Document of The World Bank FOROFFICIAL USEONLY ReportNo. 27507 - BR INTERNATIONAL BANK FOR RECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT FORA PROPOSED FIRSTPROGRAMMATIC LOANFOR SUSTAINABLEAND EQUITABLEGROWTH INTHEAMOUNT OF EUR427.20MILLION (US$505.05 MILLIONEQUIVALENT) TO THE FEDERATIVEREPUBLIC OF BRAZIL January 21,2004 Finance, PrivateSector andInfrastructure unit Brazil Country ManagementUnit Latin America and the CaribbeanRegion This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwisedisclosedwithout World Bank authorization. CURRENCY EQUIVALENTS Currency Unit - Real (R$) EXCHANGERATE December 31,2001 - R$2.65 =US$1 December 31,2002 - R$3.52 = US$l December 31,2003 - R$2.90 = US$1 WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1- December 31 Vice President David de Ferranti Country Director Vinod Thomas, Lead Economist Joachim von Amsberg Sector Director Danny M.Leipziger Sector Manager Susan Goldmark Task Manager Paulo Guilherme Correa I + 11 FOROFFICTAL USEONLY ABBREVIATIONS AND ACRONYMS AAA Atividade de Anllise e Consultiva Analytic and Advisory Activity ANA Agencia Nacionalde Aguas NationalWater Agency ANATEL AgCnciaNacionalde Telecomunicap5es Telecommunications Agency ANEEL AgCncia Nacionalde EnergiaElttrica NationalElectric Energy Agency ANP AgCncia Nacionaldo Petr6leo NationalPetroleumAgency ANPROTEC Associa@oNacionalde EntidadesPromotorasde Brazilian Association of Science Parks and Incubators Empreendimentosde Tecnologias Avanpdas ANTAQ Agencia Nacionalde Trasportes Aquaviirios NationalWater Transport Agency A N l T Agencia Nacionalde TransportesTerrestres NationalLandTransport Agency AP , Autoridade Portulria Port Authority APEX Agencia de PromoqHode ExportaeBesdo Brasil Brazilian Export Promotion Agency BB Bancodo Brasil Bank of Brazil BCB Banco Central do Brasil Central Bank of Brazil BDS Serviqos para Desenvolvimento de Neg6cios BusinessDevelopment Services BEC Banco do Estado do Cearl Bank of Ceari BEM Bancodo Estado do MaranhHo Bank of MaranhHo BM&F Bolsa de Mercadorias & Futuros Brazilian Mercantile and Futures Exchange BNB Banco do Nordestedo BrasilS.A. Northeastof Brazil Bank BNDES Banco Nacional de Desenvolvimento EconBmicoe Social National Bank for Economic and Social Development BNDESpar Empresas Participantesdo BancoNacional de Desenvolvimento Participating Companiesof the National Bank for EconBmicoe Social Economic and Social Development BOVESPA Bolsa de Valores de Slo Paulo BrazilianStock Exchange(Sao Paulo) CADE ConselhoAdministrativo de Defesa EconBmica Economic DefenceCouncil CAP Conselhode Autoridade Portuiria Port Authority Council CAPES Coordena@o de Aperfeiqoamento de Pessoal de Nivel Superior Coordination of Superior Education Improvement CAS Estrattgiade AssistEncia para o Pais Country Assistance Strategy CBLC Companhia Brasileira de LiquidaqHoe Custodia BrazilianCustody and Settlement Company CBPF Centro Brasileiro de Pesquisas Fisicas Brazilian Physical ResearchCenter CCR Companhia de Concessdes Rodoviarias Highway ConcessionCompany CCT ConselhoNacional de CiEnciae Tecnologia Scienceand Technology Council CDI Conselhode Desenvolvimento Industrial Industrial Development Council CDM Mecanismo de Desenvolvimento Limpo Clean Development Mechanism CEF Caixa EconBmicaFederal FederalSavings andLoan Bank CETESB Companhia de Tecnologia de SaneamentoAmbiental Environmental Technology Company CGC Cadastro Geral de Contribuintes General Registerof Taxpayers CGEE Centro de Gestlo e Estudos Estrattgicos Center of Managementand Strategic Studies CGF Conselhode GarantiasFinanceiras cIP Financial Guarantees Council Conselho Interministerialde Preqos Interministerial Price Council CMN Conselho Monetirio Nacional National Monetary Council CNI Confederaqlo Nacionalda Indhstria NationalConfederation of Industry CNPE Conselho Nacionalde Politica Energetica National Energy Policy Council CNPQ Conselho Nacionalde Pesquisas National ResearchCouncil COFINS ContribuiG3opara Financiamentoda Seguridade Social Social Security Contribution CONAMA ConselhoNacionalde Meio Ambiente NationalEnvironmental Council CPMF Contribuiqlo ProvisCIria sobre MovimentaqloFinanceira Provisional Contribution on FinancialTransactions CREMA Contrato de Restauraqlo e ManutenqHoda Malha Rodovidria Federal Road Network Maintenance Contract Federal CTN Codigo Tributirio Nacional NationalTax Code CVM Comisslo de Valores Mobilidrios Securities Comission CVRD Companhia Vale do Rio Doce Vale do Rio Doce Company DNER DepartamentoNacional de Estradas de Rodagem National Highway Agency DNIT DepartamentoNacionalde Infra-estrutura de Transporte Departmentof Transport Infrastructure DNRC DepartamentoNacional de Registro Comercial NationalCommercial Register Department EMBI fndice de Titulos da Divida de Mercados Emergentes Emerging Markets Bond Index EiMBRAPA Empresa Brasileira de PesquisaAgropecuiria Brazilian Agricultural Research Enterprise FAMPE Fundo de Aval h Microempresase Empresasde PequenoPorte Guarantee Fundfor Small Enterprises FAT Fundode Amparo ao Trabalhador Workers Fund FEEMA Fundaqlo Estadualde Engenhariado Meio Ambiente State Environmental Engineering Fund FGC Fundo Garantidor de Crtdito Credit GuaranteeFund FGTS Fundode Garantia por Tempo de Serviqo Private Sector Severance Fund [Thisdocument has~ a restric;ted distributionand may be used by recipients only in - _ _-_ _ ~ ~ -__I lthe performanceof their official duties. I t s contents may not be otherwise disclosed [withoutWorld Bank authorization. - A FIAS Servigo de Auxilio ao Investimento Estrangeiro Foreign InvestmentAdvisory Service FINAME Financiamento de Miquinas e Equipamentos Line of Credit for Machines and Equipment FINEM Financiamento a Empreendimentos Lineof Credit to Enterprises FWEP Financiadorade Estudos e Projetos Fund for Researchand Projects FNDCT FundoNacional para Desenvolvimento Cientifico e Tecnol6gico NationalFundfor Scientific and Technological - Development FTAA Zona de Livre Comtrcio das Amtricas Free Trade Area of the Americas FUNDEF Fundo de Manutenplo e Desenvolvimento do Ensino Basic Education DevelopmentFund Fundamental FUNDESCOLA Fundo de Fortalecimento da Escola Fund for School Improvement FUNPROGER Fundode Aval para a GeragHo de Emprego e Renda GuaranteeFundfor Income and Employment Generation I A I S AssociagHo Intemacional de Supervisoresde Seguros IntemationalAssociation of Insurance Supervisors IBAMA Instituto Brasileiro do Meio Ambiente e dos RecursosNaturais Brazilian Institute for Environment and RenewableNatural Renovlveis Resources IBGE Instituto Brasileiro de Geografia e Estatistica Brazilian Institute for Geography and Statistics IBOVESPA indice BOVESPA BOVESPA Index ICMS Imposto sobre CirculapHo de Mercadorias e Servigos State Sales Tax ICT Tecnologia de ComunicaGBes e InformapHo Information and Communications Technology IFC CorporagHo Financeira Intemacional International Finance Corporation IGC hdice de GovemangaCorporativa Corporate Governance Index EMF FundoMonetirio Intemacional International Monetary Fund IMPA InstitutoNacionalde Matemitica Pura e Aplicada National Institute for Pure and Applied Mathematics INMETRO Instituto Nacional de Metrologia NationalMetrology Institute INPI Instituto Nacional de Propriedade Industrial National IntellectualProperty Institute INSS InstitutoNacionalde SeguridadeSocial National Social Security Institute IOF Imposto sobre Operagdes Financeiras Tax on FinancialTransactions IPCA hdice de Pregos ao Consumidor Amp10 Consumer Price Index IPEA Instituto de PesquisaEconBmica Aplicada Institute for Applied Economic Research IPI Imposto Sobre Produtos Industrializados Federal Sales Tax IPO Oferta Inicial Wblica InitialPublic Offering IRB Instituto de Resseguros do Brasil Brazilian Reinsurance Institute I S 0 OrganizagHo Intemacional de Padronizagdes International Organization for Standarization ISS Imposto Sobre Servigo Services Tax MANTRA Sistema Integrado de GerCncia do Manifesto, do Trbnsito e do IntegratedTransit and Storage Management System Armazenamento MCT Ministtrio da CiEncia e Tecnologia Ministry of Science and Technology MDIC Ministtrio do Desenvolvimento, Indhstria e Comtrcio Exterior Ministry of Development, Industry and InternationalTrade MERCOSUL Mercado Comum do Sul Common Market of the Southem Cone MF Ministtrio da. Fazenda Ministry of Finance MIPEM Micro e Pequena Empresa Micro and Small Enterprises M M A Ministtrio do Meio Ambiente Ministry of Environment MME Ministtrio da Minas e Energia Ministry of Mines and Energy MPOG Ministtrio do Planejamento, Orgamentoe GestHo Ministry of Planning, Budget and Management MSME Micro, Pequenas e Mtdias Empresas Micro, Small and MediumEnterprises MST Movimento das Sem-Terra Landless Movement MT Ministtrio dos Transportes Ministry of Transport MTO Operador de Transporte Multi-Modal Multi-modal Transport Operators OECD Organizagio para CooperagHoEconBmicae Desenvolvimento Organization for Economic Co-operation and Development OGMO OrgHo Gestor de MHO-de-Obra Labor Management Organization PACT1 Programa de Apoio iCapacitapHoTecnol6gica da Indhstria IndustrialTechnology Capacity Program PASEP Programa de Formaggo do PatrimBnio do Servidor Phblico Public Employee Asset Formation Program PBQP Programa Brasileiro de Qualidade e Produtividade Brazilian Quality and ProductivityProgram PDTA Programa de Desenvolvimento Tecnol6gico Agropecuirio Program for the Development of Agricultural Technology PDTI Programa de Desenvolvimento Tecnol6gico Industrial Program for the Development of IndustrialTechnology PGBL Plano Gerador de Beneficios Livres Benefits Plan PIS Programa de Integraglo Social do Trabalhador Workers Social Integration Program PPA Plano Plurianual Multi-Year Plan PPP Parceria Wblico Privada Public-Private Partnership PROEX Programa de Financiamentohs Exportapdes Export FinancingProgram PRONAF Programa Nacionalde Fortalecimento da Agricultura Familiar National Program for Family Agriculture PSH Programa de Subsidio h HabitagHo Housing Subsidy Program R&D Pesquisa e Desenvolvimento Researchand Development RADAR Rede Agroindustrialde Desenvolvimentode Apdes Regionais Agro-industrial Regional Development Network REDEX Recinto Especial para Despacho Aduaneiro de ExportagIo Customs DispatchSystem iv RHAE Programa de Recursos Humanos para h e a s EstratCgicas Strategic HumanResources Program S&T Cisncia e Tecnologia Science andTechnology SBCE Seguradora Brasileira de CrCdito Exportaplo Brazilian Export Credit Insurance Company SDE Secretaria de Direito EconBmico Economic Law Secretariat SEAE Secretaria de Acompanhamento EconGmico Economic Monitoring Secretariat SEBRAE Servipo Brasileiro de Apoio i s Micro e Pequenas Empresas BrazilianMicro and Small Business Support Service SELIC Sistema Especial de LiquidaGloe de Custddia Clearance and Trustee System SENAI ServiGo Nacionalde Indhstria NationalTraining Service for Industry SENAITEC Centro Nacionais de Tecnologia NationalTechnology Center SFH Sistema Financeiro de Habitapgo Housing Financing System SIAFI Sistema Integrado de Administrapgo Financeira Integrated System for FinancialManagement SISCOMEX Sistema Integrado de ComCrcio Exterior Integrated System for IntemationalTrade SISNAMA Sistema Nacional do Meio Ambiente National Environmental Council SME Pequenas e MCdias Empresas Small and Medium Enterprises SNDCT Sistema Nacional de Desenvolvimento de Ciencia e Tecnologia National System o f Scientific and Technological Development SNUC Sistema Nacional de Unidades de ConservaGlo National Protected Areas Law SNV Sistema Nacional de ViaGlo National Transport System SPB Sistema de Pagamento Brasileiro Brazilian Payments Clearing System SPI Secretaria de Planejamento e Investimentos EstratCgicos Strategic Investment and Planning Secretariat SRG Secretaria de Reforma do Judiciario Secretariat for Judiciary Reform STR Sistema de Transferencia de Reservas Reserves Transfer System SUS Servipo Unico de Sahde Universal Health Service SUSEP SuperintendEncia de Seguros Privados Private Insurance Supervisor TFP Produtividade Total dos Fatores Total Factor Productivity TJLP Taxa de Juros de Longo Prazo Long Term Interest Rate TLIF Taxa de Localizaplo, Instalapgo e Funcionamento Location, Installation, and Operation Charge VGBL Vida Gerador de Beneficios Livres Life Insurance Plan V Brazil FirstProgrammatic Loanfor Sustainable andEquitableGrowth Table of Contents Page LOAN PROGRAMSUMMARY AND EXECUTIVE SUMMARY ................................................................................................................... ................................................................................................ vi1 x 1 Introduction . ............................................................................................................................ 1 2. Recent Economic Developments ........................................................................................... 4 3. Diagnosis . Beyond First Generation Reforms Moving ..................................................... 8 4. The Government Microeconomic Growth Agenda ........................................................... 11 A Scope and Impact 11 B ReducingLogistics Coststo Raise Productivity and Ease Trade .. ............................................................................................................ 15 C Improvingthe Business Environment ........................................................................... ............................... 23 D EnhancingFinancialEfficiency andDepth 38 E Transforming Knowledge into Productivity through Innovation 55 F Trade. Taxation. Labor. andContracts .. .. .................................................................. ........................................................................ .............................. 63 5. The Poverty Impact of Sustainable. Equitable Growth .................................................... 66 6. The Proposed Loan and Program ...................................................................................... A The Programmatic Framework. LoanDesign. and Possible Future Loans 72 B Linkswith the CAS. Bank Activities. andPartner Programs . . ..............72 80 C Rationale for Bank Involvement 83 D Financial Assistance and Conditions for Disbursement .. .................................................................................... .................................... .............................................. 84 E EnvironmentalIssues 85 F Risksand RiskMitigation . . ...................................................................................................... .............................................................................................. 85 Annexes 88 Annex 2: Matrix of Key Actions and Indicators ............................................................................... Annex 1: Letter of Development Policy........................................................................................ 115 Annex 3: Matrix of the Government Growth Program....................................................................... 117 Annex 4: Translated Government White Paper "Roadmap for the New Economic Development Agenda". ......... 126 Annex 5: Logistics............................................................................................................................. 132 Annex 6: The Business Environment....................................................................................................... 147 Annex 7: Corporate Insolvency Law............................................................................................ 170 Annex 8: The Financial Sector................................................................................................................ 182 Annex 9: The Innovation System.......................................................................... .............................. 207 Annex 10: IMFRelations Note.................................................................................................. 221 Annex 11: Status of Bank Group Operations ..................................................................... 228 Annex 13: Brazil at a Glance..................................................................................................... Annex 12: Statement of IFC Held and DisbursedPortfolio................................................................... 231 BRAZIL FIRSTPROGRAMMATIC LOAN SUSTAINABLEANDEQUITABLE FOR GROWTH LOAN PROGRAMSUMMARY AND Borrower: Federative Republic of Brazil Implementing Agency: Ministry of Finance Poverty Category: Not Applicable Amount: EUR427.20 Million(US$505.05 million equivalent) Terms: Fixed-spreadloan in euros, with a repayment period of 14 years including five years of grace. Commitment Fee: 0.85 percent per annum duringthe first four years and 0.75 percent per annum thereafter on undisbursedloan amounts, beginning to accrue sixty days after the loan agreement i s signed. Front-End Fee 1percent of the loan amount, to be financed under the loan. Objective: The program will significantly increase Brazil's sustainable economic growth potential, increase employment andreduce poverty. The main objective i s sustainable, equitable economic growth. Inlogistics, key actions will cut customs release times b y 40 percent, cut container handling costs inports by 10percent, lower road transport costs by about 5 percent and increase non-roadtransportation by 10percent. Improvements to the business environment will increase public-private partnership, increase cartel prosecutions by the competition authorities, halve the time to register a business in selected cities, and increase the speed of resolution and the recovery value of insolvent enterprises under new bankruptcy law. Financial sector reforms will reduce bank overheads, increase financial access and reduce credit risk, accelerate the expansion of the insurance industry, and increase access to bank accounts from 95 million to 103 million people by 2006. Ininnovation, a new innovation law will increase technology transfer contracts between universities and the private sector by 20 percent and increase the private share in R&D by 10percentage points. Supported improvements inthe Clean Development Mechanism will generate US$lOO million in carbon credits. Description: The proposedloan supports a set of microeconomic and institutional reforms (the Growth Program) that will foster sustainable and equitable growth by favoring capital accumulation and productivity gains inBrazil. It seeks the establishment of microeconomic foundations, with growth impacts that go from the immediate, through the short and medium term, to the long term: (i) reducedlogistics costs, (ii)an enhanced business vii environment, (iii) improved financial sector efficiency, access, and soundness, and (iv) increased technological progress and innovation. Benefits A successful programof continued sound economic management, structural reforms, and implementation of actions inthe four areas supported by the loan could contribute to Brazil reaching an average annual growth rate of 4 percent or more. The loan will strengthen a broad, ambitious, coherent, and politically feasible set of microeconomic reforms for sustainable, broad-based growth, employment generation, and poverty reduction through higher investment andrising productivity. This strengthening will come through a long-term strategic framework for reforms, enhanced financial flows tied to the reform program, and associated technical assistance where international experience can improve policy or institutional design. Increasing growth equitably i s important to provide employment andraise the incomes of the poor, directly reducing poverty. Higher growth i s also important to reinforce Brazil's economic stability by reducing debt ratios and to finance Brazil's new and effective social programs. Actions to increase productivity are important to make growth sustainable: environmentally, through lower resource usage, and economically, by increasing export competitiveness and thus reducing reliance on foreign savings. Measures to increase the financial access of small business and poorer households are expected to make growth more pro poor. Measures to reinforce carbon trading are expected to improve environmental sustainability. The loan will also reduce external vulnerability by covering part of Brazil's external financing requirements and bolsteringnet international reserves. Risks (i)External vulnerability: a downturn in emerging market credit conditions could harm growth prospects. Mitigation: government performance on economic management has reassured markets, and this will be reinforced by this program; a well executed growth program should increase investor confidence. (ii)Political and fiscal risks: reduced support for the government macroeconomic program could undermine fiscal discipline and thereby reduce growth. Pressures for quick social results may lead to policy choices detrimental to long-run growth. Mitigation: the programmatic framework means that future loans depend on the integrity of both growth and macroeconomic policy. Government has demonstrated a highdegree of commitment. Risks are also mitigatedby the complementary Fiscal Reform Loan series and Technical Assistance (TA). (iii) Risks that the set of actions covered by the operation i s not broadly enough defined: e.g., such risks come from the energy .sector regulatory framework and other areas of the economy such as trade and labor regulations. Mitigation: due diligence on areas of slower policy reform. TA loans inenergy andthe financial sector. (iv)Risks of weak execution of components of the growth program. Vlll ... Execution will depend on institutional capacity and reforms (e.g., infrastructure regulation on regulatory agencies, corporate insolvency law on state-level courts). Parallel reforms may also be mutually dependent, but may not proceed at the samepace: e.g., banking antitrust depends on overall effectiveness of the competition agency. Mitigation: the programmatic framework mitigates this risk by tracking and rewarding reforms. Implementation will be reinforced by a complementary TA Loan. FinancingPlan Single tranche disbursed after effectiveness. Net PresentValue Not Applicable ProjectIDNumber PE-PO80827-LEN-BB ix Brazil: Proposed First Programmatic Loanfor Sustainableand Equitable Growth EXECUTIVE SUMMARY 1. This document proposesa Single-Tranche First Programmatic Loanfor Sustainable and Equitable Economic Growth to the Federative Republic of Brazil inan amount of EUR 427.20 million. The proposed Loan would support a critical mass of microeconomic and institutional reforms, pursuingsustainable and equitable growth through increased investment and productivity. 2. Theprogram supportedby the Loan constitutesa sustainableand equitablegrowth strategy. Sustainable both economically - targeting investment and productivity while avoiding inefficient trade policy or the creation of fiscal liabilities through industrial subsidies - and environmentally -making innovative use of Brazil's natural resource base while supporting environmental oversight. The program will support equitable growth by: continuing pro-poor patterns of growth in a low inflation environment, paying heed to the business and financial needs of small enterprise and the poor, and financing pro-poor infrastructure and the country's new and better social programs. Increased investment and productivity will be key to generating employment and seizing the new opportunities represented by Brazil's growing integration into global trade. 3 . Thefirst loan would supportfour reform areas ranging in impactfrom immediateto long term. Inorder of the immediacy of impact, these areas are (i)logistics, (ii) the business environment (including the regulation of the infrastructure sectors and domestic competition), (iii)financial efficiency and depth, and (iv)innovation policy. These form a robust subset of a longer list of growth-oriented reforms on which the Government i s acting, including measures to reduce tax distortions, improve contract enforcement, deepen trade integration, and strengthen labor markets, some of which could later be incorporated into this program. 4. The loan would build on recent lending and analytical work. The proposedloan builds on earlier adjustment and technical assistance (TA) lending for financial sector and for energy sector reforms, as well as investment and TA lending for transport infrastructure and for science and technology. The proposal i s based on extensive recent analytical work, including a growth report, a report on financial access, assessment of the regulatory framework, a trade policy report, and a labor market report. It i s also complementedby the Fiscal ReformProgram of policy-based loans, which will continue to reinforce economic stability, and the Human Development program, which inter alia supports growth-enhancing education reforms. 5. Theproposed loan is a centerpieceof the Bank's planned support to a high-performing government in a key strategicpolicy area. Since coming to power, the present government has an excellent track record of policy-setting and leadership, showing firm commitment inthe face of long odds to combining macroeconomic rigor with ambitious social objectives. The return to sustainable and equitable economic growth - notjust acceptable growth rates in the short term, butrobust, broad-based growth rates over the mediumterm -i s crucial if the government is to overcome the deep debt and inequality that are the long-standing threats to social progress. The Government's program i s ambitious, technically sound, internally consistent, and politically X Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth feasible. Its sequencing and timing i s propitious, addressing difficult long-term structural and institutional issues during the return to economic expansion, issues which would be unlikely to be addressed with equal care during a crisis. The loan would support a government that i s setting an example for policy makers indeveloping countries worldwide. 6. The main goal of theproposed loan is to raise broad-based economicgrowth and employmentgeneration by supporting an integrated growth program tailored to the institutional andpolitical circumstancesof the country. The successful implementation of this program i s not only desirable in itself for higher growth, but will also reinforce the government's adherence to sound macroeconomic policies, which itself has incurred non-negligible political costs. 7. Theproposal reflects the Government's considerableprogress in defining its growth program, establishing inter-ministerial mechanismsfor its implementation, and building political support. The President has endorsed a government White Paper outlining the growth program (see also Annex 1,Letter of Development Policy). Inter-ministerial institutions for the implementation of the Growth Programhave been revitalized or created. Milestones have been reached toward reducing logistical, administrative, and financial costs to private enterprise, increasing the support (financial and business services) provided to small and medium enterprise (SMEs), and improving the environmental impacts of growth. Improvements have also been made to innovation policy, which in time should increase both technological progress and investment. 8. The Government has set theframework to allow for a substantial reduction of logistic costs, which will support increasedprice competitiveness of Brazilianproducts. A reform strategy for Customs has been approved, with the objective of decreasing clearance times by up to 60 percent by the end of the program. Second, the Government i s working on an action plan to complete the port reform, which would allow cargo thru-port transit times to decrease 30 percent, and container handling costs decrease 10percent. Third, the Government has defined a strategy aiming at improving the condition of Brazil's main paved roads, through the reorganization of the federal transport administration, and initial results inthe concession of federal roads, the decentralizationof roads of local interest to the States, and the application of pilot output-based contracts for road maintenance andrehabilitation. The implementation of this strategy should permit the improvement of road condition on half o f the main network, and an initial 5 percent reduction in vehicle operating costs. Finally, with the application of policies to foster multimodal transport, the share of non-road transportation could be expected to increase by 10percent within the horizon of the program, which will further reduce overall transport costs. 9. The business environment has been improved through infrastructure regulation, simplified SME registration and, most importantly, a new corporate insolvency law. Two new regulatory agencies have been created for land- and water-based transportation, and a law on public-private partnerships (PPP) has been submitted to Congress. Investment in key infrastructure sectors such as roads, energy, and ports could now increase despite fiscal constraints. S M E operations have been simplified by the establishment of the Simples tax registration system, while procedures for environmental licensing have also been improved. The number of days taken to start a business could be halved. Previous corporate insolvency xi Brazil: Proposed First Programmatic Loanfor Sustainableand Equitable Growth procedures are notoriously inefficient and almost never result inturnaround or the preservation of intangible assets, so the passing by the Lower House of the new bankruptcy law andthe associated amendment on tax succession to the National Tax Code represent the single most important reform supported by the proposed loan. This should intime increase the speed of resolution of insolvency cases and the recovery value of firms. 10. A key stepforward in thefinancial sector was thepassage of the Amendment to Article 192 of the Constitution. This opens the way for deep modifications to legislation governing financial system regulation and soundness, hitherto blocked by this Article (which prevented passage of separate laws governing the financial system). Furthermore, regular antitrust law will, under legal reforms currently before Congress, be extended to the banking sector subject to initial consideration of systemic issues by the Central Bank on mergers. This should increase competition with an estimated impact on spreads of 100 basis points by 2006. The financial access of the poor has also been increased b y legal changes that simplify the opening of bank accounts, which should lead to an increase of 8 million bank account holders b y 2006. 11. Innovation should increasingly transform knowledge into productivity gains with the passage of the new Innovation Law that has been sent to Congress,which will increase the incentive for public sector researchers to benefit from their own research, and increase technology transfer contracts between public and private entities, which should increase by 20 percent. Furthermore, private research may also be encouraged by better links between the private sector, public universities andresearch institutes, which will come from the creation of competitive grant funding under the Fundo Verde-Amarelo. Private Research & Development (R&D) as a share of total R&D could increase by ten percentage points duringthe life of the program. 12. Theproposed loan wouldform part of aprogrammatic framework, entailing financial support for prior progress along a multifaceted microeconomic reform program. The program includes clear scenarios and triggers for future loans. Nonetheless, an important attribute of the program i s that it allow the necessary flexibility to respondto unpredictable economic realities and political possibilities across a broad front of reforms. 