The INP estimates of direct pub- lic investment 1/ as well as indirect financial investment in the form of loans by state development banks to the private sector are shown below for 1966 along with mission estimates of investment for 1963-1965. These can be compared with the levels suggested by the rission for 1966 and 1967 on the basis of its review in May 1965. Realized INP Suggested (Msission Estimates) Program IIission Program Public Investment 1963 1964 1965 1966 1966 1967 Direct Investment a/ a/ ! a/ Billion soles 3.2 4.0 4.9 7.1 5.6 5-9 Percentage increase over previous year - 25% 23 c 5% 14/O 6,5 b/ Indirect Investment reTvelopment Bank Credits) Billion soles .3 1.6 1.7 1.5 1.5 1.7 Total Public Investment Billion soles 3.5 5.6 6.6 8.6 7.1 7.6 Percentage increase over b/ previous year - _ 18, 30%eo 8% 7$ a/TExcludes direct investment by local governments. See Tables 11 and 18e b/ Percentage increases are not shown as the data on indirect investment are generally non-homogeneous and incomplete for 1963. 22. The adequacy of tlhe level of capital expenditures proposed by INP for 1966 and suggested by the mission for 1966 and 1967 to maintain a 1/ In this report the terms direct investment and gross capital formation are used synonymously. In line with the treatment by INP, they also include acquisition of land (excluding land purchases for Agrarian Reform) and a small amount of development credits extended by regional development agencies.  - 10 - desirable rate of growth cannot be calculated precisely on such a narrow t:ime base. Nevertheless, the mission considers that the level and compos- ition of the investments, taken in conjunction with continued high levels of private investment, would provide a basis for a further high rate of growth. 23. Growth would be assured all the more by policies and measures designed to increase utilization of existing capacities of public investments in order would bring about an immediate and economical increase in production of goods and services, (e.g. improved quality of teaching instead of more schools; better utilization of irrigation waters now available rather than extending irrigation to new areas; better utilization of existing hospitals rather than new and understaffed ones; and more and better agricultural ex- tension services to farmers to enable them better to utilize existing lands and improvements or to be prepared for new ones). Benefits from other projects could be secured w:ith lower investment cost; in road construction, for example, the adoption oi modest design standards for penetration roads would require less investment yet yield full benefits, and the roads could later be improved as traffic built up sufficiently to justify higher stand- arc.s. 214. Since the major portion of production and investment in Peru is private in origin, expansion of investment in the private area is essential for vigorous growth; it wiLl therefore be important for the Government to continue favorable policies for private investment, including financial policies which would mainta:in confidence in the economy at home and abroad. 25. The following paragraphs (26 to 28) briefly review the composition and balance of the INP public investment program for 1966 and the mission's suggested changes in that program within the totals shown in the tabulation in paragraph 21 above. A sumzmary of the content and justification of the IM? program by sectors and the mission's comments on them is presented in Part Two of this report. In general, the INP 1966 program appeared to be reasonably well balanced to meet the development needs of the country. The nission was in agreement with the INP in placing special emphasis on agri- culture and in according almost one-fifth of direct investment to that sector. Owing to limitations inherent in newly created organizations and programs, it appeared that all of the large sums proposed by INP for Agrarian Reform could not be effectively applied. Furthermore, the mission considered that on grounds of technical and administrative feasibility, as well as economic considerations, the scale of proposed irrigation investments should be reduced. Agricultural development wi:Ll be also promoted by the substantial develop- ment credit program of the Agricultural Development Bank to assist in develop- ment of farm water supplies and lands, of cattle production and of other im- portant agricultural production and processing lines.  - 11 - 26. Transportation is the other most important sector in the invest- ment program. The major portion of the transportation program is allo- cated to highway construction, involving work on the Pan-American Highway and, probably more important, on major roads connecting the coast with the interior, and on roads penetrating the Selva. The mission felt that the highway program should be reduced somewhat in accord with operative capacity, and be concentrated on fewer but high priority projects. The port investments reflect the importance to Peru of providing adequate means of handling her growing foreign commerce and of improving ports on tributaries of the Amazon River; the INP was in agreement with the mission that certain port investments which had not been included in planning sub- missions to them should be scheduled in 1966. The mission also suggested that if possible a start should be made on the airport investment program in view of the high priority of adequate airport facilities in a country of great distances, difficult terrain and in some cases lack of land access. 