13. Subject to reforms, a second loan is envisaged in the next nine to eighteen months. The most likely scenario would see the second loan emphasize the business environment and the financial sector. Within the businessenvironment, key measures that have been launched are set to become law, most notably the PPP law and the corporate insolvency law. A career development plan for regulators passed into law would also improve infrastructure regulation. Meanwhile, significant financial sector legislation may follow the recent amendment of the Constitution. Other key actions would be further reforms infinancial infrastructure, including the payments system and sound measures to expand financial access. Inlogistics, key next steps would cut average net customs release time b y 20 percent, apply output-based contracts for the maintenance and rehabilitation on about 30 percent o f the federal road network, and double the proportion of non-trunk federal highways under state management. 14. A third loan is possible within the term of thepresent administration. One intention of a thirdloan would be to shift focus onto the innovation pillar.The enactment of the new innovation law would be the key step forward, while improvements to the sector funds would xii Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth make their allocation more transparent and competitive. These would have impacts on intermediate impact indicators such as the number of patents Brazil registers inthe United States and the number of technical transfer contracts between the public and private sectors and from abroad. The thirdloan would also contain a concentration of triggers inlogistics andfinance. In logistics, the port authorities would be restructured, a roadnetwork classification law approved, and quantitative targets reached in concessions and decentralization of road management leading to a five percent decrease inroad freight costs. Infinance, the proposed law inbanking competition should become effective and other reforms should enhance long-term financial markets such as insurance. 15. The Governmentis also designingpolicyinfour further areas - taxation, contract enforcement, trade integration, and labor markets -that arepart of the growth agenda.Inall four, progress i s likely soon to improve growth prospects. While the Bank maintains a dialogue with government inthese areas through AAA or supports them through other lending instruments, the program could include them upon reform progress. Intaxation, the Bank's relationship with the authorities has so far been conducted through the Fiscal ReformProgram. A variety of tax reforms are currently being debated by the Legislature and these will probably bringefficiency gains when the final bills are passed.The efficiency of contract enforcement i s an area on which the Bank has so far had input limitedthrough a pilot study, but here Government i s also preparing the ground for reforms. Multilateral trade negotiations are ongoing, with the most recent talks inMiami moving toward agreement on the Free Trade Area of the Americas. Labor markets, where the Bank provided recent analytical work, are an area where the Government i s conducting consensus-building talks with unions and employers, with a view to reform proposals to the Labor Code within the current administration. 16. The governmenthas requested an adjustmentoperationfrom the Bank to support its growthprogram. This document therefore proposes aFirst Programmatic Loan for Economic Growth. The program would build on four areas of previous Bank financial support - reforms to the financial sector, investments in transport, actions to strengthen the energy sector, and investment lending for science and technology - and would introduce new areas of action within innovation policy and the business environment. 17. Brazil has used theprogrammaticframework successfully in the recentpast, with two loans each made under the Fiscal ReformProgrammatic Structural Adjustment Loan series and the Financial Sector Programmatic Structural Adjustment Loan series, respectively. Most recently, in June 2003, Brazil launcheda further programmatic loan series inthe area of human development policies. 18. Thegrowthprogram would be supported by an accompanying TechnicalAssistance Loan. This loan i s currently under preparation and, subject to approval of the proposed adjustment operation, would be presented to the World Bank Boardof Directors within a few months. The support to the ministries involved inthe four pillars of the proposedfirst loan would be important ingenerating the reform progress for the subsequent loans inthe program. xiii Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth INTERNATIONALBANK FOR RECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT FOR A FIRSTPROGRAMMATIC LOANFOR SUSTAINABLE AND EQUITABLE GROWTH TO THE FEDERATIVE REPUBLIC OF BRAZIL 1. INTRODUCTION 1.1 With deep macroeconomicreforms but low and erratic growth, Brazil hasproved that stabilization is not enough on its own to guaranteegrowth. Inthe past decade Brazilhas transformed itself economically and laid the institutional foundations for solid macroeconomic management. Chronic inflation has been eradicated and the trio of adept inflation targeting, fiscal balance, and a floating exchange rate have created a stable macroeconomic base. Efforts have begun to make public spending more effective in attacking poverty. Health and education indicators have been transformed usingper-capita transfers to states and municipalities. Programs such as the rural pension and conditional cash transfers (like the new "Bolsa Familia") show a heightened preoccupation with malung sure that resources reach society's poorest. 1.2 Economic growth has sofar been the missingingredient to rendering socialprogress resilient and enduring. By the 1990s, many Latin American economies hadbouncedback from the "lost decade" of the eighties but for Brazil, still undergoing stabilization, the nineties represented a second lost decade for growth. While Latin American per-capita income grew at an average rate of about 2 percent, slightly above the world rate, Brazil managed only about half that (Figure 1).Inthe absence of strong financial flows to emerging markets, and with the market uncertainty of 2002, Brazil's growth has remained disappointing, and unemployment has reached record levels of around 13 percent nationally. 1.3 Recentperformance has heightened concern and strengthenedagreement- over - Brazil's growth agenda. While continued fiscal balance i s the key to reducing real interest rates inthe longrun,inthe presence of many spendingrigidities this has cut into public investment, which has fallen to about 2.6 percent of GDP.Private investment has also remained weak, partly because it awaits a more certain investment climate, particularly inrelation to government regulation. At the same time, there remains a series of microeconomic impediments to investment, innovation, and productivity, the removal of which provides an opportunity to galvanize growth. This microeconomic agenda, then, provides the chance to reinforce the macroeconomic and social reforms that Brazil has built and defended so carefully inrecent years. 1 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Figure1 Per CapitaGrowth inBrazil, LatinAmerica, andthe World1 1.4 Brazil's new administration was electedon a platform that emphasizes economic growth and inclusion. Within Latin America, President da Silva's government represents perhaps the first experiment inwhich a democratically chosen candidate, with the strong support of social movements in a highly unequal society, proposes to combine a clear commitment to social justice with a sound economic program. Throughout the region only partial combinations of these components have so far been seen, and with limited success. InLatin America and beyond, Brazil has raisedexpectations. 1.5 The Governmenthasprovided clear signs of commitmentto its strategy. Facedinitially with low investor confidence, currency depreciation, and inflation, the government increased interest rates and cut spending. The results have been impressive. Inflation and inflationary expectations have been brought in line with Central Bank targets, sovereign spreads have fallen to below 500 basis points - their lowest levels since 1998 - and conditions have been put in place for growth to resume by end 2003. The government has reinforced key institutional achievements in macroeconomic management: a highly competent Central Bank executing a well-defined inflation-targeting strategy and a credible fiscal regime pursuingprimary surpluses by enforcing a fiscal responsibility law covering all levels of government expenditure. 1.6 Beyond stabilization, the administration has made progress on the structural reforms needed for continued fiscal balance and sustainable, equitable growth. The recently passed reform to the public-sector social security system represents the most significant step to date to redress a system that i s both unfair and economically unsustainable. The tax reform currently beingdebated by the Lower House i s a first step on a long road of making the tax system less detrimental both to private enterprise and to exports, at the same time both safeguarding the sustainability of the public finances andrespecting constitutional and political constraints. 1.7 Thegovernment has also initiated ambitious measuresto improve the impact of social spending. A rationalization of Brazil's system of social assistance transfers has been launched. A new unified transfer -named Bolsa Familia - aims to reduce waste and improve targeting and coverage of the neediest. At the same time, creative mechanisms to expand transparency and public participation inpolicy making, such as the Conselho de Desenvolvimento Econ8mico (Economic Development Council), have been introduced to encourage consensus and political 'WorldBank (2002), Brazil:The New Growth Agenda, ReportNo. 22950-BR. 2 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth cohesion around key policies. Another new program -FirstJob (Primeiro Emprego) - aims to cut youth unemployment through subsidized wages and civil society-supported training and entrepreneurship. 1.8 Yet in the absence of higher growth, all these achievements are threatened both economically and politically. Weak growth places pressure on the fiscal accounts, reducing room for public investment and even social spending, despite improvements inefficiency, as well as on the arithmetic of debt sustainability. And the social and political pressures stemming from highunemployment and weak income growth place question marks over the political sustainability of the government's chosen strategy. 1.9 I npart, weak growth stemsfrom the incompletenessof the " j h t generation'' structural reforms. Fiscal rigidities and high government consumption leave little room for public investments, especially in infrastructure, which has suffered as a result. Government deficits continue to crowd private-sector borrowing out of credit markets. The financial sector i s still highly regulated and dominated by large public sector institutions. Yet growth rates may be increased without immediate progress on these fronts. Private investment may be mobilized in many sectors through improvements to the business environment. The Government's firm fiscal management is bringing down its borrowing costs and creating more room for private lending. Thus first generation reforms -unilateral trade opening, financial liberalization, and macroeconomic management - are no longer the main constraints on Brazilian growth. 1.10 Furthermore, to constructa sound growth strategy, Brazil needs topursue reforms in a sequencethat makespolitical as well as economic sense. International experience has shown that theoretically good reform programs may fail due to poor sequencing. InBrazil certain reforms - for example, further social security reform or drastically reducing directed credit - would face sufficient resistance as to be unlikely in the short run, and could easily undermine support for other advisable and less sensitive reforms. Some reforms require institutional changes that may have been underemphasized. Others take time to deliver their ultimate results. Speed and sequencing matter. 1.11 The moment is right to consolidateprogress on an ambitious growth agenda across sectors. Macroeconomic conditions are improving and creating the political space for legislative actions on microeconomic reforms, whose political costs will best be borne in an economic expansion. Such an agenda does runpolitical risks, since it involves coordinating actions across an array of sector ministries and to some extent substitutes for a competing, more economically distorting growth agenda. With strong popular support, the administration i s well positionedto buildon the emergingmomentum towards a new cross-cuttinggrowth agenda: its program aims for sustainable and equitable growth while remaining faithful to sound economic management. 3 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 2. RECENTECONOMIC DEVELOPMENTS 2.1 Brazil has consolidatedinstitution-buildingreforms that have maintainedpublic-sector solvency and liquidity under very difficultcircumstances.Since 1995, Brazil has been a low- inflation economy with increasingpublic debt. Between 1998 and 2002, the Federal Government reacted to the problem of indebtedness by continuing to battle against longstanding fiscal imbalances inBrazil's system of fiscal federalism, and generating highprimarybudget surpluses through austerity efforts at all levels of government and public enterprise. A key accomplishment, central to attaining both these objectives, has been the 2000 Fiscal Responsibility Law, which has provided a clear legal framework for enforcing fiscal discipline at all levels of government. Despite this progress, however, the present administration inherited adverse economic circumstances. 2.2 The Governmentfaced stern tests of its economicmanagement in 2003. Reflecting uncertainty about possible economic strategy, sovereign spreads on Brazilian debt had risen to over 2,400 basis points above treasury yields in 2002. In an environment where a thirdof public debt was foreign currency denominated or linked, the exchange rate had depreciated from 2.65 at end-2001 to more than 3.5 to the dollar end-2002 (and close to 4.0 in mid2002). Private capital flows had all but dried up. The resulting slowdown and inflation set the incoming administration the challenge of regaining credibility through higher budget surpluses and rigorous monetary policy to meet inflation targets. 2.3 The response of thepresent administrationhas been impressive.Primary surplus targets of 4.25 percent of GDP have been set for the remainder of the government's mandate and rigorously adhered to so far. The target primary surplus for 2003 had already been accumulated by October. After inflation targets were amended to reflect the new reality, interest rate policy has been active and has brought both present inflation and market expectations of future inflation inline with the new targets. Inflationexpectations for 2004 are about 6 percent, close to the target of 5.5 percent and well within the target band of 3 to 8 percent. 2.4 Crucial to this strategy has been the clear signal that the government was willing to tackle structural reforms necessary to bring long-termfiscal sustainability. The long-awaited reform of public sector pensions has been passed, bringingfiscal gains of the order of 0.5 percent of GDPper year for the next ten years, and introducing structural changes (such as a minimum retirement age) with important long-term benefits. A tax reform i s now under discussion by the legislature, which most importantly should bring some improvement to cascading state sales taxes. The details of the final tax reform that will emerge from the legislative process remain to be seen. 2.5 The social security reform has beenperceived by sovereign bond markets as a milestone of immense importance. While emerging market spreads in general have fallen in response to US, Bank analysis has suggested that about half Brazil's recent improvement in sovereign risk i s country specific, stemming from the government's economic management and structural reforms. The EMBI+measure of Brazil's sovereign spread relative to treasury bond yields fell to 410 basis points on January 13, 2004, a level lower than any seen since 1998 (Figure 2). 4 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Figure 2 I Brarii EM61Spreads and Exchange Rate I - - I-EMBI Sprrads ExchangeRatel 2.6 Despite this dual progress on macroeconomic management and structural reforms, the economy has remained sluggish owing to short-termfactors. Industrial output inAugust had fallen for five consecutive months. Unemployment rose throughout the first half of 2003 and has not yet shown any sign of falling (Figure 3). GDP growth for 2003 i s now expected to come in at about 0.6 percent, representing a decline inper capita income of nearly one percent. Figure 3 Unemployment Rate (new IBGE Methodology) c `m n 2 n 0 2B 8 2.7 After a difficult 2003, there are now signs that the strategy of setting a disciplined tone early in the government's mandate willpay dividends. The benchmark overnight inter-bank interest rate (SELIC) has been brought down steadily b y the Central Bank's Monetary Policy Committee (Figure 4) and the yield curve shows that future falls are expected by the market. The market forecast of the SELIC at year end i s about 16 percent. Real interest rates (calculated using one year nominal forward rates and expected inflation) are now in single digits. Most econometric models of the Brazilian economy find a lag for monetary policy to affect real output of at least 6 months, which is borne out b y the current recovery in output (rates began to fall in June, 2003). The effects of recent and future cuts to the SELIC have thus not yet been felt. Moderate growth i s forecast to resume at the turn of the year, with about 3.5 percent growth forecast for 2004. The comparison with 2000 should temper optimism, however. The year 2000 5 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth hadseen4.5 percent growth andrecordFDIflows, only for 2001 to disappoint as aresult of an energy crisis founded inflawed regulation of the sector, which inturn increased Brazil's vulnerability to the severe external shocks that came later in 2001. The analogy with three years ago illustrates that Brazil's challenge i s to remove its microeconomic impediments to growth in order to insulate itself better from exogenous factors. I Figure4 Selic Interest Rates, 2002-2003(% p.a.) 2.8 Equally encouragingfor long-run sustainablegrowth has been theperformance of the externalsector. Exports have responded to a more competitive exchange rate, climbing to levels of the order of US$5 billion to US$7 billion a month inlate 2002 and 2003. Imports have been helddown by low domestic demand, averaging US$3 billion to US$4 billion. The trade surplus has hit new highs as a result, registering US$2.67 billion in September 2003 andforecast to be close to US$24 billion for the year (Figure 5). As a consequence, Brazil's current account financing needs have fallen quite dramatically in 2002 and 2003. In2000 and 2001, the current account added US$24.2 andUS$23.2 billion respectively to Brazil's external financing needs (the main other requirement beingdebt amortization). In2002 the current account deficit was US$7.7 billion. In2003 Brazil will run a current account surplus for the first time since 1992 (of about US$4 billion: Figure 6). This reduces pressure on the exchange rate andthus risks associated with the value in domestic currency of foreign exchange-linked debt. 6 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Figure 5 I MonthlyTrade Balance, Exportsand Imports,1998-2003 I 3330 - - 6COO - 1320- .zoo3 - L O I I 2.9 Thiscreates the right conditionsto embark upon a longer-termprogram of microeconomic reforms that would not receivepriority under crisis conditions. Absent serious shocks, Brazil should now be able to focus on actions with long-term payoffs rather than crisis management. Despite the pick-up ineconomic activity expected over the coming year, the strategic challenge remains to raise Brazil's long-run potential growth rate - the rate to which the economy converges, abstracting from the economic cycles. Figure 6 CurrentAccount, Foreign Direct Investment,and I i ExternalFinancingRequirementsExcludingAmortizations (12-months Accumulated Flows,% of GDP) 7 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 3. DIAGNOSIS-MOVINGBEYONDFIRST GENERATION REFORMS 3.1 Unlike other countriesin the region, by the early 1990s Brazil had still not solved its structuralproblem of chronic inflation. Two "heterodox" stabilizations hadfailed.2 In 1994, the Real Plan finally broke the cycle of indexation and inflationary expectations in 1994 through tight monetary policy, fiscal expansion, and a crawling nominalexchange-rate peg. 3.2 Tradereforms had started earlier. Trade liberalizationhad started in 1989 and consolidated in 1991. The average tariff fell from over 50 percent prior to reform to about 14 percent by 1994. Trade volume rose from 17 to 22 percent of the GDP duringthe same period, though this proportion i s low incomparison with other continental middle-income economies (themean trade share of countries with population greater than 100million is twice that of Brazil). Nonetheless, robust empirical evidence suggests that Brazil's trade liberalization successfully reduced monopoly power andincreasedproductivity, both b y exposing firms to international competition and by facilitating access to cheaper or better input^.^ 3.3 Theprivatizationprogram was amongthe largestin the world. US$36 billion inpublic assets in steel, aeronautics, and infrastructure sectors were transferred to the private sector inthe 1990s under the ProgramaNacional de Desestatiza@o. Total sales of public shares and concession rightsin infrastructure generated US$58 billion between 1992 and 2001. Privatization i s complete in the communications andrail sectors and i s advanced in ports. Private participation rose significantly in electricity, roads, and water and sanitation. Despite remainingregulatory issues in most sectors, empirical evidence indicates that privatization increased the productivity of the privatized firms andreduced public debt.4 3.4 Anotherpillar of structural reforms wasfinancial liberalization. Financial liberalization was boostedby a set of initiatives favoring FDIand portfolio investments. In 1991, non-residents were authorizedto operate inBrazilian stock markets. In 1993-94, the scope of financial regulation6was reduced and average financial taxation decreased. Law 9249 of 1995 then cancelled taxation on the remittance o f profits from FDI.With these and other changes, portfolio investments increased to US$5.3 billion in 1997 from less than US$1billion in 1991. FDIincreasedto US$17 billionfrom less than US$1billioninthe sameperiod. The Cruzado Plan of 1986 and the Collor Plan of 1990. World Bank, "Brazil: The New Growth Agenda" Vol. I1Ch. 3 (Report No. 22950-BR); Correa (1999); Rossi J. and P.C. Ferreira (1999), "EvolupTo da Produtividade Industrial Brasileira e Abertura Comercial." PEA Texto para Discussa`o No. 651. 4 Castelar Pinheiro, A.C. and F. Giambiagi (2000), "Os Antecedentes Macroecon6micos e a Estrutura Institucional da Privatizapio no Brasil" (The Macroeconomic Antecedents and Institutional Structure of Privatization in Brazil"), in Castelar Pinheiro, A.C. and Fukasaku (eds.), A Privatizaqa'o No Brasil: 0 Cas0 dos ServiGos de 'UtilidadeR.P. Pliblica, (Privatization inBrazil: The Case of Public Utilities): OECDBNDES. Cysne, (2002), "Macro- and Micro-Economic Aspects of the Reforms," in Renato Baumann (ed.), Brazil in the Nineties, Oxford UK:Palgrave. Under the so-called "Annex IV" or Resolution 1832o f the Central Bank. 8 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 3.5 Analysts have agreed that the disappointinggrowth dividendfrom the 1990sreforms has its roots in both slow capital accumulationand limitedproductivity growth. Not even inthe 1980s was the contribution of capital accumulation to growth as small as it was inthe 1990s (Figure 7). Gross annual capital formation decreasedfrom 23.5 percent o f GDP in the mid- seventies to less than 15 percent in the early nineties, bouncing back slightly to 17 percent in 2000. Emerging countries such as Chile and China as well as OECD countries have sustained investment ratios much larger than Brazil duringthe last fifteen years. Figure 7 GrowthAccountingfor Brazil, 1951-2000 ' OTFP BCapital 0HumanCapital Employment I 1951-63 1964-80 1981-93 1994-00 3.6 Decline in investment levels in infrastructure have been particularly large. Falls in capital accumulation over the last two decades have particularly affected electricity generation and road services. These are the two infrastructure sectors with the highest estimated impact on Brazilian GDP growth in the long-rum8Average investment inelectricity generation fell to 0.68 percent of GDP in 1995-2000,less than a third its level duringthe seventies. Investments in transport have fallen to about a quarter their level relative to GDP inthe seventies. The only exception to the declining trend ininfrastructure has been telecommunications. 3.7 Productivityperformance has been relatively better. With the collapse of infrastructure investment, total factor productivity (TFP) has been driven mainly b y private investments in tradable sectors and by a general improvement inthe business environment due to structural reforms. Trade liberalization and a strong real reduced the costs of imported machinery, contributing to a modernization cycle in manufacturing in 1995~97,~ duringwhich private 7GlobalDevelopmentNetwork GrowthProject,2001. * Ferreira, P.C. and T.G. Malliagros (1998), "Impactos productivos da infra-estrutura no Brasil: 1950/95" Pesquisa e Planejamento EconGmico: 28, No.2:315-38,IPEA. For the positive impact of trade on Brazil's TFP using microdata see Lopes da Silva, D. (2000), "0 Impact0 da Abertura Comercial sobre a Produtividade da Indhtria Brasileira. " Masters Thesis, Pontificia Universidade Cat6lica do Rio de Janeiro; Hay D. (2001), "A Liberaliza@o Comercial Brasileira apds 1990e o Desempenho das Grandes Empresas Industriais," Pesquisa e Planejamento EconGmico, Volume 30, No. 2. IPEA: Rio de Janeiro; Muendler, M., L.Serven and C. Sepulveda(2001), "Productivity Growth inBrazilian Industry," unpublishedWorld Bank working paper, October 2001, reproduced as Chapter 3 of Volume I1of the World Bank's Brazil: The New Growth Agenda, Report No. 22950-BR, Latin Americaand the CaribbeanRegion. 9 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth manufacturing investment rose from 2.0 percent to 3.3 percent of GDP." Imports of intermediate inputsmay also favor TFP growth through embodied technology acquisition." 3.8 But Brazil still has a "technologygap" in relation to the technologyfrontier. Despite a recent increase inprivate-sector investment innew equipment, Brazil's technology gap i s still large.'* For the ten years up to 1993, Brazil's TFP gap with the United States widened faster than inprevious decades. Since 1994, the gap has stopped widening butTFPperformancehas not yet started to close the gap left by the previous two decades. According to this analysis, technological "catch-up" has not occurred since 1976. 3.9 The incompleteness of some `Frst-generation" reforms may be one explanation of limited capital accumulation andproductivity gains. Fiscal reforms didnot increase budget flexibility enough to allow for public investments ininfrastructure or innovation. Continuing highpublic sector borrowing has well knowncrowding-out effects on private credit and investments. Trade volume i s still low compared with other large economies such as the US, Australia, Mexico, Indonesia, China and India. Partial privatization inelectricity (where 78 percent of generation i s controlled by the public enterprise Eletrobrhs), roads, and water and sanitation may also have attenuated both capital accumulation and productivity gains. Repeated changes intaxation on the entry of financial capital13may have induced frictions on financial liberalization. And the estimated impact of FDIon productivity has been limited, possibly due to the high share of investment innon-tradable sectors.14 3.10 Butfurtherfirst-generation reforms may not be sufficient in the absence of other microeconomic and institutional reforms. Trade liberalization actually occurred almost twice as fast as in the Korean Republic, but against a background of labor market rigidities, capital market imperfections, poor infrastructure services, and low external financing.l5 Privatization in transport and electricity failed to generate sufficient competition or service expansion because it preceded the establishment of appropriate legal and institutional framework for regulation.l6 It loBielchovsky R. et a1 (2002), "Investimento e reformas no Brasil - Inddstria e Infra-estrutura nos anos 90." IPAR- Cepal: Brasilia, DF. l1 Bank:"Brazil: TheNewGrowthAgenda." Severalvariablesreflectingknowledgeandtechnologyexplain World TFP differences across Brazilian enterprises, such as the skills composition of the labor force and the share of information technology inphysical capital. Newer firms also tend to have higher productivity, as do larger and more capital-intensive firms. Firms inmore protected sectors had slower productivity growth. The "technology gap" i s measured as the difference between Brazil and U S detrended TFP. Gomes, V., M.B. Lisboa and S.A. Pessoa (2002): "Estudo da Evolu@o da Produtividade Total dos Fatores da Economia Brasileira: 1950-2000." Ministerio da Fazenda: Brasilia, DF. l3Through the IOF Financial Transactions Tax (Impost0 sobre OperaG6esFinanceiras). l4Tyler, W. (2002), "Foreign Direct Investment, Trade and Productivity Growth." Background Paper for World Bank Country Economic Memorandum, Brazil. Washington DC. l5During the last six years of its trade reform, Korea cut tariffs by 1.7 percentage point per year on average, against 3.1 in the Brazilian case, though Brazil's initial average tariff rate was higher (32 percent) than that of Korea (25 percent). There were other differences: in Korea, liberalization started slowly (1979-83) and accelerated toward the end of the period. InBrazil, big cuts were,made at the outset. Moreira and Correa (1998). l6Castelar Pinheiro A. (2003), "Regulatory Reform in Brazilian Infrastructure: Where D o We Stand?' Background Paper prepared for the Brazil Country Assistance Evaluation. 10 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth has been this regulatory incompleteness and instability - not the incompleteness of privatization -thathascurtailedprivateinfrastructureinvestment.Poorenforcementhamperscompetitionlaw and policy; burdensome licensing procedures lead to firm informality; and the bankruptcy law untilrecently provided few incentives for financial turnaround. Highfinancial spreads are caused by taxation, mandatory credit lines at administered interest rates, and lack of creditor's rights. 3.11 Moreover, political constraints imply that this microeconomic and institutional agenda representsa sensible reform program for the nextfew years. Further unilateral trade reforms and privatization may be politically difficult today inBrazil in the face of opposition from diverse powerful groups. Protecting fiscal discipline should certainly take precedence andhas already cost the government some political capital with its traditional base. Public servants have strongly opposed social security reform. Social tensions have been raisedb y highunemployment and rising violent crime in urban areas and rural land conflicts. Reforms that impose too high costs inthe short run on the affected groups - or that appear ideologically confrontational - may not represent an optimal growth strategy today. 4. THE GOVERNMENT MICROECONOMIC GROWTH AGENDA A. SCOPE AND IMPACT 4.1 The Government has committed to a development strategy aiming to create employment and reducepoverty, built on afoundation of sound macroeconomic management. Social security and tax reforms are expected to be fully approved by end-2003. A forum between the private sector and the labor unions has been created under the auspices of Ministry of Labor to draft the reform of labor laws; this discussion should be launchedin early 2004. The Fome Zero program of anti-hunger activities involving private sector and civil society actors (launched inearly 2003), the Primeiro Emprego initiative to reduce youth unemployment (approved in October 2003), and the unification of social programs as the Bolsa-Familia (announced in October 2003) make up the pillars of social policy. 4.2 Within this developmentstrategy, the Government's growth program is discussed in two official documents: "Roadmap for the New Economic Development Agenda" (Roteiro para a Nova Agenda de DesenvolvimentoEconBmico) - launchedjointly by the Ministries of finance, 11 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Planning, Development, and the Chief of Staff - and the multiyear plan (PPA 2004-07) sent to Congress in September 2003.17 4.3 The role of productivity gains in the new strategy is clearfrom the PPA and the recent White Paper. The latter stresses the role of microeconomic and institutional reforms: "The creation of a new development agenda must have as a primary objective the promotion of sustainable development with improving social welfare and income distribution.. . To attain this objective, microeconomic and institutional reforms are important, to improve economic efficiency and stimulate rising investment and saving."" 4.4 Achievements to date clearly signal the commitmentto theprogram. With the approval of a reform plan, the Government has started to modernize customs clearance, a historical bottleneck. A recent White Paper clarifies and strengthens infrastructure regulation and reinforces the role of the new transport agencies. The new Bankruptcy Law - approved by the Lower House - provides a key mechanismfor the turnaround of potentially viable firms, while the tax reform further simplifies tax collection for SMEs. Approval of the Amendment to Article 192 of the Constitution i s an essential step in approving fundamental legislation to improve the financial sector soundness. With the Innovation Law before Congress, the Government has a chance to improve linkages between public research institutes and the private sector, increasing the countries capacity to transform knowledge into productivity gains. 4.5 This is a subset of the broader microeconomicgrowth agenda. The Government i s also designing reforms infour further areas - tax, contract enforcement, trade integration, and labor markets - that are part of the growth agenda. In all four, progress i s likely soon to improve growth prospects. While the Bank maintains a dialogue with government inthese areas through analytical work and the program could include them upon reform progress, for various reasons these reform areas are not included among the measures supported b y this loan. Intaxation, the Bank's relationship with the authorities i s being conductedthrough the Fiscal Reform Program. A variety of tax reforms are currently being debated by the Legislature and these should bring efficiency gains when the bills pass. The efficiency of contract enforcement i s an area on which the Bank has so far had limited input through one study, but here the Government i s also preparing the ground for reforms. Multilateral trade negotiations continue, with the recent talks inMiami moving toward agreement on aFreeTrade Area of the Americas (FTAA).On labor markets, where the Bank providedrecent analytical work,19 the Government i s conducting l7A third document, "Industrial, Technology, and Trade Policy" (Diretrizes de Politica Industrial, Tecnolbgica, e de Come`rcioExterior),has also been issued recently. The stated objective i s to increase efficiency and investment with a central role for improving the regulatory framework for infrastructure and increasing technology diffusion. The document also emphasizes the importance of supporting R&D in the private sector and of improving the linkages between the private sector, universities and public research. The document also singles out certain sectors for attention (semiconductors, software, pharmaceuticals, and capital goods), suggesting the possibility of favoring these over other sectors. Even here, however, the document emphasizes transparency and a preoccupation with evaluating the costs and benefits of public interventions. l8 "A elaboraqzo de uma nova agenda de desenvolvimento deve ter como primeiro objetivo a promoqgo do desenvolvimento sustentivel com a melhoria do bem-estar social e da distribuiqzo de renda. (...) para que este objetivo seja atingido, s80 importantes medidas microecon8micas e reformas institucionais que aumentem a eficiencia da atividade produtiva e estimulem o aumento da taxa de investimento e poupanqa (...)" l9Brazil: The Jobs Report (2002), Report No. 724408-BR. 12 Brazil: Proposed First Programmatic Loanfor Sustainableand Equitable Growth consensus-building talks with unions and employers, with a view to reform proposals to the Labor Code within the current administration. 4.6 Other elements of the Government'sdevelopment strategy, such as macroeconomic management and human capital accumulation,areproceeding well and supported through other instruments,and therefore not containedin theproposed program. Clearly, continued stability i s a prerequisite for growth, and the main determinant of this i s the Government's own fiscal performance. Here the Government's record has been exemplary, repeatedly meeting and exceeding its own fiscal targets (and those of the IMF).Similarly, continuing improvement in Brazil's education system, particularly to standards and secondary enrollments, will be a further contributor to growth rates inthe long run. Here too there i s evidence of continuing progress, with, for example, the proposal to expand the Fundef federal fundingmechanism from basic to secondary education. And other policy areas not normally thought of as economic growth policies per se also have growth effects, such as health or social assistance programs. These areas are the subjects of other Bank operations and technical dialogue with the Brazilian government, and are thus not discussed here. 4.7 There is therefore a nested relationship between the developmentstrategy, the broader microeconomicgrowth agenda, and the growthprogram defined in this document. Development strategy includes growth determinants such as macroeconomic stability and education, which are not supported by the present program. The growth agenda contains elements which are excluded from the program for now, but could be brought within its framework, such as labor market reform or trade policy. The four areas defined above are denoted as the Growth Program: this i s where the Government has requested Bank support, the subject of this section. Figure 8 illustrates this relationship graphically. Figure 8 The Government's Development Strategy, The Broad GrowthAgenda, and The Growth Program Financial Sector m Macroeconomic Innovation 4.8 UsingFigure 8 as a compass, we may offer an overallassessmenttojustifr the approach taken in thepresent Loan Program. The Government's overall development strategy i s highly appropriate for the needs of the country: this context i s an important factor in the 13 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth consideration of overall programmatic support. Macroeconomic management, as has been explained elsewhere, has been extremely strong. Educationpolicy also promises to buildon recent positive achievements. And the new administration has brought important institutional innovations, such as participatory councils including organized civil society, into most areas of government. The growth agenda outside the program there i s a more mixed assessment. However, no reform backsliding i s expected, and these areas are therefore not seen as undermining the program. Intrade policy, the administration i s committed to freeing trade restrictions, but understandably wishes to see its own market access improve commensurately. Taxation distortions should gradually decline. Consultations with labor groups are ongoing. The program itself, therefore, i s embedded in a favorable overall setting. 4.9 The set of reforms included in the Growth Program is sufficient to deliver significant impacts in terms of growth andpoverty reduction. One World Bank study2' estimates that preventing banking crises, deepening financial intermediation, reducing government burdenon business, and improving infrastructure could raise Brazil's growth rates by between two and three percentage points. Importantly, these reform categories account for about half the authors' estimate of the impact of all possible growth reforms for Brazil: in other words, the Growth Program proposed here, consisting of transport, business environment, financial, and innovation policies, represents a critical mass of Brazil's reform agenda for economic growth. Assuming reforms with only half this impact, we estimate that the present reformprogram could have growth effects of the order of one percent per annum if pursued to completion. 4.10 Theprogram should bepolitically feasible. To implement this strategy, the government has put particular emphasis on consensus buildingmechanisms. Within the government, the coordination of the program will be done b y the Camara de Politica Econ8mica. Other inter- ministerial committees have been created or will be revitalized, namely the Camara de Infra- Estrutura, the Conselho Nactional de Cihcia e Tecnologia (CCT), and the Grupo de Trabalho do Mercado de Capitais. The Conselho de Desenvolvimento Econ8mico i s another important mechanism, which aims to improve the dialogue with stakeholders including civil society and the private sector. 4.11 Finally, these reforms representa growthprogram which is consistent with macroeconomicmanagement inthat it sets back neither the fiscal agenda (e.g., by creating contingent liabilities through industrial incentives) nor the trade agenda (e.g., by protecting certain industries.)Inthis regard, the Government has placed particular emphasis on transparency. The Government i s planning to disseminate information on existing tax incentives for productive activities and on the structure of effective protection of Brazilian industry. Both documents will improve transparency and promote scrutiny of public expenditures. 4.12 Thefollowing sections discuss the backgroundand issues, recent achievementsand future challenges, in each of the areas listed above. Section 5 then discusses the likely importance for poverty reduction of a program for sustained, equitable growth. Section 6 follows that by turning to the structure of the loan and the program. *'Loayza, P., P. Fajnzylberand C. Calderon, "Economic Growth in Latin America and the Caribbean," The World Bank, 2003. 14 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth B.REDUCINGLOGISTICS COSTS TO RAISEPRODUCTIVITYAND EASE TRADE Background and Issues 4.13 Logisticsaccountfor the largestshare of the cost of doingbusiness in Brazil. Estimated at 20 percent of GDP, almost twice the proportion in OECD countries, logistic costs represent a thirdof firms' operating costs on average and upto half insome industries. For example, while soy bean production costs inthe center-western states of Brazil are among the world's most competitive, FOB costs are about the international average. 4.14 Over the last 15years, world trade has doubled, whileglobal outputhas risen only by 50percent; in Brazil, inter-regionaltradehas increased only 50percent over the sameperiod. With globalization andthe reorganizationof production and distribution chains, logistics and related infrastructure services have taken on greater importance in determining productivity and competitiveness. Demand for customizedproducts contributes to the expansion of to-order and just-in-time production and direct-delivery technologies. In addition, many developing countries like Brazil, which used to supply almost exclusively raw materials to industrial countries, are now exporting growing volumes of manufactured products. But these new trade flows are also more volatile, since production processes can be quickly moved to more competitive locations. Indeciding on the location of productionunits,firms increasingly consider trade-offs between the cost of production and the cost of stockholding, transport and distribution: logistic costs. 4.15 High logisticcosts in Brazil have several components: (i) the absence of more in efficient multimodal alternatives, road transport still dominates the freight market (over 70 percent of goods are transported by road in Brazil), resulting in excessive transport costs in the long distance market segment; (ii) the costs and reliability of road transport services are also affected by the poor condition of the road network; (iii) inventory and warehousing costs are highnot only as aresult of the highinterest rates, but also due to inventory levels. Firms' inventory levels in Brazil are two to three times higher than inthe US, and the poor reliability of transport services due to the low quality of infrastructure i s a major determinant 21. The cost to the Brazilian economy of additional inventory holdings is huge, exceeding 4 percent of GDP assuming a 15 percent interest rate22;and finally (iv) logistics costs also incorporate highinternal administrative costs inthe absence of an industry of service providers, and, for the firms involved in foreign trade, the costs and delays associated with ports and customs. 4.16 Customsprocedures remain a strong barrier to trade.Despite some improvements in the 1990swith the introduction of operations information systems, customs procedures and practices remain outdated and continue to adversely affect firms' productivity and competitiveness. For firms involved inforeign trade, customs still represent a major cost, more than 10percent of operating costs on average. Customs' primary focus i s still on revenue collection, instead of focusing essentially on trade facilitation, border protection and transport 21 Guasch and Kogan 2001 "Inventory in developing Countries: Levels and Determinants, a Red Flag on Competitiveness and Growth", The World Bank 22De Castro, N.(2001) "Freight Transportation and Logistics in Brazil: An Overview," background paper produced for the World Bank. 15 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth security. Progress has been insufficient inimplementing the decisions of the MERCOSUL Council to ease regional trade b y harmonizing procedures and developingjoint customs operations. Clearance time on imports and exports (averaging 5.0 and 2.0 days respectively) are more than double international norms. This i s confirmed by various international studies, which emphasize that customs inefficiency i s one of the main hurdles for firms that trade with Brazil, and i s a growing problem. 4.17 I n spite of recent improvements,port costs and delays are still too high. With almost 500 million tons passing annually through its ports, Brazil has by far the largest port industry in Central and Latin America. The reform of the port sector was initiated with the Port Modernization Law of 1993, which defined a new institutional framework emphasizing privatization, competition, and decentralization. But only inthe late 1990s was progress significant, particularly with the concession of the major terminals to private operators, the opening of many private terminals for public use, and the establishment of local Port Authority Councils (CAPS),and Labor Management Organizations (OGMOs), to rationalize labor use. These changes have resulted in substantially reduced costs. For example, in Santos, once the costliest port inLatin America, container handling costs have dropped from over $300 in 1997to $180 in2000. These costs remain higher than those inRotterdam (US$lOO) and even Buenos Aires (US$120), as key reforms remain incomplete. Also, cargo transit times through Brazil's ports (i.e. the total time needed for cargo to pass through the port, from ship call to port exit gate) i s still excessive when compared to other countries (see Table 1).Outstanding issues relate to the institutional and regulatory framework, port administration and monitorin labor productivity , trade-related operations control systems, and environmental management. F; Table 1 Porttransit times compared(days) Imports: Longest 32.4 12.2 21.6 7.4 Average - 8.4 5.5 5.1 2.6 Source: World Bank,Investment ClimateAssessments 4.18 The condition of the road network has significantly deteriorated. Brazil's federal paved roadnetwork, totaling about 58,000 km, was built between the 1950s and the 1970s and represents assets of nearly US$10 billion. It carries most of the country's long-distance traffic. Maintenance has been inadequate for many years, so that today the proportion of network in good condition has declined to about 25 percent, the lowest such percentage registeredover the last twenty years. This state of affairs adds about US$500 million each year in vehicle operational costs, principally to the private sector. 23 "A Reforma Portuaria Brasileira, September2001, Ministry of Transport and World Bankjoint report. " 16 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.19 Fiscal conditions imposed drastic cuts in public expendituresfor roads, including maintenance. The national highway agency (DNER)provedunable to implement a strategy for rehabilitation and maintenance in line with the available funding. Maintenance policy- contracting out the engineering designs, rehabilitation and other works, and maintenance and supervision services through traditional, input-based contracts-proved ineffective, with procurement and implementation delays leading to design changes, cost increases, and contract modifications. As the agency's management has consisted increasingly of political appointees with little relevant experience, and subject to rapid turnover and political influence in operational decisions, DNER has seen its execution capacity deteriorate, and has been unable to implement the needed changes. 4.20. A broad highway sector reform has been initiated to address these issues, aiming to: Reclassify the highway network with a view to maintaining under federaljurisdiction only the main interregional and interstate highways of national interest (estimated at . about 43,500 km), transferring to statejurisdiction highways o f mainly local interest (about 14,500 km) Transfer highway sections with sufficient traffic to private concessionaires, recovering operational, maintenance, and upgrading costs from road users through tolls (on up to about 10,000 km), and contract out rehabilitation and maintenance combined on entire . routes of the remaining network through long-term, output-based contracts, with the contractors responsible for achieving specified levels of service (on about 16,000 km). Restructure administration, terminating DNER and establishing a national department of transport infrastructure (DNIT) responsible for executing public sector programs, a national agency for land transport (ANTT) responsible for regulating and supervising highway and railway concessions and land transport services, and a national agency for water transport (ANTAQ) responsible for regulatingprivate infrastructure and transport services in that subsector. 4.21 Thefreight transport market is still dominated by trucking. Brazil's transport market: which ships mainly large volumes of low value-to-weight commodities over long distances, would appear to favor low-cost coastal shippingor rail-basedoptions. But trucking clearly dominates with an output share of over 80 percent (see Table 2). A recent Bank report,24 comparing trucking and multimodal rail-based costs for a number of products, showed a very weak correlation between logistics costs and modal market shares. Rail-based options are substantially more competitive inmany markets but the rail market share (excluding large volumes of iron ore that are captive to the railways) i s only about 10 percent. 24BrazilMultimodalFreightTransport: SelectedRegulatoryIssues,WorldBankReportNo. 16361-BR. 17 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth output % Expenses % Rate $/OOO' billion tku $million tku Total 1,547.4 100.0 35,025 100.0 19 Source: de Castro, N.,(2001) "Freight Transportation and Logistics inBrazil: An Overview." 4.22 Multimodal transport options would thus substantially increase Brazil's international competitiveness,particularly that of thepoorer regions. Conservative estimates in the same report suggest that avoidable logistics costs were adding more than US$1.2 billion per year to the costs of external trade and at least US$1.3 billion per year to the costs of domestic interregional trade in corridors with available rail services. These excessive costs restrict business opportunities, particularly in the North, Northeast and the Center-West regions, far from the major markets and ports of the South and Southeast. 4.23 Further measures wouldfoster multimodal transport: (i) appropriate regulations and conflict resolution mechanisms for multimodal operations, and (ii) the strengthening of transport planning and the promotion of public-private partnerships (PPP) to develop critical investments neededto improve connectivity of the transport networks. Recent Achievements and Future Challenges 4.24 The Government is committed to bringing customs effectiveness to international standard. The Government has recently approved a comprehensive strategy to reform customs administration. The strategy i s based on a shift in its mission, from revenue collection to trade facilitation and border protection. For this purpose, Customs will simplify its clearance procedures for both imports and exports, and update and integrate its computerized operations information systems accordingly. The new procedures will seek to fully implement the Mercosul agreement for joint customs operations, and incorporate the new security controls requiredb y certain countries. Customs will also revise their staff performance evaluation criteria and provide them with adequate training. 4.25 Worldwide experience in reforming customs is that such a shift is difJicult and requires strong backingfrom government: it i s often associated with the perception of a loss of control over movements across borders, a sensitive topic. Inaddition, it requires a change of culture within customs, and increased efforts on transport security, which if left unchecked, may easily undo the facilitation efforts. 25 Butthe Government is committed to the reform, as shownby the 25 The World Customs Organization (WCO) Security and Facilitation task force i s in the process of drafting guidelines on the topic. 18 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth participatory fashion in which the reform has been designed and its approval by government. It i s expected that inthe medium term, with the proposed changes, average cargo release times could be almost halved from their present levels, for both imports and exports. 4.26 The re-engineering of customs procedures, combined with improved decision-support ' systems, will help reduce costs and delays. Besides streamlining existing procedures, new procedures such as advance and express release will be established, and the fast-track (Blue Lane) clearance system will be expanded. Risk management systems will be implementedto support decisions for cargo inspections, and the Radar system, which i s a database on shippers' performance, will be expanded. The integration of these systems with an updated operations information system (Siscomex), and subsequently with the operations information systems of the other agencies and companies in the logistics chain, i s expected to increase customs' effectiveness and to substantially reduce shippers' costs. 4.27 Accountability of the customs will be increased through: (i) systematic computation the and publication on internet of clearance times 26;(ii) definitionofanobjectivestaff the performance evaluation system; and (iii) the establishment of a separate budget for customs administration. 4.28 Customs effectiveness will also be increased through revision of human resources policy, to support staff duringthe reform process, and give appropriate incentives to adhere to the administration's new mission. This involves the revision of staff performance evaluation and compensation policies, on the basis of objective targets to be attained, as well as the elaboration of various training program, including exposition to international practice, participatory revision of procedures used by Customs' officers, integrity program, and scaling up of computer proficiency. The definition of an objective staff performance evaluation system and of a more adequate compensation policy will, inturn, allow the undertaking of a comprehensive internal review to examine workload issues (substantial differences in workload per staff have been identified across Customs' stations inthe country), and re-assign staff to correct the major imbalances. 4.29 Completing theport reform will bring the cost of port services closer to international levels. Progress under the port reform has leveled off inrecent years after the significant achievements of the late 1990s.Terminal operators in some ports have recently managed to negotiate agreements with labor unions to adjust the work rules and the gang sizes of for-hire stevedores, leading up to a 40 percent increase of labor productivity inthose ports. But the reform has stalled on three important fronts: the consolidation of the institutional and regulatory framework, the restructuring o f port administrations; and further progress i s still needed on labor productivity. The Government i s committed to complete the implementation of the port reform, with the objective of decreasing cargo transit time by 30 percent and average container handling cost by 10percent within the next four years (not taking into account increases that could result from the implementation of the Container Security Initiative or full compliance with the International Security of Ports and Ships Code). 26Using a methodology such as the WCO Time Release Study Methodology 19 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.30 Clear guidelines are neededtoput into practice theframework defined by the Port Modernization Law and the Transport Sector Restructuring Law. Inparticular, Port Councils (CAPs) have been established inmost ports, but the responsibilities of the CAPs, Port Authorities (APs), dock companies still controlled by the Federal Government, andthe regulatory agency (ANTAQ) are ill-defined. The formerly public dock companies which now assume the role o f Port Authorities have not yet reorganized themselves to carry out their new functions. Inaddition, several Authorities have inherited debt obligations well beyond their financial capacity. Finally, the role and responsibilities of each parties involved inthe management of the delegated ports have not been clearly defined either. 4.3 1 The Government has set up a working group to review the institutional and regulatory framework forports, and toprepare an action plan. The working group's proposal, which i s dueinthe first half of 2004, i s expected to includepolicy recommendations for further decentralization of port administrations, possible through further delegations of ports to states and/or municipalities; for the restructuring, including financial restructuring of the port administrations to turn them into effective Port Authorities; and for a clearer definition of the respective roles of CAPs, APs, and ANTAQ. On this basis, it i s hopedthat additional ports would be effectively delegated to states or municipalities within a few years, that an appropriate regulatory framework would be inplace, major competition issues resolved and security levels increased. 27 4.32 With little competition amongports or terminals,private port operators and unions lack incentivesto resolve the labor issue. Government involvement infacilitating negotiations between operators and labor unions i s therefore neededandjustified by the considerable impact of port labor productivity on Brazil's competitiveness and economic growth. An initial step has been made with the establishment of the Camara Setorial, a forum for negotiating port-related issues. It i s expected that collective labor agreements could be reached in at least the main ports inthe short term, and that a labor productivity improvement plan couldbeimplementedwhich could increase labor productivity by 30 percent in the medium term. 4.33 A broad reform is underway to revert the deteriorationprocess of the road network, with the objective of having 50 percent of the remaining federal road network 28 in good condition within the next four years. Central Government has made progress toward highway sector reform. First, with the objective of maintaining under federaljurisdiction only the main interregional andinterstate highways of national interest, the Federation has transferred about 9 percent of the remaining network to states, and i s expected to transfer an additional 16 percent by end 2006. Second, responsibility for the maintenance and operation of about 8 percent of the remaining network has been passedto concessionaires. Third, rehabilitation and maintenance have been contracted through output-based contracts on about 15 percent of the remaining network. 4.34 However, some of the reform's main elementsare still to be dealt with: the objective of strengthening highway management capacity i s still far from being achieved. DNIT was 27Inaccordance with the International Ships andPorts Security Code (ISPS), recently published by the International Maritime Organization (IMO). 28i.e. the non-concessioned network, of an extension of about 53,000 km 20 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth gradually established over the past two years, essentially by transferring the staff from DNER (which i s still in the process of being extinct) and from other departments of MT, along with the relevant contracts and most administrative procedures and systems. As a result, DNIT inherited the organization and culture of DNER and i s not yet effectively performing the planning, management, supervision and monitoring and evaluation functions for which it was created. The Government therefore established a special task force to effectively coordinate the implementation of its highway strategy, including the establishment and strengthening of the necessary planning, management, supervision and control systems within DNIT, as well as appropriate program monitoring and evaluation systems inMT and SEPLAN/SPI. 4.35 ANTT does notyet have adequate information and control systems to effectively perform itsfunctions. ANTT was established more rapidly andi s now basically operational in its regulatory and supervision functions, including for highway concessions. However, like a number of other regulatory agencies, ANTT does not yet have adequate information and control systems to effectively perform its functions. Inaddition, the body of regulations and norms necessary to allow the Agency to undertake adequately its duties remains incomplete. ANTT, with the support of the Bank, has defined, in 2002, a comprehensive action plan to remedy the existing institutional gaps. Progress in the plan's implementation has been good to date, and it i s expected that the action plan will be substantially completed by mid-2005. 