27. Among the remaining sectors, industry, including petroleum refining, was accorded 14 percent of direct investment in the INP 1966 program. However, actual investment most probably will be less since the Government is still studying the new investment in the steel plant (SOGESA) and, at best, contracting for construction and financing will be somewhat later than originally expected. N;ost of the industrial investment has priority in the sense that it rounds out existing facili- ties (the steel plant) or carries forward commitments already made. De- velopment credits to be extended by the Industrial Bank to a wide variety of industries would increase industry's share of public investment re- sources; the mission concurs with INP in the importance of the industrial credit program. Direct investment in electric power facilities consti- tutes only six percent of the INP program, mainly for on-going programs and projects, but also for initial construction work on a tunnel for the big Mantaro project, although a decision on proceeding with that project is still under consideration by the Government. The mission would accord a considerably smaller amount for Mantaro and recommends that no major work should be started for at least two years in view of other power capacities available to meet prospective demand; the amount suggested would enable the Mantaro Corporation to carry out further preparatory work on the project. 28. The social sector - housing, education and public health (includ- ing water supply and sanitation) - would be allocated almost one-third of direct investment resources in the INP 1966 proaram. The mission would give slightly greater relative emphasis to education, especially for vocational and secondary schools, and found that its suggestions were in accord with revision in investment plans then being made by INP and the education authorities. In the field of water supply and public health, the mission suggests lesser sums than INP, mainly due to limitations of operative capacity and to its strong impression that hospital construction can safely be stretched over a longer period owing to the lack of necessary  - 12 - personnel for efficient operation of hospitals. Adjustments suggested by the mission for the "cooperacion popular" program aid miscellaneous pro- grams of local or regional agencies largely reflect doubts as to the operative capacity of the executing agencies. C. The 1966 Budget Investment Program and Adjustments Suggested by the Mlission 29. Late in August, after the mission had arrived at its conclusions regarding the size and composition of a recommended 1966 program (reflected in the tabulation above), the Government submitted its proposals for its 1966 Budget to the Congress; these in effect established a proposed "Budget Investment Program" for 1966. The total estimated amount of direct invest- ment expressly included in the budget program was 5.5 billion soles; how- ever, the mission's analysis (see Table 8 ) indicates that the direct in- vestment implicit in the budget proposal is about 5.9 billion soles. To arrive at the planned investment implicit in the budget, it was necessary to add certain omitted items. These are expected disbursements from foreign loans for investment projects which the Peruvian budget law does not allow to be included in the budget until the loan is contracted, even though the local currency counterpart is provided in the budget; also, it was evident that express provision had not been made for the local currency expenditures required to complement certain foreign loans. 30. In view of the size of the financing gap in the 1966 budget pro- posals, which, as indicated in Chapter III, the mission believes cannot be ful-ly covered from new non-inflationary internal sources or external aid, the mission considered what reasonable reductions could be suggested in the direct investment outlays as a contribution toward closing the foreseen overall financial resource! gap. In the light of more recent information, it put primary emphasis on reductions warranted by relative priorities, deferrability of projects, limitations of operative capacity, or the state of readiness of projects and the status of consideration by foreign agencies of requests for external financing. At the same time, as a measure of maximizing the contribution of the reductions toward closing the gap, the proposed reductions were aimed at effecting savings primarily in local currency claims on the budget, rather than in use of external resources. 31. The adjustments suggested by the mission could not be worked ouit in the same detail as in the mission's earlier review of the fT program, given the limitations of time and difficulties of interpreting budget data. Nevertheless, the mission believes that it should be possible to reduce the level of direct public investment from the figure of 5.9 billion soles implied in the Government's budget proposal (already above the mission's earlier recommendation of 5.6 billion soles) by about 1.0 billion soles, to a level of 4.9 billion soles, and to improve the distribution of invest- ment among the various sectors, as compared to that in the proposed budget. (The adjustments suggested are shown in Table 8 and summarized in Appendix B.)  - 13 - Eighty percent of the volume of adjustment suggested by the mission would be in local currency expenditures and the remaining 20 percent in external financing. (The latter as a result of postponing certain investments or delays in carrying out others.) 32. These adjustments would result in a level of direct public capital formation no higher in nominal terms than that likely to be realized in 1965, a year during which a large expansion in public investment is taking place owing in part to the unusuaL external financing resulting from receipt of a $40 million loan from commercial banks in the U.S.; in real terms, this would be somewhat less in view of current increases in prices. Some con- sequential adjustments are suggested in the 1967 program for direct invest- ments, the effect of which would reduce them to slightly less than the previous estimates of the mission. Nevertheless, assuming a reasonable degree of stability in prices hereafter, they would represent a sizeable step-up over the adjusted 1966 program and, as indicated in Chapter III, would call for a substantia:L increase in the financial effort of the Govern- merit. 33. The role of these adjustments in the investment program as one means of dealing with the 1966 budgetary gap, was reviewed with Government officials in October 1966. Undoubtedly, a reduction of the overall order suggested would raise problems. The Government would probably encounter instances where existing commitments would make it difficult or highly uneconomic to reduce or postpone the proposed budget investment; but there may also be other cases, not known to the mission, where investments could be postponed or reduced. In any case, a reduced direct investment program for 1966 of the order suggested - about 4.9 billion soles - would still represent a very substantial contribution to the development of the economy. Even at this level, however, difficult problems of financing would still remain to be solved.  C H A P T E R III THE FINANCIAL SITUATION AID OUTLOOK A. Introduction 34. As indicated in Chapter I, the rapid rise in expenditures in the economy, particularly in the public sector investment levels has resulted since 1963 in increasing strains on Peru's resource balances. The prospects are that these strains will substantially increase in 1966 and 1967. Past strains have been reflected in rising domestic price levels, rather than in the balance of payments which benefitted from rapidly rising export; earnings. Increasingly, it is likely that the strains in 1966 and 1967 will result in pressures on the balance of payments. The present administration has committed itself - 1ike its predecessors - to maintain a free exchange market. In view of the financing problems discussed below, this commitment may be defended successfully without heavy and probably unsustainable losses of exchange reserves or without a depreciating exchange rate, only if financing of the public investment program - and of the much greater private in- vestments - can be obtained from non-inflationary sources. B. Public Finances 35, The vast array of Peru's public sector entities has only in recent years been viewed as an ensemble through which the Government could exert, in a coordinated fashion, considerable influence on the country's financial and economic developments. Besides the Central Government, there are over two hundred state and para-state organizations through which Government funds are channeled for final expenditure. Around 70 percent of all current public revenues (net of inputs of enter- prises) are collected by the Central Government. But through 1965, some 35 percent of the Central Government's revenues have been earmarked by law either for specific expenditures within the Central Government or for transfers to specified entities within the Independent Public Sector (IPS). The autonomy of the agencies in the IPS varies greatly. In general they enjoy a large degree of independence from the control of the Central Government; this is particularly true for the financially strong entities (e.g. the social security system and large public corporations) or for the entities having special political importance (e.g. the universities, the National Economic Development Fund (FNDE) or regional clevelopment corporations). The budget law of 1962 envisaged that all public entities would be included in a national functional budget. The Government is maling an effort to effect the transition to this new system and in 1965 the IPS agencies were required to submit budgets to the llinistry of Finance for fiscal year 1966 before the formulation and sub- rnission of the national budget. This is an important measure toward making the budget eventually a better instrument of fiscal and economic policy. Thu mission understands that the Government intends to proceed with its effective implementation.  - 15 - 36. Great efforts have been made by the INP to establish estimates on financial developments covering the entire public sector. As a result of these estimates and of reclassifications of accounts, a more thorough economic analysis of public sector accounts has become possible. However, more progress has been made on Central Government accounts than on accounts of the IPS agencies. Information on the latter frequently has been un- available and accounting procedures in some agencies have varied over recent years !/. The mission believes that both for the annual budgeting process and for the elaboration of the development program for 1967-1970, further progress in establishing coordinated and reliable data on the entire public sector accoun-ts is of highest priority. 