4.36 Much remains to be done to ensure that the deterioration of the road network condition can be reverted. The analysis of the federal highway road maintenance and rehabilitation program performance over the last years shows that the program failed at improving the condition of the network, mainly because of: (i) inadequate funding o f the program (on average about US$170 million were allocated per year, when studies show that at least US$300million should be allocated per year over 4 years to recuperate the condition of the network); and (ii) inadequate contract management and supervision from DNIT.The Government recently discussed options to remedy the situation and i s in the process of defining an adequate policy resolution to improve the condition of the federal road network. Inaddition, the above-mentioned task force will review the cost-effectiveness of the technical solutions used by DNIT, as well as contract management and supervision procedures within DNITinorder to streamline such procedures. 4.37 Continuing the road concessionprogram is key givenfiscal constraints. Optimistic traffic forecasts (and related investment obligations) and generous contract renegotiation rules have ledto many contract modifications that may have transferred commercial risks to road users through tariff increases. As a result, the second phase of the federal program, for about 2,500 km, has been stalled for several years under intense questioning from Government auditors. The Government has undertaken a review of concession biddingand contract documents and will update feasibility studies before proceeding with a new phase of concessions. The new highway concession model will also incorporate the public-private partnership concept that the Government i s developing separately, and which could turn more highway concessions feasible with acceptable toll structures. Depending on Brazil's investment rating and available Government funding, a total of 10,000 km of federal highways could be under concession inthe medium term. 21 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.38 Finally, two important steps remain to conclude decentralizationof federal road sections. The Government needs to ensure that decentralization agreements signed to date will be honoredby the end of 2006 (various State Governments still express doubts about their capacity without federal funding for the rehabilitation of decentralized sections). These agreements foresee, over the 2003-2006 period, the gradual transfer of 14,500 kmof federal road sections to state management. So far, about 4,600 kmhave been transferred. Inaddition, the proposed law reclassifying highway networks and complementing the legal basis for decentralization agreements, the so-called National Transport InfrastructureSystem (SNV) law, has stalled in congress on unrelatedissues, issues which have now been resolved with the law for restructuring the sector administration. The Govemment will revise the SNV law and seek quick approval, then restart negotiations with the states to further proceed with the decentralizationprogram. 4.39 Progress has been made in establishingconditionsfor efficient multimodal logistics. The recent restructuring of the federal transport administration, with the establishment of the regulatory agencies, the creation of the Inter-MinisterialCommittee for Integration of Transport Policies (CONIT), and the reorganization of the Transport Ministry will gradually allow the Ministry to refocus on two of its core tasks, the formulation of transport policy and planning transport infrastructure maintenance and development. The reorganization has permitted, inter alia, the consolidation of planning duties under a single secretariat, which now works on integrated development strategies along the main multimodal transport corridors rather than on isolatedprojects. 4.40 Planning efforts in the Ministry aim to bring transportplanning capacity up to international standards, focusing on: (i) efficiency inthe financing and management of road rehabilitation; and (ii) incentives for redistribution of freight away from trucking to more efficient multimodal options, through appropriate regulations and critical infrastructure improvements to resolve connectivity bottlenecks. 4.41 The Government is also seekingto increaseprivate sectorparticipation in infrastructure. Progress has been made in: (i) drafting a law improving the framework for PPP, addressing the main limitations of the existing concession law; (ii) preparing for the creation of a PPPunit inMPOG, responsible for identifying and structuring infrastructure projects suitable for financing by the private sector with minimumgovernment support; and (iii) defining innovative arrangements to leverage public resources, through, for example, securitization of public assets or cash flows. 4.42 The Government is preparing a comprehensivesystemfor monitoring and evaluating (M&E)of public expenditureprograms, including infrastructure. This system would bethe basis for annual reviews of the PPA and for proposing revisions to Congress. The Planning Ministry (MPOG),which coordinates the PPA, i s responsible for the design and implementation of the M&E system. Sector ministries will, with guidance from MPOG, establish or strengthen appropriate M&Esystems for their own programs, which would in turn form a solid foundation for the monitoring and evaluation system of the PPA.Discussions are ongoing between the Govemment andthe Bank to define Bank technical support. The Transport Ministry has already manifested interest in piloting the M&E system at the sector level. The Government expects to have the Planning andTransport Ministries systems in operation inthe medium term. 22 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.43 ANTT has madeprogress toward substantially improving the competitiveness of the railways. Regulations for railway captive shipper rates, joint and interchange traffic, access pricing and branch line abandonment have been developed and will be issued inthe short term. Plans have been prepared for a geographical restructuring of the railway concessions inthe Southeast region which, if approved, would increase the railways competitiveness and market shares. But the Government still needs to reach agreement with the state of STio Paulo on a plan to resolve critical railway connectivity bottlenecks in the metropolitan region (due to increasing commuter train services) and in accessing the port of Santos. 4.44 The Government also intends to issue rules, and tofacilitate the adoption of standards, for the development of multimodal transport services. Rules are needed to define the respective responsibilities, and liabilities, of multimodal transport operators with respect to individual carriers, adopt a unifiedbill of lading, and to resolve relatedinsurance and taxation issues. Establishing effective conflict resolution mechanisms i s also important for efficient multimodal operations. Finally, the Government will work with the industry to facilitate the selection of formats for electronic data interchanges, commodity certification, and for the standardization of intermodal equipment. c.IMPROVING THE BUSINESSENVIRONMENT 4.45 The "business environment" is defined in this document to be government laws, regulations, and administrative procedures, governing the birthof firms, their investments and everyday operational decisions, and bankruptcy proceedings. We exclude from this definition other factor market-driven outcomes that affect firms, notably labor skills and costs, the cost and availability of credit, and logistics costs (discussed separately). Because of its specialized nature and relevance to only a subset of companies, we also exclude innovation policy (treated separately below). We discuss Brazil's business environment in four areas: (i) infrastructure regulation, and (ii) domestic competition (including barriers to entry), (iii) business development services provided by the public sector, and (iv) bankruptcy and related law. (i)Infrastructure Regulation Background and Issues 4.46 I n the 1990s, Brazil carried out major reform programs in the infrastructure sectors with disappointing results in terms of investmentexpansion. The reforms were built around privatization, unbundlingtelecom and electricity companies, and new regulatory frameworks. Regulatory reform followed international practice in separating commercial, regulatory, and policy activities. Intelecom, port, railways, and energy, new legal frameworks also emphasized competition. But while these reforms reduced fiscal burdens and improved operational performance, the results in terms of lower prices, improved services, and increased investment have - with the exception of telecom -been disappointing. Inkey sectors such as roads and electricity, Brazil has not closedthe gap with most of it international competitors. 4.47 The weak investment response is linked to apoor regulatory framework. Private investors are concerned with "regulatory opportunism," the appropriation of rents once 23 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth investment costs are sunk. Uncertainregulations increase the risk of regulatory opportunism and thereby the premium charged for investments ininfrastructuresectors, which can add more than 25 percent to final tariffs.29 4.48 I n Brazil, one componentof the regulatory risk is thepoor concession design. Ill- defined property rights and liabilities inconcession contracts generate frequent conflicts. For example, contracts should ideally specify contingent actions to mitigate currency risks, but most contracts provide no guidance in this respect: appropriate financial products are often not even available. Many existing concessions in water, roads, and energy contain weaknesses stemming from the award process or from other features of the concession contracts. Recent examples of problems exist in water (the city of Limeira), toll roads (the state of Parani) and electricity (Minas Gerais) (see Annex 5). 4.49 Another component of regulatory risk is the incompletenessof the legal environment. The least developed regulatory framework i s water and sanitation, where the attribution of legal rights between municipalities and states remains the central problem. Legal conflicts have emerged because article 30(v) of the Constitution allocates municipalities the rights over the provision of local services in the case of pre-existing natural resources and economic resources (such as sewage companies). Many natural resources are shared across municipal boundaries, however. Several privatization attempts have been blocked by court actions, with final Supreme Court decisions still pending. The Government i s sponsoring one Legal Bill (PL 41047/2001) to regulate this subject. 4.50 The 2001 energy crisis highlighted reform failures related to regulation andpricing distortions in thepower sector. Brazil had embarked on a major power-sector reformin 1995, initiating vertical unbundlingand privatization. Sixty-four percent of distribution and 23 percent of generation assets were privatized. The Government introduced an independent system operator (ONS) to be responsible for central cost-based dispatch, a wholesale electricity market (MAE), and a new regulatory agency (ANEEL)to supervise the sector. Parallel reforms inthe upstream gas market ended the legal monopoly of Petrobris, but inthe absence of deeper structural reforms, competition has been slow to develop. The 2001electricity supply crisis was caused by one of the worst droughts on record, which affected vast areas of the country, causing the failure to refill the large hydroelectric reservoirs on which the country depends. A sensible power rationing scheme was enforced, minimizinghardship, and in 2002 precipitation returned to normal and the reservoirs began recovering. But the crisis brought to light serious limitations inthe organizationof the power system. Generators anddistributors hadhadlittle incentiveto ensure reliable supply to end-users and distributors had hadno way of covering the costs of supply margins.In some cases, generators could increase profits from rationing. Under these circumstances new merchant plants have no incentive to enter the market. At the beginning of 2003, Brazil's electricity sector thus found itself in an awkward intermediate position between a state-controlled and a private-led market: neither wholesale market mechanisms nor central planning were adequate. The Government's more recent response i s discussed below (see section below on Recent Achievements andFuture Challenges). 29World Bank (1999), Report No. 19568-BR. 24 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.51 The concession law has major weaknesses.Ingeneral, the law gives too much power and discretion to public authorities. The interpretationof several legal concepts remains ambiguous, prolonging contract negotiations and increasing transaction costs. The concession law limits options substantially for public-private partnerships (PPP). Regulatory arrangements are neither transparent nor consistent across sectors, and are vulnerable to political interference, ' leading to rent seeking. Enforcement i s difficult, with regulatory agencies set up only last year, and unclear provisions in concession contracts with respect to information disclosure requirements. Finally, there i s little scope for resolving disputes other than through cumbersome and unpredictablejudicial processes. 4.52 A third component of regulatory risk is regulatorygovernance.InBrazil, infrastructure regulatory laws are imprecise about accountability and transparency. Beyond formal independence, it i s essential that regulatory agencies explain the rationale for their decisions. Even the well-viewed ANEEL has receivedcriticism inthis regard. Furthermore,judicial review of regulatory decisions takes place at the first level of the judiciary, which lacks relevant expertise and training. 4.53 Despitepracticalfiscal difficulties,funding for Brazil's regulatory agencies is provided for by law. Sector laws provide for the financial independence of regulators. For example, ANEEL receives 0.5 percent of revenues collectedinitsjurisdictional market, reasonableby international standards. Intransport, fundingof ANTT and ANTAQ consists of allocations from the general budget. Agencies must comply with public expenditure rules and oversight requirements and are accountable for the use of public funds. The funding of agencies i s central to their credibility, as discretion over funding can constitute a means of subverting their independence. 4.54 Staffpolicies are a bigger issue. Independent regulators differ from many government agencies inthe high specificity of knowledge, hence the importance of staff continuity and competitive salaries to improve the quality of regulation, increase predictability, and reduce "revolving door" departures to the private sector, where regulatory expertise i s inhigh demand. InBrazil, the regulatory agencies havenot been allowed to establish their own hiring mechanisms, compensation, or career policies. Agencies are today fully staffed by temporarily assigned employees, many originally employed by former regulatory bodies or former state- owned firms. Personnel from regulatedcompanies often continue to draw compensation from career positions within these companies. 4.55 Finally, good governancerequires the appropriate definition of boundariesbetween regulatorsand the executive.Ambiguity currently stems from (i) proliferation of the "executive" agencies to bypass rigidities inpublic administration; (ii) poor definition of important policy issues by the executive or legislature, creating "self-legislation" by infrastructure agencies (e.g., asset price evaluation inthe electricity sector); (iii) involvement the of agencies outside their conceptual mandate (e.g., universal services, granting concessions, conducting auctions); and (iv) the lack of clear planning b y the executive body. 25 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Recent Achievementsand Future Challenges 4.56 One important achievement has been thepreparation of draft PPP Law. This will introduce more flexibility for infrastructureprojects intwo ways: (i) allowing for the use of public funds as a complement of private resources, and (ii) making concession criteria more flexible. The government has taken steps toward the establishment of a PPP-unit within the Ministry of Planning, with the aim to identify "bankable" projects and structure project financing. 4.57 Afterfive months of broad consultationwith theprivate sector and the civil society, in September 2003 the governmentissued a landmark White Paper on reg~lation.~~ This should reduce uncertainty by setting out the overall "regulatory policy" of the current administration. The document reinforces the role of independent regulatory agencies in infrastructure, and recommends regulator mandates that do not coincide with the election cycle, improving technical capacity, improved transparency and accountability, and clearer definition of roles between executive, legislature, and regulator. Another consequence of the recommendations will be the definition of a formal career applicable to all federal infrastructure regulators. A draft law i s being prepared b y the Ministry of Planning. 4.58 The White Paper recommends the restoration of planning capacity in government. As one consequence, Casa Civil has prepared one draft law giving the executive the right to grant concessions and conduct auctions, and another law establishing performance contracts as the main instrument of public control of regulatory agencies (both drafts are at the stage of public consultation). A key challenge i s to define the appropriate mechanism to make the performance contracts as effective as possible while preservingregulatory independence. 4.59 Overall, agencies still lack the skills, information and regulatory instrumentstopursue oversightfunctions such as reviewing tariff structures and monitoring compliance with standards. It will be necessary to develop regulatory accounting and information standards, cost and financial models; and efficiency andproductivity measures. 4.60 Several legislativechanges are imminent. The government i s planning to send the electricity reform project to Congress in 2003. Inwater and sanitation the government intends to pass a new law in early 2004. Secondary legislation will be needed. The legal and regulatory framework for transport infrastructure has significantly improved. The reorganization of the Federal Transport Administration has been approved by law and implemented resulting inthe creation of two independent regulatory agencies for land transport and waterborne transport and the reorganization of the Transport Ministry around core tasks of policy design andplanning of maintenance and development. An amendment of the constitution may be required to provide for the revision of regulatory decisions by the second level of the judiciary. 4.61 Thedetails of the new power sector model should become clearer in the coming months, reducing investor uncertainty. InDecember 2003, the Government announced the new 30"Analysis and Evaluation of the Role of Regulatory Agencies under Current Institutional Arrangements inBrazil" (Andise e AvaliapZo do Papel das Aggncias Reguladoras no Atual Arranjo Institucional Brasileiro) - issuedjointly by Casa Civil, the Czmara de Infra-Estrutrua and the Czmara de Politica Econdmica. 26 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth model, attempting to correct some of the shortcomings due to the incomplete implementation of the previous model. The main objectives that the Government identified were to: (i) guarantee electricity supply; and (ii)achieve reasonable regulated consumer tariffs. At the same time, the Government preserved some of the pillars of the old model, such as competition "for" and "in" the power market, and confirmedits intention of abiding by all existing contracts. 4.62 Execution of the new model willfulfill most of thefollow-up actions describedin the 2001 Energy Sector Loan. While the basic structure of the new model has been defined, key elements remain to be confirmed by laws, decrees, andresolutions. Most importantly, the complete unbundlingof generation and transmission i s proposedin the new system. To guarantee continuity of electricity supply distribution companies will be responsible for their load forecast and forced to contract 100percent of their expected demand. To ensure reasonable consumer tariffs the Government will establish competition "for" and "in" the market. New concessions will be granted based on the lowest tariff bids, and distribution companies will have to purchase all energy through a competitive procurement process. Generators will be able to challenge the Government's planby competing with alternative projects. 4.63 Nonetheless, in the eyes of theprivate investor, despite all the ongoing efforts, the new power sector model is still uncertain. Some investors fear that a concentration of power inthe hands of the Ministry may preempt some of ANEEL's roles as an independent regulatory agency. Brazil still has excess capacity, but clarity of the new model i s key to initiate a new investment cycle. Under continued uncertainty, the risk would be that low investment in 2004 couldjeopardize supply in 2007. (ii) The Competitive Environment and Administrative Barriers Background and Issues 4.64 Competition law enforcement, part of the competitive environment, is gradually evolving in Brazil. Law 8894 of 1994 broadly resembles competition laws inother countries, legislating for anticompetitive behavior, including the abuse of market dominance, as well for the control of mergers. It also grants formal independency to CADE (Conselho Administrativo de Defesa Econbmica), the body renderingfinal decisions on antitrust cases, through fixed two- year mandates for commissioners (extendable once). It extends to SEAE (Secretaria de Acompanhamento Econbmico) in the Ministry of Finance economic advisory roles previously restricted to SDE (Secretaria de Direito Econbmico) at the Ministry of Justice, the latter being responsible for carrying out preliminary legal investigations and handling administrative procedures before submittingfiles with opinions to CADE.31Despite this complexity, enforcement has made discernible progress, not only interms of the number of cases on which CADE has ruled, but also in terms of the advocacy roles increasingly played by SEAE and SDE. 4.65 Two remaining weaknesses are the small number of hard-core cartel cases condemned and the complex enforcement of merger controlprovisions. Contrasting with the growing emphasis on anti-cartel enforcement adopted by other antitrust agencies and with the 31Clark, J. (2000) "Competition Policy and Regulatory Reform in Brazil: A Progress Report." OECD Competition Policy Review, Vol. 2, No.3.; and OECD (2001. "Brazil - OECD Economic Surveys." Paris: OECD. 27 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth condemnation of more than 15 international cartels since the mid 1990s, only one domestic cartel case was successfully prosecuted by CADE between 1994 and 2000. This low activity on hard- core cartel prosecutionowed partly to its limitedinvestigative powers and partly to the increase inmergers submittedfor review (merger reviews rose from 46 in 1997 to 226 in 1999 and 584 in 2002). Moreover, the multiplicity of agencies involved and a low threshold for submission of mergers caused delays in enforcement of merger control.32Finally, mergers must be filed 15 days after "occurrence" and private sector actors disputed the legal definition of occurrence, particularly since CADE has been particularly aggressive in fining non-compliance with the 15- day rule. Moreover, post-merger notification makes it harder for CADE to adopt structural remedies for anticompetitive mergers: most remedies have been behavioral, which international experience has shown to be much less effective at protecting competition and consumer welfare. 4.66 Institutionalfragmentation and the lack of a stable corps of qualifiedprofessionals are probably the most immediate obstacles to stronger competitionlaw enforcement. The Brazilian system i s unique inthat three government bodies are involved in competition law enforcement, working within an unclear division of legal attributions. Enforcement i s then further weakened b y dispersed actions and hightransaction Efficiency could be improved by a review of staffing assignments across the three organizations. Salaries are uncompetitive with the private sector although the three institutions have a significant annual budget (more than US$10 million excluding salaries). 4.67 Legal reform could also improvegovernance and efficiency. Decisions on mergers have raisedconcerns over the independence of CADE. Disputes over large and controversial cases are not uncommon but the risk of their being politicized could be reduced by an increase inthe term appointment of commissioners. Legal attributions might also be better allocated, coupled with mechanisms for greater accountability. Revision of CADE decisions by "first-level" courts may also jeopardize its effectiveness. Pre-merger notification would reduce conflicts, while revised merger thresholds might reduce the number of mergers to be reviewed by the authorities. 4.68 Poor competitionin infrastructure industries ispartially caused by weak enforcement of pro-competitionregulation. Competition i s not naturally born with privatization but depends on regulation. Sector laws in telecom, electricity, and ports have clear provisions for increased competition as a key principle of the regulation, but it i s still unclear how these provisions will be implemented. There is no institutional mechanismto resolve conflicts between promoting competition and other objectives of regulation. And despite agreements between regulators and competition authorities, SDE and SEAE's roles inthe enforcement of competition law intelecom have been taken over by the regulator, Anatel. Sector laws also provide for open access of competition inbottleneck segments, but the implementation of open access has been uneven across sectors. Inthe gas industry, for example, negotiations for access to Petrobrhs pipelines took over a year and eventually had to be ruledby the regulator. 32Both SEAE (Secretaria de Acompanhamento EconGmico) at the Ministry of Finance and SDE (Secretaria de Direito EconGmico) at the Ministry of Justice have to issue non-biding technical opinions. Article 54 provides for the submission of merger or acquisitions involving firms from economic conglomerates whose worldwide sales were equal or greater than R$400million (roughly US$1333 million). 33The Global Competition Report ranked Brazilian antitrust second last among more than 50 countries surveyed for two consecutive years (2001 and 2002). 28 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.69 Competitiondid not naturallyfollow infrastructure privatization. Infrastructurereforms were conceived to encourage competition to the extent possible, since empirical evidence suggests that infrastructure performance i s greatly affected by the extent of competition in (or for) markets.InBrazil, vertical break-up characterized electricity privatization, while horizontal break-ups occurred in electricity and in telecom. Petrobrhs still has a de facto monopoly over oil refiningbut competition has increased upstream anduntilrecently separate accounts were kept between Petrobrhs andTranspetro (the subsidiary of Petrobrhs that owns gas pipelines). But in all these industries sunk-costs are high, local demand low, and incumbents may have cost- advantages: all these factors impede the emergence of competition. And fiscal considerations have dominated competition concerns in several privatizations, while merger control enforcement has faced institutional and political limitations. 4.70 Competition is lacking in several key sectors. Companhia Vale do Rio Doce (CVRD) controls (direct or indirectly) much of the railway system: privatization transferred a state-owned monopoly to the private sector. Two large port terminals inSantos andRio de Janeiro were privatizedto the same controller groups, reducing inter-port competition. Joint ventures such as CCR, which comprises some of the largest constructing firms operating inBrazil, jeopardize competition in bids for transport contracts. And cross-participation in electricity generators coupledwith the predominant position of Eletrobrhs (over half of generation capacity i s still controlledby it or its subsidiaries) diminishcompetition inelectricity generation. 4.71 The competitive environmentin Brazil is also damaged by government-generatedentry barriers.These include unduly complicated business registration processes, costly andtime- consuming labor regulations, restrictive standards registration procedures, and difficulties in acquiring and developing land or receiving environmental licensing. These costs deter investment and the formalization of new firms. Already the level o f informality, even among formally registered firms i s substantial. Inthe recent World Bank Investment Climate Survey of Brazil, firms estimated that they declared only 67 to 73 percent of their sales for tax purposes. Only 19 percent of the firms inthe sample (andless than half of the large firms) reportedhaving audited financial statements - compared with 92 percent inMalaysia and 75 percent in China. 4.72 High start-up costs also inhibit entry and investmentby making it less likely that new firms becomeformal and hence grow. Lack of entry can also reduce productivity directly: new f i r m s have been found to exhibit both higher and faster growing p r o d ~ c t i v i t yEvidence on . ~ ~ entry costs comes from two main sources: the World Bank "Doing Business" database and SEBRAE.35Both use similar methodologies, though there appears to be significant variation in estimates for some of the steps inthe process andtherefore in overall time and cost to register. 4.73 Time costs are the main administrativeproblemforfirms in Brazil. Brazil does not have excessive pecuniary costs of firm registry; nor does the number of procedures to register appear a major concern, although 15 procedures inBrazil i s still higherthan Korea (12), Chile (lo), and Mexico (7).36But the average time to complete required procedures to establish a 34 World Bank (2002), "Brazil: The New Growth Agenda," Report No. 22950-BR. 35 ServiGoBrasileiro de Apoio aos MCdio e PequenasEmpresas, Brazil's public agency for the support of SMEs. 36 World Bank, 2003 Doing Business database. 