37. Tne public sector in Peru participates only marginally in public utilities or in industrial enterprises. Gross sales by public enterprises in 1964 are estimated at nearly two billion soles, about two percent of GDP. Most of these sales took place in steel, fertilizers and petroleum pro- ducts. This means that in terms of generating savings in the public sector, l:ittle reliance can be put on profits made by enterprises, and that savings come essentially from taxes. However, as public investment in selected industries (e.g. steel, fertilizers) and public services (e.g. irrigation, water supply, hospitals) is increased, it will become more urgent to apply adequate pricing policies in such enterprises or services and to control their costs. (a) Recent Trends in Public, Finances 38. The outstanding feature of Peru's public sector during the past few years has been a great leap forward in its participation in the nation's economy. Current public revenues rose from 15.5 percent as a percentage of GE? in 1960 to nearly 20 percent in 196L4 and 1965, while current public expenditures during the same period increased more rapidly from barely -twelve percent of GNP in 1960 to around 18 percent in 1964 and 1965. Con- sequently the current account surplus, i.e. savings generated by the public sector itself, has declined from a peak of 2.6 billion soles in 1962 to 1.7 billion soles estimated for 1964 and 1965; in relation to GNP, they declined since 1962 from nearly four percent to around two percent of GM? in 1964 and to slightly less in 1965. 35. The rapid increase in revenues has come mainly in indirect taxes which in 1965 are estimated to reach four times the level achieved in 1960; in GNP terms, indirect taxes have risen from 3.6 percent in 1960 to 8.4 percent in 1965. The increase in indirect tax revenues took place in import duties and even more in domestic turnover taxes, in both cases from higher rates and new taxes as well as from a substantial increase in tax 1/ For these reasons the mission has introduced any additional evidence available; in particular it has made use of data on the domestic banking system and on foreign borrowing. On this basis, some adjustments in the INP estimates have been introduced. Mission estimates on public finances including a number of adjust- ments in IDMP figures are shown in detail in Table 18A.  - 16 - 'base. In contrast, during the period 1960-1965, revenues from direct taxes suffered erosion through a variety of special exemptions; as a result, and despite generally rising incomes, revenues from direct taxes have fallen from 4.8 percent of GNP in 1960 to four percent in 1964/1965. Other current revenues (including taxes) earmarked for certain ministries in the Central Government or for agencies of the IPS, have moved roughly in line with growth of GNP, yielding some five percent of GNP: about 35 percent of these funds go into Social Security System. 40. These changes in the revenue structure during the last few years have resulted in a tax system which suggests that future revenues will move in line with changes in production and price levels. The overall revenue level compares favorably with many other countries in a stage of development similar to that of Peru. Nevertheless, as the Government is aware, the present revenue system has considerable short- comings as regards the effects of taxation on the efficient allocation of resources and the equitable distribution of the tax burden among Peru's population. The rapid rise in turnover taxes levied at various production stages - inducing vertical integration - and the heavy reliance on import duties - often associated with excessive protection - have introduced distortions, particularly in industrial investment, detrimental to the efficiency of the economy. Moreover, no progress has been made on the revenue side towards a minimum equity objective. In view of the severe income distribution problems, greater reliance on direct taxes at the personal income level - as well as on selected progressive indirect taxes - will eventually be required. 41. An important and most difficult task which the Government must face is to analyze the economic returns from its current public expenditures. CuLrrent public outlays increased between 1960 and 1965 by around 80 percent; for socia'l services alone bhey trebled. Although the mission was not in a position to analyze the quality of all current expenditure, it is evident from several sector appraisals that many increases in current outlays have not been associated with maintenance or improvements in the quality of services obtained from such expenditures. This is true, for example, in expenditures on education, which are the most important component of all current outlays (25 percent of total). Some 4.5 percent of GNP is pre- sently spent on education and recently enacted legislation assures that, because of salary increases alone, this percentage will rise to probably over five percent in 1966/1967. IThile the quality may be expected to improve (as a result of teacher training and similar factors), that level is higher than in most countries where the entire population of school- going ages actually obtains schooling. In the field of public health, where current outlays are now between five and six times the 1960 level, considerable imbalances and inefficiencies have been found. Moreover, increases in public wage expenditures, viewed by some as a measure of distributing income more equitably, have benefited relatively few. At the same time they have contributed to strains on public finances which have added to inflationary pressures detrimental to the economy.  - 17 - 42. The bulk of the public sector savings is generated at the level of the Central Government, in social security institutions and in a few enterprises. Savings of the Central Government, however, are largely channeled to the IPS in the form of transfers, often in the form of proceeds of special accounts or allocations fixed by law. Transfers of savings from one to another entity in the IPS or to the Central Government have been of minor significance. As a result, some entities in the IPS (and even some entities within the Central Government) have accumulated substantial savings in the form of deposits in the banking system while other entities in the IPS have had to rely on contributions from the Treasury of the Ceneral Government. The Central Government, in turn has had to borrow fr4om the banking system, piimarily from the Central Reserve Bank, in order to finance not only its current and capital budget but also its transfers to the IPS. It is also, aside from the State Development Banks included in the IPS, the only public borrower from the Central Bank, which in the absence of a domestic capital market, has been the ultimate source of public sector borrowing. 43. The sale of capital goods, mostly houses and land sub-divisions by the National Housing Board, has become, since 1963, one of the major sources of domestic finances as shown in the following tabulation of the main heading of public finances from 1963 to 1965. The proceeds of these sales are estimated to finance some 15 percent of public sector capital outlays. Also repayments of loans to the State Development Banks have provided an increasing source of finance in the last few years. Public Sector 1963 1964 1965 (Billions of soles) Revenues +16.4 +19.3 +22.2 Current expenditures -14.14 -17.6 -20.5 Savings + 2.0 + 1.7 + 1.7 Sale of capital goods and repayments of development credits + .1 + 1.0 + 1.2 Net domestic borrowing (including use of cash balances) + .2 + 1.3 + 1.5 Net external financing + 1.2 + 1.6 + 2.2 I]nvestment expenditure (including development credits) - 3.5 - 5.6 - 6.6 Note: Details may not add up to totals on account of rounding. 'iource: Mission Estimates, Table 18. 44. Domestic financing of public investment has been supplemented by substantial disbursements on external loans. During the years 1963/1964, gross disbursements on external loans financed 47 percent of all public sector investments in those years (including new credits extended by the  - 18 - 'State Development Banks). If account is taken of amortization payments, net receipts from foreign sources amounted to 29 percent of public sector investments (including new credits from State Development Banks). Prac- tically all of these disbursed funds were attached to projects or to credits extended by the Stiate Development Banks, Only at the turn of 196h/1965 did Peru obtain large fulds (us $40 million) from private U.S. banks, which were not linked to specific projects or credits. Utili- zation of these funds is expected to lift foreign financing of total public sector investment in 1965 to 49 percent on a gross or to 34 percent on a net basis. - (b) Budget Proposal 1966 and Outlook for 1967 45. At the end of August 1965, the Government sent its budget proposal for 1966 to Congress. The proposal contains the budget of the Central Government as well as the budgets of the main entities of the IPS and also makes allowances for local governments. (The budget proposal is subject to further but probably marginal amendments when information on the budgets of some minor IPS entities, now lacking, becomes available.) Only with such amendments will it be possible to fully relate the budget proposal for 1966 to public sector finances of the preceding years. Estimates of public sector revenues, expenditure and financing for 1965 and :1966 derived from budget figures and amended by available other information, and illustrative estimates for 1967 made by the mission are summarized in the following tabulation: 1965 1966 1967 Budget Budget NIission Public Sector Revised ProposaLi/ Estimates (Millions of Soles) Revenues +22.2 +24.6 +2804 Current Expenditure -20.5 -21.5 -25.3 Savings + 1.7 + 3.2 + 3.1 Sale of capital goods and re- payment of development credits + 1.2 + 2.0 + 2.0 Net domestic borrowing (including use of cash balances) + 1.5 + 2.4 + 0.8 Net external financing + 2.2 + 1.7 + 1.9 Investment expenditure (including development credits) - 6.6 - 7.6 - 7.7 Financial investment b/ (excluding development credits) - - 1.7 - Note: Details may not add up to totals on account of rounding. a/ For details, see Table 11. _,/ See Table 8, footnote 5, and paragraph 47. Source: Table 11 and 18.  - 19 - L6 Available information on the 1966 budget proposal does not yet permit a full analysis of all its elements insofar as the IPS is con- cerned. The following discussion, therefore, concentrates on the Central Government budget; but it also makes allowance for the deficit of the IPS insofar as it affects the public sector's reliance on the banking system. The Central Government revenue estimates for 1966 foresee a ten percent increase above revised 1965 estimates on the basis of existing tax rates, plus an increase of SI. 190 million to result from selected reimposed and some small new taxes. The rate of increase foreseen in the budget proposal for current expenditure of the Central Government is 14 percent despite the stated intention of the Government not to provide for any general salary adjustments for public sector employees. Most of the increase in current expenditure is the consequence of higher salaries for teachers - required under a law passed by Congress in early 1965 - and of a substantial expansion in agricultural services which are to help carry forward the Agrarian Reform program. As a result of these revenue and current expenditure developments, Central Government savings would decline from S/. 1.7 billion in 1965 to S/. 1.6 billion in 1966. Should a general salary adjustment take place - a possibility that cannot be discounted in the light of recent sharp price increases - current expenditure might well increase by at least S/, 150 million and probably by an amount closer to S/. 500 million. The mission understands, however, that in such a case the Government would request Congress to adopt newi tax measures to cover the increased outlays resulting from new salary increases for public employees. 47. The proposed budget foresees a marked increase in savings in the IPS in 1966 (to S/. 1.6 bi'llion from an estimated level of savings of SI. 0.9 billion in 1965). The basis for this increase is not evident, and clearly needs further investigation; it had neither been envisaged in the Public Investment Program of the INP (which had foreseen a SI. 1 billion savings level) nor are there new taxes or sharp increases in sales prices of goods and services provided by state enterprises to support such an increase in IPS savings. On the other hand, the IPS budget includes a very sharp increase in transfers (S/. 1.7 billion) to the private sector - other than through the State Development Banks - which in effect more than absorb the apparent increase in IPS savings. This apparent increase in financial transfers to the private sector, largely by the Social Security Funds, is a new development still under investigation by the budget office of the Government. V8. The plans of the Government to maintain or even increase the already substantial investment effort, while amortization payments on debt incurred in recent years become increasingly heavy, when considered in the light of trends in public sector savings, raise serious questions as to the capacity of Peru to finance its proposed public sector activities in 1966. Noreover, mission estimates of an illustrative nature made for 1967 suggest that problems of financing the 1966 budget are not merely of a short-term nature which could be overcome by temporary measures. Both the 1966 budget proposal and 1967 estimates demonstrate clearly that  - 20 - without vigorous government action, public sector savings will in- creasingly fall short of the financing needs in the immediate years ahead even with external financing assumed to continue on a substantial scale. 49. External financing according to mission estimates may contri- bute S/. 2.8 billion and S/. 3.4 billion to the 1966 budget proposal and to 1967' respectively, in the form of disbursements from known and potential loans related to government projects and to State Development Banks. This assumes that the proceeds of a U.S. $15 million bond issue - S/. 402 million - will be applied to the 1966 budget; Peru is presently discussing with a group of U.S. investment bankers the floating of this issue in the near future. 50. Gross inflows of funds for 1966 and 1967, however, will be partly offset by rising amortization payments on outstanding external debt. Thus net external resources, instead of representing 34 percent of total public investment as in 1965, would drop to 23 percent in 1966 and 24 percent in 1967. It; would be difficult to avoid this reduction in the percentage of net borrowing; given the limitatiorns of time, and lack of substantial additional projects suitable for external financing, it would be necessary to obtsin some general program finrt,cing in order to maintain the public inv-estment outlays implicit in the bild-at pro- posal for 1966. Prospects for disbursements on general programr financing, in 1966 in addition to the projected $15 million bond issue, appear slim. Alternatively, some Peruvian authorities have considered the possibilities of refinancing 1966 and 1967 naturities of certain selec,ted ex-':crnal debt weighing heavily on this period; this would have a similar effect in freeing funds for general financing of the investment program. But given the uncertainties of such an operation, no allowance has been made in the mission's financial estimates for such refinancing. 5l. The Gover.nment recog.nizes in its 1966 budget message to Congress the serious problems whichi it faces in financing the proposed 1966 budget. The ra..s-s ge s't;ates that the Government was not yet in a position to present measures which would assure a "permanent"' financing and that only a transitory financing was being proposed for the time being. Beyond 1966, tl..e budget message em>phasizes (a) the needs for a tax reform designed to chanuL tbe structure of h'he tax system and to provide an adequate level c,f reI.1 resou,-ces for the p;blic sector and (b) the necessity of carefully scrutini:7r> uurrent ex;;ri>;ares which in recent years have increased to very higa .!<-c