29 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth business inBrazil (about 152 days) i s the second highestin Latin America (Figure 10).Brazil ranks well behind Mexico (51 days) and takes more than five times as long as Chile (28 days). The comparison i s starker if we include some o f the more important OECD countries (Figure 10).Brazil i s significantly higher than comparators such as Mexico, Korea or Chile which approach the OECD average ofjust over 30 days. Inthe most innovative countries, such as Ireland, Australia, and the US, time to register a company i s often below ten days. Figure10: Time Neededto Registera Company LatinAmerica ComDarison OECDcomparison ........... .".. . . . .. . . . ...... ...........".. ". .. .I 40 20 0 Source: DoingBusiness Database 4.74 The lack of unification between Federal, State and Municipal registration processes is one main cause of delays. For example, a firm must register with federal, state and municipal tax registries: about 25 days on average. By comparison, a firm can complete all registration requirements in half that time (12 days) inIreland. Some processes, such as the need to be a member of trade association, appear to be vestiges of the past with little value to g ~ v e r n m e n t . ~ ~ According to the Doing Business database, the bulk of time to register i s taken at the municipal level: 120 of the 158 days (76 percent). There i s also great variation between municipal (and between state) administrations (see Annex 6). Data suggest local discretion to ration entry, whether inpursuitof rents or simply to comply with outdated norms. 4.75 Thereare myriadfurther permits and licenses needed at the state and municipal level. These range from municipal health and fire inspections to hurdles to acquiring and developing land. These processes show similar levels of variation intime and cost. Inmany cases, the same information or copies of the same forms are required by multiple agencies. The cumulative effect of these requirements can remove the incentive to register a business formally. This may leadto a vicious circle of informality, which erodes the tax base and government ability to provide public goods, further reducing the attraction of operating formally. 4.76 Brazil is probably the developing country with the oldest and most consolidated environmental licensing system, launchedin the early 1970s. Brazil i s something of an exception among developing countries, since it has qualified personnel and well-developed 37The variability of experience i s quite wide. Sebrae, using expert interviews in 2000, catalogued the variation in requirements, time, and cost to register in each state inBrazil. O f the twenty-six possible forms that a firm could be asked to produce in order to register with the state tax authority, only one (the "declaration of individual firm") was required by all states. Mirroring this heterogeneity, the minimum time to process a request once all forms are submitted ranges from 1to 15 days and the costs from R$2.18 inMaranhZo to R$103.5 inRondBnia. Sebrae (2000). 30 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth procedures including standardized and widely disseminated impact assessments. But while the system has achieved participation and transparency, it can be bureaucratic and adversarial. Government procedures still treat environmental issues outside the planning process and this encourages subsequent litigation. The risk of beingcaught or fined for non-compliance i s low (although rising through the work of the Ministtrio P6blico and environmental agencies): entrepreneurs and agencies alike regardthe license as the end of the process. Three types of licenses are required at different stages - prior, installation, and operation. Even though operation licenses have to be renewed at regular intervals, there i s rarely follow-up. This i s largely a consequence of low budgets and capacity, but also stems from the fact that monitoring and enforcement are often carried out by different departments within the same agency. 4.77 IBAMA has also had to assume an inappropriately widepolicing rolefor environmental regulations. Since sector policies are often unclear about the environment, most projects tend to leave environmental issues for when an environmental license i s requested. One consequence i s that IBAMA must negotiate with sector agencies policies which are the responsibility of the Ministry of Environment. Inlarge infrastructure projects, the scope of licensing remains unclear. For example, the indirect impacts of roadbuildingin frontier areas are far more important than the direct impacts. But while many of these indirect impacts may be of an environment nature - such as increased deforestation - many are not - such as effects on indigenous communities or population growth. IBAMA has thus inflated its mandate to license many economic activities. RecentAchievements and Future Challenges 4.78 Since2001, importantprogress has been achieved in the enforcement of competition law in Brazil. There has been increasing emphasis on cartel investigations. In2002, CADE condemned two collusion between gasoline stations inFlorian6polis (SC) and Goiinia (GO). In September 2002, 260 cartel investigations in30 different industries had been started by SDE. Several institutional measures have been taken, including the launching of a "Leniency Program" and the signing of an agreement with FederalPolice, both aiming to improve investigative techniques. Steps have also been taken to harmonize merger analysis undertaken by SEAE and SDE and speedup their investigation on benign cases. The government i s preparing a draft law for the rationalization of work between SEAE and SDE as well as further amending the current antitrust legislation. A different piece of legislation i s due by end 2003 allowing for the hiring of permanent personal by CADE. InMarch 2003, a cooperation agreement between the Brazilian and U.S antitrust authorities was ratified by the Brazilian Congress. An agreement between Brazilian and Argentinean authorities was signed in 2003 to facilitate the implementation of the FortalezaProtocol - a 1996 agreement among Mercosur countries on common competition policy principles. 4.79 Agreements to improve the enforcement of competition law in infrastructure have recently beenput inplace. The overall principle of relating competition and regulation has been accepted by government. This year, the White Paper on regulation policies proposes the adoption of a notification system between the regulatory agencies and the competition authorities. A specific achievement in telecom has been the definition of interconnection tariffs based on long- runmarginal cost. Ifproperly enforced, this regulationmay improve competition intelecom. Future challenges remain the adoption of the above mentioned notification system and a better 31 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth definition of the interface between competition andregulatory issues. The roles of SDE and SEAEon antitrust cases inthe telecom sector should also be clarified. The implementationof the long-run marginal cost principle will require a large effort by Anatel. The appropriate definition of open-access in the natural gas industry i s still pending. Preliminary negotiations indicated an undesired outcome with the new regulation granting a de facto monopoly of Petrobris over most local markets (with perhaps the exception of Comgas). 4.80 There arefour mainfuture challengesfor government authorities in the competition enforcement. These are rationalizing competition law enforcement, establishing a stable corps of sufficiently remunerated qualified professionals, a new law to improve governance and efficiency in competition law enforcement, and amending the constitution to provide for revision of antitrust decision at the second-level of the judiciary. 4.81 There have been some attempts to reduce the time needed to register a company, for example the "Sistema Ficil" in a few selected states, but they have yet to be assessedrigorously. Such an analysis, particularly over a few years and across states, would determine whether such efforts significantly reduce administrativebarriers and allow for more efficient implementation across states and municipalities. 4.82 The environmental authoritiesare aware of theproblems of their managementsystem, in particular licensing. The NationalEnvironmental Council (CONAMA) has established a committee to review the system. The current administration i s attempting to mainstream environmental issues into sector policies. The Ministry of Environment (MMA) has been focusing on the energy and transport sectors, with IBAMA dealing at the more operational level with counterparts such as the National Petroleum Agency (ANP), National Electric Energy Agency (ANEEL), National Water Agency (ANA), andNational Transport Infrastructure Department (DNIT).Efforts have been made to clarify guidelines and incorporate environmental issues upstream inproject design. The government has made efforts to assign responsibilities and integrate the environmental activities of the three tiers of government (e.g., efforts to regulate Article 23 of the Constitution). 4.83 Many problems of the national environmental management system and of licensing remain beyond the domain of the environmental agenciesthemselves.Regulating and controlling small and medium enterprises remains a formidable task in a country where half the economy i s informal and largely outside government control. This i s particularly serious in specific highpolluting sectors typically carried out by small-scale operators. It may also be difficult to make the system much more flexible. Environmental laws and regulations inBrazil are stringent, comparable to OECD countries. Even if enforcement i s lax, authorities have no way of giving license to activities outside the norms and regulations. The MinistCrio P6blico has been playing a major role inensuring compliance with the legislation, supervising the performance by environmental authorities. 32 Brazil: Proposed First Programmatic Loanfor Sustainableand Equitable Growth (iii)Business Developmentand Export Services Backgroundand Issues 4.84 Brazilian public-sectorbusiness developmentservicesfocus on SMEs.Federal programs for SMEs are mainly implemented by six institutions: Sebrae, Apex, BNDES, Banco do Brasil, and FINEP.38There are more than 30 federally funded programs for access to credit, business development services (BDS), access to technology, and export promotion. With resources from Treasury, Sebrae's budget and the earmarked taxes that go to the Workers Support Fund(Fundo de Amparo ao Trabalhador or FAT), these have disbursed R$2.7 billion in 1998-2002, 90 percent through BNDES. 4.85 Sebrae is the main source of BDS. In2003, Sebrae spent approximately R$1.1 billion (60 percent of its budget) on six BDS programs: including access to technology and innovation (12 percent), training (15 percent), and market access (10 percent). Sebrae i s partially funded by the social contribution tax (COFINS, a 0.3 percent payroll tax), for an estimated R$677 million in2003: payment for services corresponds to less than 10percent of its revenues. The institution i s managedb y three directors appointed by the Board, which i s composed by five institutions from the federal government and eight business associations. Activity i s mostly at the state level. 4.86 Themost importantgovernmentsources of creditfor SMEs are Banco do Brasil and BNDES. In2002, the two institutions providedR$10.7 billion (0.8 percent of GDP).BNDES programs - such as Finame, Finem, BNDES-Automitico and BNDES-Exim - are not strictly specific to SMEs, although banks gain increasing access to these lines as they increase lending to SMEs. Banco do Brasil administers at least two credit programs targeted to S M E s (Proger Urban0 Empresarial and MPEMInvestimento). There are three guarantee funds for SMEs: one administered by BNDES (Fundo de Garantia para a Promo@o da Competitividade), one b y Sebrae (Fampe) and one by the Ministry of Labor (Funproger). Significant S M E funding i s also provided outside the formal financial system: the factoring industryprovides up to R$27 billion per annum in credit, to cite the largest category. At an even smaller level, Banco do Nordeste's CrediAmigo i s Latin America's largest micro-finance organization, and several other banks are starting or have started similar operations. 4.87 Technology-relatedfinancialsupport isprovided by Finep, mainly by means of the ForumB r a d de InovaGaes (Brazilian Innovation Forum) and the Apoio a Arranjos Produtivos Locais (support to local production clusters). Since 2002, Finep and Sebrae arejointly implementing the Programa de Apoio Direto a Inova@o with the objective of improving technological performance of SMEs and funds of roughly R$80 million. 4.88 Apex is the Brazilian export-promotionagency also responsiblefor supporting SMEs exports.It i s funded by 12.5 percent of the social contribution tax and i s administeredby the federal government. Through matching grants (normally up to 50 percent o f the cost), Apex provides support to different activities such as marketing research; business training; product and ~ 38 Brasil; BNDES - Banco Nacional de Desenvovimento Econdmico e Social; FINEP - Financiadora de Estudos e Sebrae - Sewico Brasileiro 2s Pequenas e Mkdias Empresas; Apex - AgEncia de PromocBo de Exportagces do Projetos. 33 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth processes compliance (IS0 certification included) and other related services. UntilJuly 2003, Apex had supported 368 export programs, 200 of which still inplace, at a total cost of roughly R$386 million. Two-thirds of the programs are targeted to specific sectors or productivity chains most of them on industries where Brazilpresents international comparative advantage (such as agribusiness; leather and footwear). 4.89 Micro and SMEs are expanding numerically but are characterized by low capital, technology,productivity, and growth. Micro-enterprises and SMEs accounted for 62 percent of Brazilian employment in 2000.39Micro-firms correspond to about one-third of total employment and this employment increased by 5.4 percent annually between 1996 and 2000 versus a 1.5 percent growth rate in large firms. In 1997-2000, birthrates of micro-enterprises exceeded mortality rates, resulting in an annual expansion of 6.7 percent inthe number of micro-firms. Yet firm growth measured by change insize classificationwas in~ignificant.~'Productivity of large f i r m s i s about six times higher than mi~ro-enterprises.~~Productivity differentials are in part caused by informality, which deepens known failures in credit, information and technology markets: high costs of formality constitute further obstacles to the adoption of new technology and New products introduced by SMEs are predominantly developed internally, while new processes are acquired from other firms or institutes (for 82 percent). 4.90 Thesefactors contributeto thephenomenon of the "missingmiddle" of the Brazilian private sector: the relative scarcity of medium sizedfirms. Although this phenomenon i s oft- cited and highly plausible, there i s actually a paucity of reliable cross-country comparisons to suggest that medium-sized firms are any rarer inBrazil than in any other middle-income economy. Ongoing work at the bank usingthe new Investment Climate Survey i s investigating the veracity of this phenomenon, as well as possible causes such as financial barriers, the costs of formality, and labor market structure. 4.91 The importance of capital goodsfor SMEs is striking. In 1998-2000, at least 63 percent of SMEs expenditures on technology were related to the acquisition of capital goods (77 percent for micro enterprises), against 50 percent of the average firm and 43 percent for large firms.43 Large firms spent on R&D, training and industrial projects almost as much as in acquisition of capital goods, while expenditures inthese activities was less than half the expenditure of capital goods inthe case of medium firms and less than one quarter in the case of micro-firms. Similarly, far fewer SMEs undertake training than large firms and large firms are far more likely to cooperate with other firms or research institutes to develop new products or processes. 39 Guimariies, E. (2003) "AvaliaGiio das Micro, Pequenas e MCdias Empresas no Brasil" Background Paper for the Project. 40 Najberg, S., F. Puga and P. Oliveira (2000) "CriaGilo e Fechamento de Firmas no Brasil: Dez. 1995Dez. 1997" Textos para Discussilo 79. BNDES: Rio de Janeiro. 41 Guimarzes, E. (2003) "Avalia@o das Micro, Pequenas e MCdias Empresas no Brasil" Background Paper for the Project. 42 Parente, S.L. and Prescott, E.C. (2000), Barriers to Riches, Walras-Pareto Lectures, vol. 3. Cambridge and London: M I T Press; Djankov, S., R. Porta, F.Lopez de Silanes and A. Shleifer, (2000) "The Regulation of Entry" NBERWorking Paper No. W7892. 43 IBGE(2000) Pesquisa Industrial Inovapio Tecnoldgica. Departamento de Indhtria. IBGE:Rio de Janeiro. 34 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.92 SMEsface bureaucraticand informational barriers to exporting. Between 1997 and 2001, SME's share in exports decreasedfrom 35 to 31 percent. SMEs report customs requirements, port costs, and access to information regarding marketing opportunities and access rules related to product quality as the main obstacles. SMEs claimthat complying with quality standards and establishing external partnerships with local distributions are the two most effective export ~trategies.~~Central Bank rules over foreign exchange transactions may also have greater effect on SMEs than on larger firms. 4.93 Export credit is limited. The major export financing program, PROEX (Programa de Financiamento ?is Exportagaes) has provided direct financing to exporters since the early 1990s (with resources from Treasury) equalizing interest charges with those prevailing ininternational markets. To provide export credit insurance, SBCE (Seguradora Brasileira de CrCdito h Exportagfio) was established in 1998 and has since been supplemented b y resources from the federal budget. I t s monopoly position i s no longer guaranteed b y law. RecentAchievements and Challenges 4.94 Despite the number of instruments,federal programs to support SMEs lack coherence, targets, and transparency. The emphasis on credit to the detriment of BDS and technology- related services runs against international experience, which suggests that credit i s most effective when combined with BDS and technology services. Where financial and technological services are provided (e.g., b y Finep), few are targeted to SMEs. Sebrae services are focused on SMEs but lack clear objectives and measures.Despite a sound reputation inthe business sector, Sebrae lacks transparency: a federally funded institution runindependently of government without clear mechanisms for monitoring or evaluation of its programs. 4.95 TheMinistry of Development,Industry, and Trade (MDIC) recently simplified export procedures. In2003, 59 export regulations were consolidatedinone legal document (the Portaria Consolidade de Exportagfio), 29 M D I C regulations (Portarias) that imposed unnecessary requirements were eliminated, the number of export products requiring government authorization was reduced, the registration of exports was simplified, and sales registries were abolished for coffee, aluminum, and cocoa. These changes reflect an important advance interms both of simplification and transparency of the rules. 4.96 The Government is attemptingto improvefinancial accessfor SMEs and micro- entrepreneurs.FromJune to September 2003, the Government announced a series of measures (see section IV-D below). Access to bank accounts has been eased and funds inthe banking system earmarked for lending to the poor and micro-enterprise. The public banks have also initiated a series of new lending programs for such entities at concessional terms. Although access may increase, earmarking and the capping of interest rates may also discourage private intermediation. 44Tinoco, G. and F. Ribeiro (2002) "Um levantamento de atividades relacionadas 2 atividade exportadora das empresas brasileiras: resultados de pesquisa de campo junto a 460 empresas exportadoras," In Pinheiro, A.C, R. Markwald and L.V. Pereira: "0Desafio das Exporta@es." BNDES: Rio de Janeiro. 35 Brazil: Proposed First Programmatic Loanfor Sustainableand Equitable Growth (iv) The New Bankruptcy Law Background and Issues 4.97 Poorly designedprocedures surrounding corporate insolvency hinder turnaround of viable enterprisesin distress and impede the efficient functioning of credit markets. As illustratedby the decomposition of spreads in Section IV-D below, the availability and cost of credit in Brazil has been significantly affected by its weak framework for creditor rights. Difficulties associated withjudicial debt collection weaken creditors' rights and render credit more expensive.45A major weakness inthe framework for creditor rights inBrazil has been its antiquated framework for corporate insolvency, embedded largely in the 1945 Lei de F a l e n ~ i a s . ~ ~ Although it provides for both a concordata process (reorganization inthe case of insolvency) as well as falencia (liquidation), the system has been characterized by weak creditor protection and few meaningful rehabilitation options, resulting in disproportionately high default rates of potentially viable companies, long delays and erosion of asset value in liquidation processes. As a consequence the cost of exit of non-viable companies i s increased and productivity and employment inthe real economy i s reduced. 4.98 I n thepresent system, the reorganization (concordata)option only providesfor a moratorium on debt to avoid or suspend the declarationof bankruptcy and does notpermit negotiated mechanismsfor reorganization of the business. There are no provisions allowing parties (debtor I creditors) to negotiate a plan and only unsecured creditors are encompassed. Write-offs andreschedulingof debts are rigidly prescribed by law. There are no special regulations to ease access to credit duringthe concordata, to maintain a going concern, and the entity may not dispose of real property or give secured guarantees without court authorization. All settlements of debt takes place under courtjurisdiction with no voting rightsfor creditors. In practice, protractedcourt disputes, lack of qualified supervisors, andjudicial activism in favor of the debtor delay bankruptcy declaration. 4.99 Moreover, under bankruptcy and liquidation (fal2ncia)proceedings, the disposal of assets is slow and ineffective. Upon declaration of bankruptcy, pending creditor actions and interest on debts i s suspended, rendering it difficult to obtain credit to maintain a going concern. Assets of the estate remain unused until their sale. While the law allows the debtor to continue operating underindependent management, in practice this rarely occurs. Rights of secured creditors are impaired by the precedence given to labor and tax claims. Inbankruptcy proceedings, secured interests rank below several other claims, including notably, labor, social security and tax claims. Once bankruptcy proceedings have been concluded, there are few funds left over even for secured creditors. Inaddition, assets are sold individually to the detriment of the borrower's intangible value. 4.100 Legal shortcomingsare compoundedby an insufficient regulatory and administrative framework. The Lei de Falhcias makes no provisions for an independent and qualified court- 45 Discussed extensively in Brazil: Access to Financial Services (World Bank, 2003-Draft); basedoninputsfrom Armando Castelar Pinheiro, and from Pinheiro and Cabral (2001) "Credit Markets in Brazil: The Role of the Judiciary and Other Institutions". 46 Decree Law 7661 of June 21, 1945. 36 Brazil: Proposed First Programmatic Loanfor Sustainableand Equitable Growth appointed administrator. Judges generally appoint a lawyer to perform the role of administrator. There are no provisions for committees of creditors and there i s no regulatory framework for qualifying participants, such as administrators, liquidators and insolvency practitioners. This leads to significant disparities inthe quality and reliability of the system. Frail state courts, overburdened in mostjurisdictions, compound problems of slowness and non-uniform quality. RecentAchievements and Future Challenges 4.101 I n 2003, Brazil made landmark progress in addressing issuespertaining to creditor rights through the submission of aproposed new lawfor bankrupt~y.~' There was a simultaneous submission to Congress of parallel amendments to the tax code (Cbdigo Tributiirio Nacional - CTN), addressing problems of tax succession, which forms an integral part of the proposed new framework for bankruptcy. Major efforts to update the corporate insolvency legislation began in 1993 with the "Biolchi Project" and experienced several amendments until the House of Deputies approvedthe latest version on October 15, 2003, representing the culmination of intensive and protracted effort^.^' The Bill i s now under review inthe Senate and i s expected to be approved in the coming months. 4.102 Theproposed new insolvencyframework is a major advance over the existing system, providing an option to reorganize in or out of court and striking a reasonable balance between liquidation and reorganization, which: Establishesflexible and modernjudicial and extrajudicial restructuring proceedings to replace the ineffective concordata. Options available in the recuperationprocess will be greatly increased, including delay of payment or partial debt forgiveness; division, incorporation, merger; substitution of the administration; collective labor agreements on salaries or employment; partial sale of assets andjoint administration, among others; Significantly increases theparticipation of stakeholders (both increased creditor and employees)in insolvencyproceedings through a Recuperation Committee (Comit2 de RecuperaGlio),and the Assemble`iaGeral de Credores (Creditors General Meeting), and permits them to approve a legally bindingrestructuring plan; Improves creditorprotection by including all creditors inthe restructuring andbankruptcy process, by respecting secured credits in liquidation, and by providing preferred status to new creditors to borrowers during an insolvency process; Givespriori0 to selling the company as a going concern in the case of bankruptcy, preservingthe value of intangibles and allowing the debtor to remain incontrol of assets while restructuring i s negotiated and executed; 41Further details and analysis o f the new proposal, relative to the present framework, are inAnnex 7. 48 SubemendaAglutinativa Global cis Emendas de Plenario ao Substitutivo Adotado pela ComissHoEspecial ao Projeto de Lei No. 4.376-BA993 (PL no. 205, de 1995,apensado), presented to Congress together with proposed amendments to the Tax Code inthe form of a Complementary Law (PLP 72/2003).The World Bank has been actively engaged in assessing and commenting upon the present and proposed new insolvency frameworks through the evaluation of observance of standards and codes ("ROSC"), and through technical assistance. The present Bill reflects many of the suggestions which arose inthis context. 31 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Permits a simplified restructuringmechanismfor micro and small companies;limits court oversight (and thus scope for judicial activism); andintroducesa number of additional features which comply with international goodpractice, such as the treatment of claims on receivables and forward contracts. AccompanyingAmendments to the National Tax Code (CTN) 4.103 Afirst key achievement of the CTNamendmentis the abolition of tax succession. Under the current tax legislation, the buyer of a company has to assume all outstanding tax debts and social security liabilities (tax succession). This i s a clear impediment to the sale or transfer of an insolvent company as a going concern and depresses asset valuations. Any judicial asset sale, such as going concern acquisitions of a bankrupt company, i s free from tax succession. 4.104 Other major areas of progress are an effective end to thepriority offiscal claims, and enhancedprotection to secured creditors.Secured creditors rank pari passu with fiscal obligations, as for each dollar repaidto the tax collector, one dollar has to be repaidto secured creditors up to the value of the guarantee. It also provides protection of guarantees from seizure to pay tax arrears. Tax fines have been reduced to have priority only over subordinated credits, and the debtor may pay past tax and social security liabilities ininstallments. 4.105 Togetherthese measures representa remarkable strengtheningof theframework for corporate insolvency. Although there remain areas where the proposals fall short of international best practice and some problems of fragmentation and implementation remain, the new law i s essentially well-designed. The Bank has extended significant assistance to the Government reform agenda in these areas through technical assistance loans andproposes to continue to do so through a proposed new TA loan. D.ENHANCINGFINANCIALEFFICIENCYANDDEPTH (i)Financial Intermediation Spreads Background and Issues 4.106 Financial intermediationspreads in Brazil have beenfalling (Figure 11).Brazil has been notorious for high spreads between borrowing and lending rates, which inMay 2003 stood at 47 percent, on average, ranging from almost 60 percent for individuals to 28 percent for enterprises. There has been a reduction in spreads inrecent months, to some 43 percent on average in September 2003. It i s noteworthy that the decline has been mostly due to a fall in spreads on individual loans, to 52 percent, while spreads on enterprise loans have been largely unchanged. This suggests that factors affecting spreads to enterprises are more structural and long-term in nature, while spreads on individual loans may be more susceptible to short term interest rate movements. 4.107 I n an accountingsense, high bank spreads in Brazil can be decomposed intoprofits (41percent), taxes (29percent), cost of default (17percent) and administrativeexpenses (13 38 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth percent).49(Figure 12.) However, there are deeper structural issues underlying these findings. Thus highdefault costs point towards difficulties inupholdingandenforcing creditor's rights, due to both legal limitations as well asjuridical practice. Andthere i s limitedrecovery of asset value even if creditors' rights are recognized. The share of default in spreads has shown some upward trend from mid-2000, rising from around 9 percent in April 2000 to almost 21 percent in September 2002. This suggests that initiatives to reduce default would contribute to reducing spreads and expanding credit. High overheads and administrativecosts may suggest limited competitive forces, which in turn may reflect the large share of directed credit inthe economy. High overheads are also due to factors such as the highcosts of opening and maintainingbank branches, due to regulatory and precautionary requirement^.^' Finally the significant contribution of high taxation, both explicit and implicit, to bank spreads i s clear. Figure 11 Rates, Spreads, and Reserve Requirements /o Trends in Interest Rates [Jan 2001 Oct 2003) . 49Astraced by the Central Bank through its multi-year project on Taxas de Juros e Spreads Bancaria. Figures are from February 2003. Cardoso and Koyama (1999) also highlight these factors as well as high funding costs. A cross- country comparison by DemirguG-Kunt and Huizinga (1999) shows that the large net interest margin of Brazilian banks (fifth among 76 countries considered) reflects the high ratios of overhead (highest among 76 countries), taxes (fifth largest), loan loss provisions (13th largest) and net profits (24th highest) to total assets. 50 Discussed in Belaisch (2003); IMFDo Brazilian Banks Compete?;also see World Bank (2003) Brazil: Access to Financial Services,Draft. 39 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Recent Achievements and Future Challenges 4.108 Recent initiatives to reduce spreads through major reforms to bankruptcy legislation, which represents a significant strengtheningof creditor rights, have already been discussed in Section IV-C. Further contributors to high spreads -financial taxation and lack of competition in the financial sector - are discussed below. 4.109 There has been some recent convergenceof controlled lending rates towards the market rate. The TJLP rate,51which i s the base rate for a substantial part of BNDES investment lending,has remained largely constant (declining inSeptember 2003 from 12percent to 11 percent) despite the cuts inthe overnight funds rate. Inspite of the fact that the falling overnight rate i s purely cyclical (that is, dependent on the expected path of inflation), the non co-movement of the TJLP nonetheless indicates a reduction of the subsidy element in longer-termlending. Figure 12 100% 4 0% 3 5% 80% 3 0% 60% 2 5% 2 0% 40% - 1 5% 20% 1 0% : 0 5% 0% 0 0% Feb. Aug. Feb. Aug. Feb Aug. Feb. Aug. Feb. 1999 1999 2000 2000 2001 2001 2002 2002 2003 Ind,recttaxation+ FGC Dtrect taxatton J N e t Bank margin LmmmDefaukexpenses ~ A d n u n i n r a t l vcosts e --CTota Monthy Spread (ii)Financial Sector Taxation Background and Issues 4.110 Asflagged above,financial sector taxation is an important contributor to high spreads infinancial intermediation. A detailed discussion of issues in this regardi s presented in the documentation for the previous two programmatic financial sector loans to Brazil, and especially, inthe more recent Second Programmatic operation.52 Recent Achievements and Future Challenges 4.111 Financial sector taxation in Brazil has recently experienced modest reduction and rationalization in some areas. At the time when the last Programmatic Loan for the Financial Sector was presented to the Bank's Board, a proposal for the partial exemption of the CPMF (ContribuiqZio Provis6ria sobre Movimentaqiio Financeira), on stock market transactions, and other specialized transactions, was under consideration inthe Congress. InJune 2002 this 51 '*PFSECAL-1and Taxa de Juros de Longo Prazo. 2 loandocuments (Nos. P7448-BRand 24067-BR). 40 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth proposal was approved by Congress, as a art of the vote of approval for the extension of the CPMF for a further two and a half years.S P 4.112 As of November, 2003, afresh proposalfor the extension of the CPMF was being debated in Congress. The new bill includes a proposed exemption of the CPMF tax on transactions from a proposed new form of bank account, the Investment Account. The Investment Account, announced by the government in October 2003, would be a new form of bank account, from which qualified financial investment and trading activities would be permitted, and all such activities would enjoy the CPMF exemption.54This extends the effort towards exempting the CPMF where it would impact upon financial market liquidity and would also help to broaden the base of small savers and investors able to enjoy the benefits of CPMF exemption. Untilnow, given the exemption of the CPMF on stock transactions, and the zero rating enjoyedb y mutual funds, the incidence of the CPMF hadbecome regressive innature, impacting particularly on small savers and investors who didnot trade through stocks or mutual funds. 4.113 I n other areas offinancial sector taxation, progress is uneven. While the reform inthe PIS andCOFINS tax from a turnover to value-added system impacts significantly on the real sector, the basis for calculation for the financial sector remains broadly the same, that is, the spread between the revenues minus financing cost. However, new rules for a more comprehensive and precise calculation of the spread have been introduced." There has been a small increase in the rate of the COFINS for the financial sector (4 percent insteadof 3 percent).s6Other taxes impacting upon the financial sector (the IOF, the ISS, and the direct income tax for financial institutions) remain unchanged. These movements must be viewed against overall fiscal tightening needs of the country during this period. 4.114 Implicit taxation of thefinancial sector, through reserve requirements, has been recently reduced as economic stability has increased, though the gains are damped by new allocative requirements. Due to macroeconomic turbulence, basic reserve requirements on savings deposits were raised from 10to 15 percent inJune 2002 and on savings deposits from 15 to 20 percent the following month. InAugust 2002, additional reserves of 3-5 percent were j3 Constitutional Amendment 3712002 of June 12,2002, which extended the incidence of CPMF until 31 December 2004 (article 84). While the rate was maintained at 0.38 percent for 2002 and 2003, a reduction to 0.08 percent was proposed for 2004. Exemptions were also permitted on transactions from specialized current accounts including clearance and settlement accounts and accounts set up for securitization transactions through companies established as special purpose vehicles. (Portaria MFno227, of 11July 2002; D O U 12.7.2002). j4 This form of account is yet to be made officially available. Instruments eligible for purchase or trade from this account would include various forms of investment funds the FIF (Fundo de Investimento Financeiro) and the FAC (Fundo de AplicaGdo em Quotas), equity, housing and privatization funds, savings and investment clubs, mortgage bonds, private and public debt purchased directly and derivatives. However, the purchase of goods, real estate, or consumer goods would not be eligible. 55Instruggo Normativa SRF no247, de 21 de novembro de 2002; D O U de 26.11.2002 - Anexo I- Base de CBlculo do PISPASEP da COFINS: Instituigdes financeiras e assemelhadas 56The increase from 3 percent to 4 percent for the financial sector was established by Law 10.684, o f May 30 2003. For the real sector, the government increased the rate from 3 to 7.6 percent (MP 135, of October 30,2003). However this apparent rate increase accompanied the substitution of the turnover basefor Cofins for the real sector for a value added tax in order to eliminate the cumulative nature of Cofins. 41 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth imposed, and were raised two months later to 8 and 10 percent respectively. InFebruary 2003 basic sight deposits reserves were raised from 45 percent to 60 percent. As the economy stabilized, a significant reduction inbasic reserves for sight deposits was announced in August 2003 (from 60 percent to 45 percent); however, the net reduction has been somewhat less due to a simultaneously announced increase inreserves by up to two percent, with an exemption for micro-credit loans made from this amount. Although this was introduced against the backdrop of the substantial 15 percent reduction inbasic reserves, and at a time of extremely tight credit, this constitutes a new form of directed credit. (iii) Anti-Trust and Competition Oversight in the Banking Sector Background and Issues 4.115 The relatively high concentrationin Brazil's banking industry, coupled with the consistently high profits of Brazil's banking system in recentyears, has led to queries regardingpossible links betweenhigh bank spreads and banking sector competition. Concentration has increased since the mid-l990s, following a number of closures, merger and acquisitions, as part of a rationalizationprocess. The five largest banks inBrazil have been estimated to account for 49.7 percent of total assets, 55.3 percent of total loans and 57.9 percent of total deposits.57This has prompted a review of present arrangements for competition and anti- trust oversight in Brazil's banking sector. 4.116 Thefinancial system in Brazil atpresent is not subject to Brazil's CompetitionLAW, since under existing regulations for financial institutions, the Central Bank i s responsible for the oversight of both mergers and acquisitions as well as market conduct issues inthe banking sector.58The role of the anti-trust authorities i s limited to other sectors. However, inconsistent case law has blurred this division of responsibilities in the past.59In2001, the Central Bank's exclusive authority to approve all merger and acquisitions of financial institutions inBrazil has been confirmed in a highlevel legal opinion.60 4.117 Inpractice, the effectiveness of competitionand anti-trust oversightin the banking sector is currently limited. The Central Bank analyses bank mergers from the perspective of financial system stability, but has limitedexpertise in assessingmarket concentration and competition issues. Existing resolutions on bank mergers and acquisitions provide for almost automatic approval of transactions by the Central Bank, as long as the holding company i s in good health, minimumcapital requirements are met and the bank participates in deposit j7 Nakane, Marcio (March 2001), A Test of Competition in Brazilian Banking, Banco Central do Brasil. Other sources estimate that 70 percent of all short-term bank deposits are held by Brazil's five largest banks (Marcio Aith, "Fusdo de bancos devera passar pelo Cade" at Folha de S. Paulo, April 03) 58See Section IV-C, which details the role o f different institutions in Brazil's competition enforcement system. Law 4595 of 1964; Brazil's Financial Institutions Law, vests oversight responsibility (including for competitive behavior) for the financial system with the Central Bank and the National Monetary Council. 59For example, in the case of Banco Brascan, CADE analyzed and approved the acquisition. In the case of the acquisition of Banco BCN by Banco do Bradesco, however, approval was given only by the Central Bank and courts refrained from imposing penalties for the missing CADE approval. 6oAGU (Advocacia Geral da Unido) Opinion 01/2001, ProcessNo. 1.006908/2000-25. Approved by the President. 42 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth insurance.61As a result, competition issues are inadequately addressedinthe analysis of bank mergers. Recent Achievements and Future Challenges 4.118 To address these shortcomings, a new legal bill has beenjointly presented to Congress by the Central Bank and CADE in November 2002, whichproposes a division of responsibilitiesbetween the Central Bank and anti-trust authorities. The Central Bank's responsibility will be limitedto systemic acts of concentration which affect the "good functioning" o f the banlung sector. All other competition issues are to be transferred to anti-trust authorities.62The proposed Bill has to be approved by two parliamentary commissions before it can be voted upon. Senate approval i s expected in late 2004. 4.119 The new proposal could help to reinforce competition in thefinancial sector. However it mustbe recognizedthat a transfer to the general framework of competition enforcement would leave implementation subject to the limitations of the present process - the multiple roles and opinions of the three agencies and lack of clear precedence. CADE i s currently not equippedto handle a significant increase in financial sector competition cases. Furthermore, transactions can be filed with the anti-trust authorities a priori or a posteriori. Inpractice, 99 percent of mergers and acquisitions filings occur a posteriori and the authorities have no capacity to unwind completed transactions. Within the proposed bill, the notion of `good functioning' of the financial sector i s not defined, leaving the Central Bank with a large degree of discretion. While this provides flexibility for the analysis of systemically important transactions, it could limit the predictability of Central Bank decisions and open a window for political influence. The Government has established a study group including the Central Bank, CADE, SDE and SEAE 61Resolution No. 2212. Further resolutions on bank mergers include Resolutions No. 1655, 1770,2099 and 2309. 62 Projeto de Lei Complementar 3441200. A necessary precondition for changing the Banking Law and improving competition oversight has been fulfilled by the recent amendment of Article 192 of the Constitution, allowing for several complementary laws to make up financial sector legislation. 43 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth to draft a code of conduct for acts of mergers and acquisitions of financial institutions. Further actions should focus on capacity building in CADE and coordinating the roles of all the agencies. (iv) The Legislative and Institutional Infrastructure for Financial Deepening Backgroundand Issues 4.120 Financial depth in Brazil, gauged by the ratio of credit to GDP, is somewhat greater than in other major countries in the region, though considerably below some emerging markets in East Asia (Figure 13). Innominal terms, credit has expanded, but credit as a share of GDPhas declined, inpart due to the "crowding out" of bank intermediationby government borrowing. Insuch an environment, the complementary role of capital markets in the provision of long term finance grows inimportance. Assets of key segments of the institutional investor market, which are sources of the long term finance needed for investment and growth (including insurance and pension funds), accounted for 21.5 percent of GDP in 2003, up from 17.5 percent in2000; closely approaching credit as a share of GDP.Closedpensionfunds account for the largest share of total assets - 14.5 percent of GDPin 2003.63 Figure 13 % Private credit / GDP 1 - $billion /o R$ billion h 50 1,000 4c 800 30 600 20 400 ..20 200 10 200 Total0-1 0 0 - 63These data do not include mutual funds, estimated at over 27 percent of GDP in mid-2003; however this includes double counting sincepension funds put assets inmutual funds to gain CPMF exemption. 44 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth RecentAchievementsand Future Challenges 4.121 A major legal impediment to the ability of Brazil'sfinancial sector to grow and mature has recently been lifted, with the amendment of Article 192 of Brazil's Constitution. This constitutional provision required the financial system to be governed by a single overarching law, thus preventing the development of appropriate and specialized legislation for different segments or themes inthe financial system. Approval of Constitutional Amendment No 40 on May 29th, 2003, paved the way for a series of reforms by allowing the individual treatment of different issues by appropriate complementary laws. Currently, four projects of complementary law relevant to the financial sector are inthe Senate, and another (on bank competition oversight, discussed above) has also been presented to Congress.64Amendment 40 also revoked ceilings of 12percent on interest rates of non-financial entities. 4.122 The amendmentalsopaves the wayfor fundamental legislativeproposalsfor the financial system on central bank autonomy and bankfailure resolution. Draft new legislation to provide a legal underpinning for the autonomy of monetary policy inBrazil has been under preparation for some time, and its presentation to Congress has awaited the amendment of Article 192. As the monetary counterpart to the Fiscal Responsibility Law, this would provide a foundation for inflation targeting regime adopted by Brazil in 1999. Its presentation to Congress i s considered likely in 2004. Also under preparation for a significant period has been a revised law on bank failure resolution, which would provide a counterpart, for the financial system, to proposed new legislation for corporate i n ~ o l v e n c yMeanwhile proposed amendments to the . ~ ~ statutes of the FGC, (Fundo Garantidor de Crkditos, the deposit insurance fund administrator), which would expand its role inbank failure resolution and also broadenits financing options and give more responsibility to management have also been approved.66 4.123 Parallel to reforms in the legal infrastructure, significant improvementsin thephysical infrastructure for the safety and soundness of Brazil's financial system have been provided by its new payments system, now successfully installedand running. Residual risks inthe system are under evaluation. The Brazilian Real Time Gross Settlement System (Sistema de Transferencia de Reservas, STR), was launched successfully inApril 2002 and the volume of operations it i s processing has grown rapidly. Meanwhile its technological platform has been upgraded and residual risk inthe STR and the SELIC system are now being audited. 4.124 There is a considerableroomfor improvement in the efficiency of retail payment instrumentsand systems, which still lack interoperability. After approval from its Board of Directors, the BCB i s currently working on what has been called SPB-2 (Sistema de Pagamento Brasileiro-2), a second generation reform aiming at the modernization of payment instruments, especially those intended for low value payments, in order to promote cheaper and more efficient 64 The four which are under consideration by Senate commissions include PLS 336, on credit cooperatives, PLS 341 on insurance, PLS 349 on social security and PLS 350 on securities distribution. 65 See Program Document for the Second Programmatic Financial Sector Adjustment Loan (Report No. 24067-BR; May 20, 2002). As discussed the main drawback of the current system i s the process of extra-judicial liquidation by the Central Bank, governed by Law 6024 of 1976. Through its program of technical assistance to the Central Bank, the World Bank has supported the process of preparation of new legislation inthese areas. 66 Resolution 3024 of the C M N of October 24,2002. 45 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth substitutes for cheques andcash itself. Paper instruments, such as cheques and currency, demand hightransportation andprocessing costs, a burdento both the financial andnon-financial system. Fraudandcounterfeiting are also more likely to be associatedwith such instruments. Another issue in the retail payments system i s the economic and social cost associated with idle capacity inretail payment systems infrastructurederived from the low level of interoperabilitybetween banks and clearinghouses, among Automatic Teller Machine networks and among deposit terminals at sales outlets networks and the lack of standardization in systems communication protocols. These obstacles prevent all participants, direct and indirect, from benefiting from scale economies. A stocktaking analysis for SPB-2i s expected to be completed by the endof 2003, and inthe following year ablueprint would be developed for overall retail systeminBrazil which will include the definition of the role of the BCB. 4.125 Associatedprogress is underway in the area of securities clearance, settlementand depositoryfacilities with the advanced testing of the messaging capabilities and internal procedures of the BM&FAssets Clearinghouse, the ongoing reform of the SELIC system. Measures have also been taken to strengthen and clarify the oversight role of the Central Bank in the risk management at clearing houses. (v) The Supply of Credit and the Role of the Banking System Background and Issues 4.126 Since the assessment undertakenfor the secondprogrammaticfinancial sector adjustmentloan, Brazil'sfinuncial sectorperformance has remained strong and there is some recent increase in the supply of bank credit to the economy. Key trends are the relative strength of domestic banks versus a relative retreat of foreign banks, decreasing interest rates and spreads, solid balance sheet fundamentals, good profitability and growing financial intermediation. The ratio of loans to deposits increased to 80.8 percent at the end of June 2003 compared to 79.5 percent inDecember 2002, albeit below its 2001 level of 85.2 percent. Total loans grew by 10 percent year-on-year at end June 2003. Recent regulatory changes improve incentives for expanding core bank businesses, includingreduced reserve requirements for demand deposits andincreased capital requirements for foreign exchange operations. As a result, interest income from foreign exchange operations decreased significantly to 2.9 percent of total interest income at the end of June 2003, compared to 10.4 percent at end 2002. Reduced access to a historically attractive revenue source effectively forces banks to redirect their operations towards core lending businesses. As a result of the ongoing intrinsic financial flexibility o f Brazil's banking system in a volatile operating environment, the rating agency Moody's changed the outlook on all financial strengths ratings for Brazilian banks from negative to stable in October 2003. 4.127 Yet Brazil is probably the only major Latin American country that still requires its banks to allocate a material portion of certain liability classes to specific economic sectors judged to be capital deprivedsuch as housing and agricultural. Directed credit inBrazil has includedthe earmarking of 25 percent of sight deposits for agriculture and 65 percent of savings deposits for housing finance.67There has been a further mandatory allocation of 2 percent of 67 O f which 80 percent (52 percent of the total) i s at below market interest rates, for low income (SFH) housing. 46 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth demand deposits for micro-finance (discussed further below). Although undertaken against the backdrop of unusually severe credit constraints over 2002 and early 2003, and finally introduced intandem with an overall reductioninreserve requirements of 15 percent, its impact onresource allocation would be distortive in character, in addition to the impact on spreads, as a `tax' on bank intermediation. 4.128 Federal banks continue toplay an important role in the banking sector and have a proportionately lower contribution to intermediation. The top five federal banks accounted for 41 percent of total assets, 42 percent of total deposits and 37.8 percent of total loans inJune 2003. Followingrestructuring in June 2001, federal banks' interest income from loans i s proportionally lower than for private banks (only 43.8 percent comparedto 61 percent from the top five private banks); with the difference beinggenerated mainly from substantial securities income (46.5 percent of interest income). Capital adequacy of the top federal banks, albeit still below private banks, has improved markedly following their recapitalization in 2001; Banco do Brasil now has a BIS ratio of 13.7 percent and the Caixa Econ8mica Federal of 18.4 percent. Recent Achievements and Future Challenges 4.129 I n view of their stabilized situation there are no radical restructuringplans underway for the largefederal banks, Banco do Brasil (BB) and the CaixaEconomica Federal (CEF). However, bothbanks are in the process of modernizing their operational procedures and emphasizing risk control measures. Plans for increased private participation inBanco do Brasil, anticipated in mid2002, are on hold. However, governance standards inBB's public shareholdings have been improved.68Internal governance and controls have also improved.69 Second, BB has developedmore stringent credit appraisal policies and has created a credit recovery department. InJune 2003, BB increased its loan loss reserves to 130 percent of its non- performing loans (NPLs) as compared to 107 percent inDecember 2002. Third, BB has begun to write down a portion of its large deferred income tax and social contribution assets. 4.130 At the CEF, too, management has begun to build up a "Global Risk Monitoring Model" the objectives of which are to develop andprovide risk management tools, and to consolidate and monitor exposure to risks. It i s estimated to need a year before final completion. Similar to BB, three new Vice Presidencies have been established in2003 in order to make sure that credit, market and operational risks are identified and controlled. Management i s also taking steps to improve the accuracy of the information processed by the IT area. However, these measures will probably take 18 to 24 months to become fully effective. CEF has also increased provisioning for the contingency of unauthorizedFCVS (Fundo de Compenscao de Variacoes Salarias) transactions. The CEF i s also trying to shielditself from risk exposures though subsidized housingloans, andi s now only prepared to undertakepopular housingfinance through the government's flagship direct subsidy Programa de Suporte 6 Habitacilo de Interesse Social (PSH) program. Moreover, Caixa i s moving away from its role as the sole provider of Publicly held shares no longer comprise PN or preferred shares. See PFSECAL-1 and 2 loan documents (Nos P7448-BR and 24067-BR). 69 The internal audit committee now reports to the Board instead of to the President; internal divisions have been instituted between the capital markets operation and the Risk and Credit departments, which previously were under the control of a single head. 47 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth housingfinance, and inrecent auctions of PSHfunding, its shares have diminished to around 80 percent (from near 100 percent a short time ago). 4.13 1 Meanwhile residualprivatizationsof State Banks have recently resumed. It i s anticipatedthat two of the remaining state banks inthe hands of the federal government may be privatized in the next six months; Banco do Estado de Maranhilo (BEM) slated for auction in January andBanco do Estado de Ceari (BEC). The Central Bank has begun the process of pre- qualification of prospectivebuyers for the first of these, (October 1998) while for the latter, the State governor i s negotiatinglast details on the bank's service contract. It i s expected that by mid- 2004 the bank will be privatized. 4.132 In the area of bankingsupervision it is clear that the independence and improved transparencyof policy decisions gained under thepreviousgovernmenthas continued.In terms of specific key projects for strengthening supervision: (i) on the development of a Work rating model i s now largely complete, but has yet to be implemented: however, supervisors plan to use the rating system at all onsite examination starting after January 2004. (ii) There are plans to extend and enhance the centralizedcredit risk database, supportedby previous operations and usedby the bank supervisors as a monitoring tool. The enhanced version (Phase 11)i s expected to be operational by the end of 2004 or early 2005. The new version will include more detailed information on the borrowers and a more user friendly system for both supervisors and bankers. I t has been suggested that improvements inPhaseI1will permit the Central Bank to process information (from the C V M system) on commercial paper issuedby traded institutions. (vi) The Complementary Role of Capital Markets and Venture Capital Backgroundand Issues 4.133 Although Brazil's capital markets are the largest in Latin America in absolute size, theyplay a limitedrole in theprovision of longtermfinancefor investment in Brazil's corporatesector. Brazil's history of macroeconomic instability, very highreal interest,rates,large government borrowing needs, extensive public intervention in the market for long term capital and a taxation regime that has hurt liquidity of many forms of financial contracts have all contributed to the emasculation of local capital markets. When coupled with world wide economic shocks, and the burstingof the technology bubble, it i s apparent why there have been few recent substantial IPOs and why venture capital i s under developed. 4.134 Moreover, Brazil is characterizedby apronounced segmentationin the access offirms tofinance. Although larger firms inthe tradable sector often find adequate financing solutions through Brazil's development bank, the BNDES, or inmajor offshore markets, SMEs or companies in the non-tradable sector face limited financing options. Micro-enterprises or SMEs face high collateral requirements includingpersonal guarantees, reflecting problems with contract enforcement. It i s thus not surprisingthat inBrazil factoring and leasing are relatively well developed financing techniques while capital market and venture capital financing are very limited. 48 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Recent Achievementsand Future Challenges 4.135 Brazil's capital marketsperformance in 2002 and 2003 have reflected thepolitical and macroeconomic uncertaintiesfacing the country. The Bovespa index reached a low in September 2002 at 8,622, down over 32 percent compared to the start of 2002. Since then, the market has rallied, with calmer international markets and positive national indicators, and at end October 2003 was up almost 60 percent (17,982) since the beginningof the year. Market capitalization and trading volume also increased over the year, by 27.6 percent and 34.1 percent respectively (endOctober 2003). Despite this rally, there has been a sustainedfurther contraction inthe numbersof listedcompanies tradedonthe exchange, which reduced by twenty-ninein 2002 (399 at end-2002, down from 428) and further reduced by twenty seven by the endof October 2003 (372 down from 399). 4.136 CVMhas continued neverthelesswith itsprogram of regulatory reform, issuinga number of important Instructions in 2003, including instructions for brokers and dealers, on buyback and trading by a compan in its own shares, on venture capital funds and on mutual funds for asset backedsecurities7'Progress has also been achieved over this periodinthe adoption of higher governance standards by listed companies.71At end October, 2003, there were 2 companies listed on the New Market, 29 companies under Level 1Corporate Governance and 3 companies under the much more stringent Level 2; up from 19 Level 1andzero Level 2 companies at end 2001. Moreover, BOVESPA's IGC index, an index of good governance companies, has shown an increasingspread over its all-share index, the IBOVESPA, over the past two years.72 4.137 Meanwhile, recent trends in the risk capital segment o capital markets (including venture capital andprivate equity) have been di~appointing.~'Overthe periodbetween 1996 to 2002 not only have the aggregate value of transactions inthe risk capital segment of the Brazilian capital markets declined, the absolute number and average value of deals closedhas also substantially declined. Particularly in the last three years, one critical source of venture capital / private equity in Brazil; foreign direct investment, either via key global private equity funds, or through direct private capital equity investments, has virtually collapsed. There has been a parallel decline in local funds. Internationalfunds still provide 46 percent; however, local company V C funds as well as special funds established inBrazil can be expected to become more important than at present in the next few years. Some of the problems are business cycle 70 Instruction 388 of April 30, 2003 (securities analysts); Instruction 390 of July 8, 2003 on the negotiation, by public companies, of shares emitted by them, by means of transactions using options; Instruction No 391 of July 16, 2003 deals with the creation, functioning and administration of Participatory Investment Funds; and Instruction No 393 of July 22,2003 deals with mutual funds for asset backed securities. 71 For details on the Bovespa Novo Mercado, and its codes of governance, see httr,://www.bovesDa.com.br/. Companies already listed on Bovespa are of course allowed to migrate to the Novo Mercado if they follow its requirements. Three companies have already published material information about their proposed migration to Novo Mercado including one for Level 2 (Petrobrh), and at least another three are preparing for adhesion to Level 1. 72InJune 2001, the two indices were adjusted to a base of 1000; by end-October 2003, the IGC was at 1464 while the IBOVESPA was at 1228. 73 The current status and proposed reforms in Brazil's risk capital markets, comprising both venture capital and private equity, are described in greater detail in Annex 8 to the present document. 49 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth related, and there may be a spontaneous revival. However the average time to exit still remains very long inBrazil (around 6 years) reflecting the relative lack of liquidity and capitalization of local equity. 4.138 The authorities recognize that developingthis segment of the Brazilian capital markets requires a package of reinforcing actions and have embarked upon them. First, steps have recently been taken to increase institutional investors' investment limits inflexible risk capital market segments (CMN resolution no. 3121/03). Brazil's closed pension funds do not permit portability and therefore have more locked-in liabilities. They thus have inbuiltincentives to invest inthis asset class. Second, the C V M has issued a new complementary regulation (CVM Instruction 391/03) governing the development of private equity funds. This regulation i s inline with international standards. Third, coupled with actions to improve the regulatory framework, the framework for enforcing shareholder agreements has also improved with a recent Supreme Court decision to holdthe Arbitration Law to be constitutional. This will now allow by-laws or a written shareholder agreement to be enforceable or amenable to settlement via third party arbitration. 4.139 Additional actions are under consideration, which could be achieved inthe short term, including an increase in open pension fund investments inrisk capital, streamlining the P O process and reducing costs of issue, improving processes for shelf-issue, and increasing competition in services associated with new issues. There continue to be excessively high transactions costs inundertaking an PO. Taken together, fees account for almost 4.3 percent of issue size for issues around R$40 million. A new C V M instruction relating to public offerings i s already under final discussion at the C V M commission, which would reduce costs for issuers by increasing competition inthe provision of these services. The new regulation will also permit the use of shelf registration, and other techniques that can reduce overall transactions costs of issuance. 4.140 I n the medium term the authorities have decided to take other measures tofoster the financing of innovation and risk capital. These measures include: simplifying antitrust filing requirements and investigating actions to reduce legal uncertainty inthe provision of risk capital. Antitrust filing requirements inBrazil are administered by CADE under the Competition Act which gives CADE very broad authority to review any acts that may limit or otherwise restrain open competition. The authorities have agreed to consider introduction of a size threshold or other conditions for exemption of private equity transactions. Legal uncertainty arises from the many forms ofjoint liability for owners and managers, which potentially extends to possible civil, labor, social security, tax, and consumer liabilities. Beyond this, court rulings have also allowed a harmed party to hold shareholders personally liable, and under the new Civil Code (January 2003), this may have increased. The government i s aware of these issues and plans to address them inthe future. 4.141 Finally, the government also seeks to rationalize it's own role in risk capital, reviewing and better coordinating the role of the multiple entities involved -BNDES-BNDESPAR via its operation inmanaging stocks and venture funds; FINEP, which i s part of the Ministry of Science and technology and runs the so-called INOVAR program, SEBRAE which i s supporting small and micro-enterprises and via ANPROTEC represents over 200 incubators throughout Brazil, and finally, the Universities, which play different roles. The authorities have committed 50 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth themselves inthe short to medium term to review and recommend changes inthe roles and functions of these agencies allowing a better focus of government interventions over the cycle of taking firms from the early incubator stage to a public offering. (vii) Institutional Investors and Capital Markets Insurance and Pension Funds - Background and Issues 4.142 Pensionfunds and insurance companies can contribute to economicgrowth by providing long-termfinance to theprivate sector atfavorable terms, contributing tofinancial innovation, andpromoting sound corporate governance. InBrazil, the contribution of pension funds andinsurance companies to financial intermediation andgrowth has yet to achieve its potential, due, among other reasons, to their moderate size relative to banks, the partial success inincreasingmembership andmobilizing resources, under-fundingproblems inclosed pension funds and excessive financing of the public sector (which accounts for roughly half of their portfolios). Inorder to fulfill their potential role these institutional investors must strengthen their capacity to invest and manage risk.Today the pension fund and insurance sectors inBrazil have assets accounting for 21.5 percent of GDP in 2003, up from 17.5 percent of GDP in 2000. Closed pension funds account for the largest share of total assets-14.5 percent of GDP in 2003-but in recent years the insurance sector has grown at faster rates, due in good part to the increased demand for the pension products offered by insurance companies. Recent Achievements and Future Challenges 4.143 The Government has been implementing policies designed topromote the sound growth of institutional investors, and enable them toplay a more important role infinancial intermediation. During2002 the Government passed regulations allowing the creation of closed pension funds by professional associations and trade unions, and inthe second half of 2003 the first funds of this type were authorized. These new funds will operate on a definedcontribution basis, are expected to attract a large number of new members and mobilize a significant amount of resources. The Government has also allowed insurance companies to offer a greater variety of pension products, and this has contributed to an expanded membership in open pensionplans in recent years. The Government expects to expand further membership inthe complementary pension system, through the creation in 2004 of pension funds for civil servants, in the context of a pension reform that i s trimmingthe excessive pay-as-you-go pension benefits of public sector emp~oyees.~~ 4.144 The Government has also taken steps to improve thefunding status of closedfunds and insurance companies, by encouraging the shift from defined benefit to defined contribution plans, the imposition of stricter funding requirements and extraordinary contributions for closed funds, the softening of return guarantees for pension products sold by insurance companies, and the drafting of solvency margins for life andnon-life products offered by the insurance sector. The Government plans to strengthen further the regulatory framework for closed funds and insurance companies during 2004. Areas of regulation that need to be strengthened further 74Many of these issues will be treated in depth by the Fiscal Reform Loan Series. 51 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth include internal corporate governance rules, the role of auditors and actuaries, funding and solvency regulations (taking into account the continuous increases inlongevity), and product regulation (especially disclosure). 4.145 Brazil's insurance sector is much smaller than itspensionfunds, with totalpremia amounting to some 2.8percent of GDP, and around US$l6 billion in assets.75 Yet these also account for over a third of total insurance assets for Latin America and growth inpremia has been very rapid inrecent years. Traditionally based on non-life insurance, its products until recently have been dominatedby motor vehicle insurance. 4.146 The life insurance market, hitherto dominated by group life insurances, has recently and successfully introduced new productsfor thepensionplan market. Relatively recently, economic stabilization has encouraged longer term saving. A new insurance product has been brought to the market (the VGBL, in2002), to complement an existing product, the PGBL, for open pension schemes. These products target pension plans, each with a slightly different tax treatment. The products have been very successful and have transformedthe market. Given their success, it will be important for the industry, going forward, to ensure that realistic long term risks andreturns are reflected inproduct design. The industry i s aware of the desirability of providing for updates of mortality tables and o f the need for features which allow for appropriate cognizance of prevailing market conditions at the time of payout. 4.147 Brazil's insurance market also has a less internationally commonproduct (capitalization) which combines a regular savingfacility with a lottery component. Although these products are popular, it i s clear that the financial benefit i s heavily biased in favor of the issuer of the contract and against the customer and better product disclosure to consumers would be advisable. A key short term objective for the authorities is to develop mechanisms to improve transparency with respect to this product, encouraging or even enforcing improved transparency. 4.148 SUSEP,the supervisorfor the insurance sector, has made very impressiveprogress over theprecedingfive years to improve both the quality of the regulation and the veracity of supervision of the insurance sector. Recent regulatory improvements include, for the new life insurance products, a requirement for prudent actuarial evaluations; a draft requirement for a solvency margin; moves to develop a new mortality table. Technical capacity within SUSEP is, however, inneed of development. Efforts are ongoing to adjust supervisory procedures in line with new IAIS principles, the enhancement of the valuation and solvency regime inthe light of emerging new accounting standards for insurance, and the enhancement of disclosure. 4.149 One reasonfor limited technical skills and product innovation is the existence of the reinsurance monopoly held by the ZRB. The IRB itself has been in an improvingfinancial position. Uncertainty and a lack of recruitment has meant that the staffing resources with relevant expertise have been progressively eroding. Fromtime to time, consideration has been given to some liberalization in the IRB monopoly, by allowing other entities into the domestic market. Indications have been that a number of the larger global reinsurers would seek to ''More details on Brazil's insurance sector are in Annex 8 of this document. Although pension funds are much larger than the insurance sector as institutional investors, these will be discussed in greater detail under the Fiscal Reform Program. 52 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth establish operations inBrazil. The IRB should also transfer some of its tasks of a supervisory nature back to the insurance supervisor (SUSEP). (viii) Expanding Financial Access Background and Issues 4.150 Although Brazil is not noticeably underservedfinancially relative to comparator countries, thepace, equity and efficiency of growth could be expanded by greaterpenetration offinancial services to small enterprises, and to thepoorer segments of society. Issues relating to this have been detailed in depth ina recent Bank Key Achievements and Future Challenges 4.151 From May, 2003, the government has introduced a series of new measures aimed at supportingfinancial access to thepoorer segments.77 There i s considerable emphasis on an expanded interface between the banking system and the financially underserved. Brazil's banks provide the bulk of its financial services and remain the mainstay of all intermediation. As such they can provide a means to expand access on a significant scale. 4.152 The new measures include,first, eased access to the banking system, through (i) the establishment of simplified accounts for individuals, which offer a basic package of bank services and are free of charge up to certain transaction limits; (ii) simplified conditions for opening a bank account, without the needfor proof of income;78(iii) an expansion in the scope of services offered by correspondent banks including the opening of accounts and credit f a ~ i l i t i e sand~(iv) payroll loans.80Suchmeasures for basic or lifeline banking have been ; ~ commonly adopted in several countries and if well administered can be a good practice technique to broaden access to financial services for the under-served population. Many of these were discussed inthe recent Bank study on Access to financial services.81 4.153 More controversially, the measures also include the reservation of 2percent of sight depositsfor micro-finance lending, including loans to thepoor and loans to small business." Ifnot usedfor this purpose, theseresources will instead be deposited as unremunerated reserves at the Central Bank. Interest rates on loans made from these resources will be capped at 2 percent per month. Banks may undertake these micro-credit operations directly or through micro-finance entities; however inthe latter case the interest rate caps are bindingon the on-lender. 7GReport No 26036-BR June 2003. Draft. 17Furtherdetails on these measures are availableinAnnex 8 of this document. 78CMNResolution 3104of June 25,2003 and CMNResolution 3113 of July 31,2003. 79CMNResolution 3110of July 31, 2003 8oProvisional MeasureNo 130of September 17,2003. *'Report No 26036-BR; June 2003. Draft. 82Law No. 10735 of September 11, 2003 (formerly Provisional Measure No 122 of June 25, 2003) and CMN Resolution 3109 of July 24. 53 Brazil: ProposedFirst Programmatic Loanfor Sustainableand Equitable Growth 4.154 I n parallel, Brazil's largefederal banks have adjusted their micro-finance operations under a series of individually designed schemes. The BNDES bank will restricts on-lending rates for micro-credit financed by BNDES credit lines to 2 percent or 5 percent per month, depending on loan size. At CEF, holders of its new special accounts, the Caixa Aqui, will have access to pre-approved rotating credit lines, also at the 2 percent rate. At the Banco do Brasil, a new subsidiary has been established, - Banco Popular - as an independent subsidiary, specifically for micro-credit, with its operations fundedby the 2 percent sight deposits of the parent bank. Banco Popular will use only correspondent banks to provide its services, which will be contracted on a fee-per-transaction basis. Inkeeping with other federal banks, the CrediAmigo program at the Banco do Nordeste do Brasil also plans to adopt the new interest rate ceilings. The Government has also approved new regulations allocating R $ l.1billionfrom FAT to Banco do Brasil and CEF to expand working capital credit for S M E S ,and has also approved ~ ~ measures to expand subsidized credit to the poor for the acquisition of construction material.84 4.155 Additionally, in the cooperative sector, recent measures include the easing of membership restrictions on new cooperativestopermit ((open"structures, with easier conversion to such structures in certain regions.85Efforts have also been made to put credit cooperatives and banks on the same regulatory footing interms of comparable structures for capital requirements, and to limit the preferential terms for use of special government programs such as the PRONAF. Other new measures include the creation of funds for projects in `special interest sectors' through funds constituted as special purpose vehicles or venture capital funds.86 Two types of mutual funds have been conceived; the Real Estate Investment Fundand the Credit Rights InvestmentFund.These new proposals have yet to be implementedandtheir final form i s unclear. 4.156 The most debatable in the series of new measures is the reservation of sight depositsfor the new micro-loans, and the terms and conditionsfor such new micro-finance loansfor the poor andfor small businesses, including especially the interest rate ceiling imposed on these loans. Additional reserves impose a de facto tax on the banking system, and mandatory microlending increases the potential for heightened credit risk. Additionally, interest rate ceilings imposed on such loans can crowd out normal micro-finance lending and will impact adversely on the micro-finance sector, especially, in combination with the proposed increase infunding costs to TJLP 8 percent for BNDES funding, for a1but the smallest loan sizes. Often such low- + interest rate programs fail to reach intended beneficiaries. The cost of such programs lies not only in the volumes of funds intended to be made available but also inthe interest rate differentials between these funds, and market rates, eventually borne by society. Moreover, considerable international experience has demonstrated that interest rate caps are unnecessary andmay leadto an inefficient use of such funds. 83CODEFAT (Deliberative Cuoncil of the Worker Protection Funds) Resolutions 331 and 332, allocating R$800m to BB and R$300m to CEF. 84CODEFAT Resolution 327 establishes arrangements for the provision of loans for construction, up to R$17,500 per loan, and a maximumterm of eight years (only for individuals). CMNResolution 3106 of June 25,2003. 86 Medida Provisdria Provisional MeasureNo. 122of June 25,2003. - 54 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.157 The governmentpoints out that the recent measures werepart of a widerpackagefor the banking system, which reduced implicit taxes.The new requirement to direct 2 percent of sight deposits towards micro-loans (or to keep them as unremunerated reserves at the Central Bank) was introducedin parallel with a recent overall reduction of 15 percent inreserve requirements. Hence intotal there i s a substantial net reduction. It i s also argued that the 2 percent interest rate cap, as well as low-cost funding, i s only applied to the smallest size loans and a distinction i s thus made between 'social' micro-credit, and 'normal' micro-credit. There i s an expectation that the bulk of micro-credit would continue at market determined terms and that 'social' micro-credit would only account for a small part of the market. Thus it was considered that Brazil's micro-credit sector overall would not be distortedby the new measures. Inaddition, at the time of their introduction, credit conditions were at their tightest in a period of several years, which was impacting particularly on small business. 4.158 Goingforward, it will be important to see how significant, in terms of scale, the new ((social"schemes will be and whether they do significantly affect the overall micro-credit market, or the risks andportfolio quality of the banking system. The Ministry of Financei s prepared to take the budgetary implications seriously and supports proposals for monitoring and assessment. Such programs need to be closely monitored in terms of cost, impact on clients as well as on participatingfinancial institutions, and outreach, with a view to their gradual phase-in to rates which are closer to market rates, and to the adoption of incentive compatible measures for commercial banks. E.TRANSFORMING KNOWLEDGE INTOPRODUCTIVITY THROUGHINNOVATION Background and Issues 4.159 Brazil has been a pioneer of Science and Technologypolicies in Latin America. The country has had an explicit federal science and technology (S&T) policy since the 1969 development plan, which proposeda National System of Scientific and Technological Development and an associated fund. Since then, Brazil has had a bewildering array of policies and subsidies, which taken overall have lacked stability and coherence. 4.160 Early investmentsgeneratedsome results in terms of building institutionsto support S&T objectives. Brazil has its own Ministry of Science andTechnology and a National Council on Science and Technology (CCT), aiming at defining S&T strategies and coordinating inter- government initiatives. It has established two strong federal institutions CNPq (Conselho Nacional de Pesquisas) and Finep (Financiadora de Estudos e Projetos) for promoting basic research, including post-graduate studies, and financing private-sector technology investment^.'^ CNPq directly administers several research institutes with international reputation among which CBPF (Centro Brasileiro de Pesquisas Fisicas) and IMPA (Instituto Nacional de Matemitica Pura e Aplicada). Successful research centers are attached to other ministries, such as Embrapa (Empresa Brasileira de Pesquisa Agropecuriria) and Inmetro (Instituto Nacional de Metrologia), *'CAPES(CoordenagBo de AperfeiEoamento de Pessoal de Nivel Superior), attached to the Mistry of Education, i s also responsible for improving the qualifications - mostly supporting post-graduate studies - of university professors. 55 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth an industrial technology institute maintainedby the Ministry of Development, Industry,and Trade (MDIC).@ State-owned companies also runresearch centers, such as PetrobrBs's Cenpes, while SENAI (Servigo Nacional da Inddstria) supports technology centers. 4.161 As a consequence, Brazil has been able to generate selective evidence of scientific and technological success. The number of active scientists andresearchers rose from 15 to 78 thousand between 1992 and 2000. The share of publications of Brazilian researchers increased from 0.6 percent to 1.4percent of the world total between 1990-2000, notably inmicrobiology (2.1 percent) and agricultural sciences (3.1 percent).89Brazilian scientists were the first to crack the genetic code of the Xylella bacteria that attacks orange trees and vines. A group of Brazilian scientists i s being funded by Brazil and the United States to unravel the genome of the bacterium spreading Pierce's disease. World-class technology programs have been developedin aeronautics (Embraer), satellites (CBERS), biotechnology (Genoma), tropical agriculture (Embrapa), and deep-water exploration (Petrobrgs). Petrobrhs, for example, held 55 patents in the US in 2001, while Embrapa accounted for one half of the total agricultural research spending throughout Latin America in 1996.90 4.162 Nevertheless, overall technological performance measures of private sector innovation are low. Most aggregate output measures of innovation indicate that Brazil i s in a low to intermediate position." Analysis by the World Bank92suggests that on U S patents and scientific publications, Brazil has historically under-performed similar economies by about 80 percent. It performs better in terms of technology absorption: private technology transfer surged inthe mid 1990s, and the technology transfer index of the World Economic Forum for 2003 ranks Brazil third among 56 non-core innovatorcountries, behindonly Malaysia andIndia. There is still scope for improvement: trade of capital goods i s low by international standards93and information and communication technologies (ICT) access i s also Even licensing agreements play more importantroles elsewhere: World Bank research shows only 2 percent of Brazilian firms would consider licensing operations from international sources among their three main sources of technology acquisition, versus 24 percent of Chinese firms.95 88 Besides federal institutions, Brazil has several state-level institutions, such as the IPT (Instituto de Pesquisa Tecnoldgico) and Fapesp inthe state of S6o Paulo. 89Ministerio da Ciencia e da Tecnologia (2002): Indicadores de Ciencia e Tecnologia. 90 Beintema, N.M. et al (2001) "Agricultural R&D in Brazil - Policy, Investments and Institutional Profile," Washington, DC: IFF'RI-Embrapa-Fontagro. 91For example, the technology index of Sachs and Vial (2002) ranks Brazil 49th ina group of 75 countries in2001, slightly better than China (52th) and India (66th) but worse than Chile (42th) and Singapore (18th). The innovative performance of Brazilian firms (measured by patents granted in the US) was outpaced by that of India and Singapore, countries with much fewer patents granted than Brazil 15 years ago. 92Latin America Region, Chief Economist's Office (2003), "Brazil InnovationBrief." 93See De Ferranti et a1(2003): "Closing the Gap inEducation and Technology". World Bank: Washington, DC. 94 In 2000, 4.4 percent of the Brazilian population had personal computers, against 5.0 percent in Mexico and Argentina, 8.2 percent in Chile, 23.7 percent inKorea and 58.5 percent inthe US. 95Investment Climate Survey Database, World Bank, 2003. 56 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Figure14 PatentsGrantedinthe US 250 - 200 - Singapore I / 150 - loo 50 - rc Br;. ~~ 4 India m 0 7 1987 1989 1991 1993 1995 1997 1999 ~ Source: USPTO. 4.163 Although federal funds for R&D have declined, low private-sector innovation levels are caused more by the low effectiveness of R&D expenditures than by a shortage of inputs. In 1998, Brazilian R&D spending was the largest inLatin America as a share of GDP and spending per researcher i s in line with income levels.96But federal R&D spending declined on average 3.1 percent per year between 1996 and 2002, while MCT expenditures on R&D have fallen 4.1 percent (Table 3). Brazil i s outperformed b y all countries inthe sample except China interms of R&Deffectiveness, measured by the ratio of U S patents to R&D expenditures. The share of universities' expenditures in total R&D inBrazil i s also large (Table 4). Table 3 BrazilianFederalDisbursementonR&D (1999 R$'000) 1996 1,088 2,525 1998 879 -17.0% 2 198 -9.6% 2002 820 -21.0% 2,050 -13.1% Source: SIAFI 96Information provided by MCT indicates the share of R&D expenditures in the GDP to be 1.05 percent. Depending on the methodology of calculation, the value may be closer to 0.7 percent. Both values are however lower than high growth East Asian countries. 57 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 4.164 Incentivesfor public R&D are misaligned in two main ways. First,cost-effective output-orientedresearch in not duly rewarded. Second, nor i s the transfer of public-sector generated knowledge to the private sector encouraged for commercial application. Seventy-five percent of the Brazilian R&D efforts are aimed at "general knowledge improvement" as opposed to any specific activity, an emphasis on basic research that i s much higher than that found in Mexico (4 percent) Spain (7 percent) or Portugal (25 percent), countries with arguably comparable cultural heritage. International evidence shows that if such spending i s not submitted to the appropriate incentive regime, university R&D will be ineffective inproducing productive applications. Public research institutes raise the same concern. Universities and government research centers combined for more than half R&D expenditures inBrazil in 2000.97Higher. education and public research centers have few incentives to address private-sector knowledge needs to the extent their public research budgets are earmarked. Indeed, the fact that Embrapa obtains a significant part of its research budget through competitive biddinghas been argued to be one important reason for its R&D effecti~eness.~~ Table 4 R&D Spendingand EfficiencyinBraziland SelectedCountries (Patents per million of R&D (% GDp) :::archer) (% total R&D) expenditure) Brazil 1.05 122,100 43.61 0.018 Source: Based on WDI data. 4.165 Brazil offers tax incentivesfor private R&D similar to those in developed countries (e.g., accelerated depreciation and carry-forward provisions). Tax-breaks to private R&D are provided by at least five different laws, amounting to R$1.8billion in 2003 (three times higher than in 1995), of which roughly 80 percent (R$1.5billion) are applied to IT industriesby law 97Red Iberoamericana de Ciencia y Tecnologia (RICyT) database. Available at www.ricyt.org/Indicators. 98See Beintema, N.M.et al. (2001): Agricultural R&D in Brazil - Policy, Investments and Institutional Profile. Washington,DC: IFPRI-Embrapa-Fontagro. 58 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 8,248/91. Sector concentration anddesign issues make the overall impact of these tax-breaks unclear on R&D costs. Since 2000, fourteen sector funds have been created totaling R$846 million.These sector funds have the objective of providing stable public R&D funds. They are disbursedby FINEP, mainly as grants, with diverse objectives, recipients, and duration." Disbursementshave been unstable and slow and the laws governing them generally create obstacles to their optimal use."' 4.166 Intellectual Property Rights are afurther source of low innovative output. Low private R&D investments may be due to low expected net private returns. IPRlaws inBrazilare still inadequate despite recent improvements (especially regarding licensingprocesses, simplifiedin 1993). INPIstill lacks appropriate humanand financial resources and delays are still an issue. 4.167 The Fundo Verde-Amarelo and the Infrastructure Fund have better defined objectives: respectively to improving cooperation between the private-sector and universities and to support modernization o f R&D infrastructure. These two funds are free of constraints on resource allocation by sector and use subsidized loans and risk-sharing instruments.'" 4.168 Overall Brazil lacks a clear technology and innovation policy. A coherent set of measures focused at a few well-defined objectives i s essential. A common vision i s necessary on how to translate public investment inknowledge into productivity and growth. An example of clear strategy and related success i s Embrapa, the coordinator of the Brazilian Agricultural System of Innovation: state agricultural extension companies, university institutes, other public research centers and the private sector.lo2 4.169 It is necessary to improve the definition of roles among different institutions and to coordinate with non-federal initiatives. The establishment of an executive committee for each sector fund to define strategy and resource allocation undermines a unified government innovation policy. FINEP- which i s currently financial institution and executing agency for the Sector Funds- needs a clearer role. The roles of Centro de Gestao e Estudos Estratkgicos (CGEE), the Conselho Nacional de Ciencia e Tecnologia (CCT), remains partially defined. Recent Achievements and Future Challenges 4.170 New initiatives in licensing and capital goods acquisition have encouraged technology absorption. Technology transfer deregulation started in 1991 and further steps were taken in 99 For example, through Curta-Convite Finep publicly invites firms to submit there projects together with universities or research centers. Funds goes to the public institutions and requires matching by the private sector which can be financed by Finep under its normal credit-lines. The Edital de InovaqBo aims at supporting the spill- over of firms and incubation activities by means of typical grants. Projects can last from 6 months to 4 years. looMost sector funds go to the industries where they are raised, an unnecessary rigidity. The laws also set regional targets for resource allocation, inconsistent with the economies o f scale and agglomeration inherent to R&D. Each fund has its own executive committee composed of government, private sector and university representatives. lo'A further instrument is support to technology-oriented companies through the Contec-Condiminum risk-sharing program of BNDESPAR (a subsidiary BNDES). See Beintema, N.M.et al. (2001): Agricultural RbD in Brazil - Policy, Investments and Institutional Profile. Washington,DC: IFPRI-Embrapa-Fontagro. 59 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 1993. The time for INPIto register contracts was shortened and several administrative procedures were waived, which partly explains the subsequent boom inroyalty payments. But several unnecessary requirements still induce delays.lo3 than nominal tariffs, access to More credit i s a constraint to importing capital goods. 4.171 The drafi Innovation Law should improve effectiveness of public R&D expenditures. Although modest in scope, the law clearly improves the incentive regime for more results- orientedpublic research and development inthe private sector. The new administration i s working on an improved proposal, based on a new round of consultations with civil society and the private sector. 4.172 Two sectorfunds -the Verde-Amarelo and the Infrastructure funds -provided for the creation of better targetedfunding and the reduction of the cost of private-sector R&D, through risk-sharing,a matching-grant mechanism, and) and a subsidized interest-rate mechanism.lo4In 2002, Venture Fora were held in Silo Paulo andFortaleza, leading to selected private venture operations. 4.173 The Government published theprinciples and objectives of its science and technology strategy in July 2002.lo5 The document however i s not yet to be transformed into an executable strategy to transform knowledge into productivity gains. InDecember 2002 an assessment of the impacts of tax-breaks on R&D was sent to Congress, suggesting a commitment to improving monitoring and evaluation of innovation policy in Brazil. The new administration has started to revitalized the CCT and also better defined the role of the CGEE. 4.174 Future challenges may be summarized infour dimensions: Easing technology absorption by: strengthening the diffusion of technical standards and norms; facilitating acquisition of imported and local capital goods; facilitating acquisition of computers and internet access; simplifying government licenses and authorizations for technology transfer agreements; and supporting technology extension services (for example the SENAITECS); Increase the effectiveness of public R&D by: improving incentives for productivity in public research institutes and universities; encouraging technology transfer from the public to the private sector through licensing by universities and public research centers to the private sector or facilitating entrepreneurship by public sector employees; and establishing incentive regimes for partnerships between public research institutes and the private sector; Foster private sector participation (in funding and expenditure) by: strengthening IPR enforcement; reviewing tax incentives and implicit subsidies to R&D; rationalizing management of the sector funds; emphasizing matching grants; supporting private research centers; reviewing public incentives for private funding of tertiary enrollment lo3 See FIAS (2001), "Brazil - Legal, Policy and AdministrativeBarriers to Investmentin Brazil." Volume I. FIAS- IFCNorldBank:WashingtonDC. lo4 PortariaMinisterial 5992002, PortariaMinisterial596/2002, andPortariaMinisterial 597/2002(all MCT). The Science,Technology, and Innovation"White Book" (Livro Branco: Cigncia Tecnologia e Inovapio). 60 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth and labor training; facilitating joint-venture for R&D and supporting venture capital funds; Define and implement a coherent federal technology and innovation policy by: strengthening policy-making and coordination capacities, enhancing the management of the CCT and creating a "Technology and Innovation" sub-committee within the CCT; improvingmonitoring and evaluation; and better defining the role of FINEP. Innovating in Environmental Markets Background and Issues 4.175 The Kyoto Protocol aims to reduceglobal greenhousegas emissions: it targets reductions in OECD and transition economies of 5.2 percent from 1990 levels by 2012. It also states that OECD countries will purchase part of the emission reduction commitment through trading mechanisms, namely (i) Joint Implementation, a trading mechanism between OECD countries andEconomies inTransition and (ii) the CleanDevelopment Mechanism (CDM), which sets up a "Certified Emission Reduction" trade between industrialized countries and developing countries. C D M transactions foresee that OECD countries can purchase "Certified Emission Reductions" (CERs) from projects in development countries to contribute to their reduction commitment. For the Kyoto Protocol to enter into force, 55 percent of countries representing 55 percent o f global emissions must ratify the treaty. It i s not expected that the Protocol enters into force before the end of 2004, due to Russia's undefined decision on its ratification. 4.176 The Clean DevelopmentMechanism (CDM) representsan opportunityfor Brazil: the first global environmental trading scheme, with the objective to reduce global greenhouse gas emissions. Brazil's private sector i s prepared to take advantage of this market,estimated as several billion dollars per year to development countries. The Brazilian Government has taken a leading role in the negotiation of the CDM, promotion and implementation are now needed to send positive signals to the investment community. RecentAchievementsand Future challenges 4.177 First experiencesdemonstratesthat CDMprojects can increase access to clean technology andpromote local environmental and social benefits. All C D Mprojects have to be approved by the Federal Government, ensuring that they contribute to sustainable development inthe host country, based on predefined sustainability criteria. 4.178 Latin America and Brazil have been among the mostproactivepursuers of the CDM trading opportunity.The private sector and civil society see carbon finance as a natural extension of their desire to attract FDIand technology transfer. Brazil was an early advocate of including the C D M within the Kyoto Protocol, and i s basing a significant part of its sustainable development strategy on the country's ability to attract external financing through the provision of global environmental services for biodiversity protection and climate change mitigation. The World Bank, through the Prototype Carbon Fund(PCF) and related carbon-finance vehicles, has played a leading role in the implementation of Kyoto and could be an important partner in developing Brazil's market overseas. Under development i s a project to use landfill gas for 61 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth power generation and improve sustainable waste management practices ("Nova Gerar" inRio de Janeiro State) and a number of cogeneration projects to use wood residues to generate power. Further potential has been identified inthe iron and steel, forestry, waste management, sugar cane, petrochemical, renewable energy, and transport sectors. 4.179 TheBrazilianprivate sector has shown interestin the CDM, which now needs a governmentresponse. Inmost developing countries, there i s a lack of capacity and interest form the private sector. Brazil i s the opposite: a large range of proposals and transactions are already being prepared. International and domestic investors have pressed the Government to be more proactive toward CDM. Inorder to trade Emission Reductions, the Government must declare that projects contribute to sustainable development. So far the Government neither has defined sustainable development nor endorsed projects. An Interministerial Commission for Climate Change chaired by the Minister for Science and Technology has been created, responsible for issues related to the Kyoto Protocol and the CDM, although further changes are needed to approve and monitor projects more efficiently. 4.180 Brazil has substantialopportunitiestoparticipatein carbon trading both before the Kyoto Protocol's ratification and afterwardsonce the Protocol is inforce. The current, pre- ratification market consists of two segments: . The voluntary market, consisting of carbon trades made b y governments and business who want to "learn by doing" inthe emissions market before it i s legally binding, or by f i r m s hoping that the carbon credits acquired through these early trades will be grandfathered and thus recognized as valid. For example, the U S Chicago Climate . Exchange voluntary market has specifically allowed trade with Brazil inits first phase of active trading. The European Union trading market, which sets up a carbon credits trading system among the EUmember countries based upon the greenhouse gas emissions allowances that the EUmember states agreed to in the Kyoto Protocol negotiations. The EUsystem will begin operation inJuly, 2005, whether the Kyoto Protocol i s in force b y then or not. A side agreement, currently under final stages of review, would allow (within limits) carbon credits generated indeveloping countries (through the Clean Development Mechanism) to count on an equal basis with emissions reductions made inEuropean countries. There i s every expectation that this agreement will be concluded; that C D M credits will be acceptable up to at least 400 million tons intotal carbon emissions to meet the EU'sneeds inthe 2005-2012 period; and that these credits will count against EU country emissions quotas even without Kyoto Protocol entry into force. 4.18 1 Next stepsfall intofive categories: (i) develop transparent sustainable development to criteria to provide orientation to project developers, (ii) to create a C D M authority, (iii) create to mechanisms to screen C D M projects and provide no-objection and approval letters to sponsors (mandatory under the Kyoto rules), (iv) to implement an outreach and investment promotion strategy, and (v) to prepare mechanisms for carbon crediting and the effective transfer of Certified Emission Reductions (CERs). 62 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth F.TRADE,TAXATION,LABOR, CONTRACTS AND Deepening Trade Integration 4.182 Brazil has repeatedly expressed the desire to deepen its trade links with the rest of the world. Brazil trades less as a percentage of GDP than almost any other country. This i s inpart explained by its continental size and its distance from major markets, but it i s also an outcome of historical policies andprocesses. Even controlling for the size of the economy, for example, Brazilian trade flows are low, although they have been increasing. Total trade in 2000 (imports and exports combined) was approximately 23 percent of GDP. In2001 this hadrisen to 27 percent, comparable with India, another fairly closed economy. By comparison, in China this statistic i s about 50 percent and in an export-based economy such as Malaysia it i s higher than 200 percent. 4.183 Simulationssuggest that trade reform would not only increase growth in Brazil, but that it wouldfavor thepoor. For example, a computable general equilibrium model suggests tariff uniformity within Mercosur would leadto a 1.4 percent increase in the income share of the poorest third of the population. A more reformist 50 percent tariff reduction by Mercosur coupled with bilateral10%reements with the FTAA andEUwould raise the income share of this a group by 4.4 percent. 4.184 Other than negotiated trade agreements, increasedtrade integration will occur through microeconomic reforms to remove non-tariff barriers to trade, such as inefficient customs, ports, and high freight costs within Brazil. Many of these reforms are part of the Government's Growth Program as described in Section IV of this document, and are covered by Bank technical assistance and financial support inthe proposed loan program. Reducing Tax Distortions 4.185 There is agreement in Brazil about the urgency of tax reform, andproposalsfor a limited tax reform are currently under considerationin Congress.Most meaningful proposals create clear winners and losers within the federal system, making consensus solutions hardto achieve. The system i s also highly complex, incorporating revenue sharing among federal, state, and municipal governments and many earmarked taxes. Brazil will also have to maintain high levels of taxation to generate the primary surpluses needed to reduce public debt. 4.186 Nonetheless,there is broad agreement on some elements of reform. The federal tax structure i s dominatedby two forms of distorting taxes that impose unnecessary costs on the economy: turnover taxes and payroll taxes. Turnover taxes account for roughly 30 percent of taxes (counting so-called contributions but excluding FGTS), including the PISRASEP and COFINS. The burden varies between enterprises depending on production structure, distorting relative prices, input mixes, industrial concentration, and decisions on whether to outsource businessactivities. Payroll taxes add to the cost of labor inthe formal sector, creating an lo6 World Bank (2003), "Brazil: Trade policies to improve efficiency, increase growth and reduce poverty," restricted report. 63 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth incentive to operate informally, with losses of scale economies and access to credit markets. Payroll taxes, including social security contributions, the salario educagdo, and payroll training levies (the various "S" taxes), account for slightly over 25 percent of federal revenue. 4.187 One option would be tophase out COFINS, PIS/PASEP, and perhaps the industrial products tax (IPI)and replace them with afederal valued-addedtax (VAT).This would provide a broad-based source of indirect tax revenues, while eliminating the distortions caused by cascading taxes. A VAT could also be made much more progressive than the current structure of indirect taxes. The risk that a federal VAT could raise aggregate VAT excessively could be mitigated by usingas broad a base as possible and supplementing with excise taxes on alcohol and tobacco. Alternatively, turnover taxes could be replaced by a broadened federal income tax. Deductions, many benefiting mostly higher income taxpayers, could also be reduced. 4.188 Taxation at the state level is a source of significant economic inefficiency. The ICMS, a VAT, accounts for 91percent of state tax revenues. Brazili s unique in assigning aVAT to sub- national governments. With 27 different VAT regimes, there are wide variations inrate structures, exemption policies, and administrative procedures, complicating compliance for firms with sales inmore than one state. The present proposal before Congress aims to simplify this. Butperhaps the most pernicious effect of the ICMS system will not be addressedby the present reform: the fiscal wars between states, which have damaged the states' main source of revenue. Moreover, the base of the tax has become concentrated on the relatively few goods and services for which administration i s most straightforward, particularly fuel, power, and telecommunications. Since these are businessinputs that many companies are unable to deduct fully from other tax liabilities, this reduces the competitiveness of Brazilian firms. 4.189 One option would be tofederalize the ICMS and create uniform rates and exemptions throughout Brazil, reducing compliance costs. Proceeds could be distributed among the states on a basis other than origin, reducing interstate tax wars and tax exporting. Another option would be to leave tax administration at the state level but impose uniform national rates and exemptions and a zero rate on interstate sales. Inprinciple this would reduce interstate tax exporting, but in practice it would create a strong incentive for fraud. Proposals to address this flaw through an interim federal tax on interstate sales may be difficult to implement. 4.190 I n the longer term, Brazilian tax reform should aim to move towards increasing direct taxation and decreasing indirect taxation. Brazil's present system of indirect taxation i s both price-distorting and quite regressive. Meanwhile, direct taxation accounts for a small part of the total: personal and corporate income taxes make up only 25 percent of federal revenue. Many at the top end of the income distribution avoid paying income tax altogether. Exemptions at the lower endtherefore mean that personal income tax inBrazil i s mainly paid by the middle classes. A logical tax reform would broaden the base of both direct andincome taxes while at the same time lowering many tax rates and decreasing evasion and avoidance. Strengthening Labor Markets 4.191 Brazil's labor market displays considerableflexibility in response to macroeconomic fluctuations: this i s reflectedin moderate (although rising) unemployment by international standards, highjob turnover, and relatively flexible labor-market adjustment through wages. This 64 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth flexibility in part follows from the high level of informality inBrazilian labor markets (workers operating without formal employment credentials and outside the protection of the labor code). Even among formal firms, the World Bank's recent Investment Climate Survey found that 23 percent of workers were informal. Flexibility also hides several other symptoms of microeconomic inefficiency, most notably low productivity andhighjob t~rnover."~The interaction of the labor justice system, the network of unions, heavy regulation of formal-sector benefits and severance payments, and low overall education levels, creates low productivity and sluggishformal-sector employment growth. Labor market outcomes are particularly damaging for the poor. 4.192 Recent Bank analysis of Brazilian labor market regulations, institutions, and outcomes has made strong recommendations: eliminating subsidies for labor turnover such as the tenure- based guarantee fund severance scheme (FGTS: Fundo de Garantia por Tempo de Serviqo), moving labor negotiations from labor courts to the workplace, reducing non-wage benefits while maintaining a moderate minimumwage, and eliminating overlaps in income security programs while at the same time increasingtheir coverage. These policies would align workers' incentives to raise productivity (and thus wages), price labor correctly to increase employment, and improve income security. Most fundamentally, current labor market regulations reduce employment. The Investment Climate Survey found that 66 percent of firms would add workers ifnot for hiringandfiring costs andthat these firms would addon average 39 percent of their workforce. Eighty percent of the firms who report that they would increase hires state that the principal reason for not doing so i s "laws and regulations regarding the firing of workers." 4.193 There may be important interactions between labor market institutions and innovation. Some simulations suggest labor market rigidities as the largest barrier to technology adoption and hence long run competitiveness."' Labor market rigidity may thus be as responsible for Brazil's low technology adoption rates as, say, trade policy or lack of absorptive capacity. 4.194 The Brazilian Government has launched stakeholder consultations with employer organizations and labor unions over how to reform labor institutions. Recommendations are not expected until later in 2004, and it remains to be seen how these will feed into proposals for reforms to institutions or laws, most importantly of the labor code (CLT: Consolidaqiio das Leis do Trabalho). It i s therefore too early to judge the prospects of significant reform progress inthis area at present. It should be added that this i s an area of considerable contentiousness and debate within Brazil. This loan does not directly support reforms in this area. 4.195 A well-designedproposal could create a growth dividend. Reforms to severance payments (such as making the FGTS fine payable to government and paying market rates on FGTS accounts) would raise productivity through firm-specific human capital and at the same time reduce litigation. Regionalminimumwages could reduce informality and increase social lo'The standard measure of job turnover comes from the Monthly Employment Survey (PME) interviews with presently unemployed workers and hence is biased upward. Alternative measures directly from transition data show lower turnover. Adjusting for the low education and youth of the Brazilian workforce in fact makes Brazilian job turnover look more in line with other developing economies. lo*Parente, S.L. and Prescott, E.C. (2000), Barriers to Riches, Walras-Pareto Lectures, vol. 3. Cambridge and London: MIT Press. 65 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth protection, while at the same time increasing employment. Freedom to create unions could be increased. Labor courts could be made swifter and fairer. And the reach of unemployment insurance, training, andjob-search assistance could be increased, increasing productivity through more efficient worker-firm matching. Improving Contract Enforcement 4.196 The Government is preparing the groundfor judicial reforms to try to reduce inefficiencies in contract enforcement comingfrom court delays and uncertainty over the basis of legal decisions. Despite exploratory analytical work,'o9 this i s an area where the Bank has not maintained an intense dialogue with the Brazilian Government to date. This loan does not directly support reforms inthis area, despite the fact that this area could be a crucial reform for increasing economic growth in the next few years."' Meanwhile, the Bank i s continuing to contribute in the form of a new study in what i s undoubtedly an important area. 5. THE POVERTY IMPACT OF SUSTAINABLE, EQUITABLE GROWTH 5.1 It is a valid question to ask whether the new economic growth program can be expected to have satisfactory impacts on poverty. The economic growth of the "miracle years" occurred against a backdrop of rising inequality and persistent poverty. Research suggests that this was at least in part owing to the capital intensity of that growth."' And despite poverty reductions inthe mid-nineties associated with the Real Plan, the poverty headcount had untilrecently remained flat since 1995. 5.2 There are reasons to be optimistic about thepoverty reducing effects of the new growth agenda in Brazil, however. These reasons come in three categories. First,there i s evidence that - despite being weak - the growth that has occurred since the Real Plan inBrazil has been "pro- poor" in the sense that the poor have shared proportionally in overall income growth. Second, there i s a close relation between renewed growth and the protection of recent accomplishments in Brazilian economic and social policy that are inthemselves highly pro-poor, namely the elimination of inflation and the improved targeting of social spending. Third comes evidence that the specific policies supported by the proposed program will be pro-poor. Ineach category there i s ample evidence, documented in the paragraphs below. lo9 "Judicial Performance andPrivateSector Development," World Bank, 2003, 110 See Castelar Pinheiro, A. (org.) (2000), "Judiciary and Economy in Brazil" (Judiciririo e Economia no Brasil), SBo Paulo:EditoraSumarC. `I1 Bacha, E. and R. Bonelli, "Accounting for Brazil's Growth Experience: 1940-2002," Rio de Janeiro: Casa das Garc;as.Also Pinheiro,A.C., I. Gill, L.ServCnandM.R.Thomas, "Brazilian EconomicGrowth, 1900-2000:Lessons andPolicy Implications," GlobalDevelopmentNetwork. 66 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth (i) TheDirect Effect of Growth on Poverty Reduction 5.3 Since 1980,poverty levels in Brazil have been drivenby economicgrowth, while inequality has remained constant.Work by the government think-tank PEA has decomposed variations in poverty since the late seventies into variations attributable to changes in the level of income versus variations attributable to changes in income distribution.lI2 Given Brazil's middle income status, there i s clearly huge potential to reduce poverty by income redistribution - a given fall in the poverty rate would cost Brazil a smaller fraction of GDP inredistribution than a poorer country. But until now this potential has remainedunexploitedinthe face of rigid government spending and social spending patterns that leave income distribution largely unaltered. 5.4 To the extentthatthesepatternspersist, the key to reducingpoverty in Brazil is re- ignitinggrowth. We do not want to rule out significant improvements inthe progressive distributive effects of social spending, and there i s reason to suppose that Brazilian social policies are getting more egalitarian (see subsection B below). At the same time it would be unwise to predicate Brazilian poverty reduction on social spending alone. 5.5 Moreover, economicgrowth itselfsince the Real Plan has been `$ro-poor", in the sense that the incomes of thepoor have risen at least asfast as the average. This may be relatedto the elimination of highinflation, which has been illustrated to have regressive distributive effects (as well as being bad for growth). One way to analyze the extent to which growth i s pro-poor i s to look at variation in growth rates between the Brazilian states, and to ask whether inequality rose faster inthose states that grew faster. Previous World Bank analysis used this approach to estimate that post Real-Plangrowth has not increasedinequality. Another way to put this i s to estimate (usingvariation across states) the elasticity of poverty to income growth. The same Bank report echoed other Brazilian research and predictions usingcross-country variation in finding that this elasticity has been approximately 1.O inpost Real-Plan Brazil. Moreover, the findings suggested that this elasticity hadrisen versus earlier periods. 5.6 Brazil's elasticityof poverty with respect to income growth suggeststhat onepercent of additionalgrowth would cut Brazil'spoverty rate by approximately0.3percentagepointsper year. This wouldrepresent slow progress, but almost certainly under-estimates the true importance of economic growth to poverty reduction inBrazil, givenits importance in safeguarding social programs (next section) and economic stability (below). (ii) Safeguarding Stability 5.7 Despitecurrent market optimism and the commitmentof government,macroeconomic stability, and therefore poverty, still depend onfactors external to Brazil. A serious downturn in emerging market credit conditions could still place the Brazilian economy under considerable strain. There remain at least three related sources of vulnerability, all of which a return to growth would alleviate: debt, interest rates, and external financing needs. `12Cited in "Brazilian Social Spending by Central Government: 2001 and 2002" (Gasto Social do Govern0 Central: 2001 e 2002), Secretariat of Economic Policy, Finance Ministry, Brasilia, November 2003. 67 Brazil: Proposed First Programmatic Loan for Sustainable and Equitable Growth 5.8 Brazil'spublic debt to GDP ratio, currentlyjust below 60percent, is high, although not outlandish by international comparison (OECD countries often have higher debt ratios, e.g., Italy and Belgiumboth above 100 percent, as do some middle-income countries, e.g., Turkey above 75 percent). But several factors combine to drive up base interest rates and therefore the cost to Brazil's Treasury of servicing this debt. One factor i s low growth itself: in debt sustainability calculations (undertaken by any lender to the sovereign in determining the price at which they are willing to lend), a higher growth rate makes borrowing more sustainable: a lower growth rate therefore implies higher borrowing costs. 5.9 A secondfactor behind Brazil'sfinancing costs is Brazil's high externalfinancing needs, basically the sum of the amortization of past external liabilities plusthe current account deficit. Annual amortizations are currently about US$40 billion; the current account closed 2003 insurplusfor the first time since 1992, from deficit levels above US$20 billion (more than 4 percent of GDP) in 1999-2001. External financing needs of the order of US$40 billion therefore make Brazil's currency vulnerable to the investor perceptions and external events that govern short-terminternational credit flows. Inrecent years Brazilhas issued up to a quarter of its public debt in (or indexed to) foreign currencies. But this i s only a short-term solution: foreign exchange-linked debt augurs future instability by forging a link between a weaker real and higher debt. For this reason, the Brazilian have recently taken advantage of present favorable market conditions to effect an aggressive reversal of debt management strategy, cutting the proportion of foreign-exchange linked debt issued from 38 percent in late 2002 to 22 percent inlate 2003. 5.10 A thirdfactor has been inflation. Residual concerns about inflation have ledBrazil to linkabout half its debt to the overnight inter-bank interest rate (SELIC), the rate usedby the Central Bank of Brazil to set monetary policy. In so doing, the Treasury essentially assumes the riskof higher future inflation andineffect guarantees the bondholder areal return. Here again lies a vicious circle: SELIC-linked debt reduces the Central Bank's anti-inflation credibility (since there are government liabilities contingent on raising rates) and thus has the perverse longer-term effect of raising real interest rates further. Figure 15 How Competitive Growth Affects Macroeconomic Stability for Brazil I Growth cuts Eases political / 68 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 5.11 Thisaccountmakes clear how productivity-ledgrowth (including more competitive exports)can break Brazil's macroeconomic vicious circles (see Figure 15). Broad-based growth i s an end in itself. But in Brazil's present circumstances, microeconomic reforms for productivity-led growth bring additional macroeconomic benefits: 0 Higher income growth will lower the debt ratio directly, thereby lowering Brazil's cost of borrowing, and thus its public-sectorborrowing requirement; 0 figher future growth will further lower financing costs by improving debt sustainability; 0 More competitive exports will help to cover external financing needs, reducing exchange rate risk and the need for issuingdollar-linked debt; 0 Growth through productivity i s non-inflationary, and will improve the credibility of the BCB's inflation targeting regime - not only directly by reducing political pressures for monetary expansion, but also indirectly by reducing the need for SELIC-linked debt - thereby lowering real interest rates. 0 Politically, higher growth will increase investor confidence incontinuing strong economic management. (iii)Protecting Social Spending Programs 5.12 Alongside economicreforms, socialprograms have made significant strides. The improvements in social programs provide further reason to believe that higher economic growth will be reflected infalling poverty, since these programs will be protected politically and nourishedeconomically by higher growth rates. 5.13 Both educationand health indicatorsimproved dramatically in Brazil in the nineties. Primary enrollment has become near-universal and infant mortality rates have nearly halved in many areas. Ineducation, the percentage of 7 to 14 year-olds in school rose from 81 to 97 percent between 1991 and 2000 although school quality remains an issue (one achievement has been the introduction of standardized tests). A challenge i s now to provide secondary school places for the increasing numbers of pupils coming through the system, many from less privileged backgrounds than inthe past. Inhealth, infant mortality per thousand live birthsfell from nearly 48 to less than 30 duringthe same period, while life expectancy at birthincreased from 65.6 to 68.1 years. Such progress has been equaled b y few countries. Against a backdrop of weak income growth, most of this progress i s owing to changes in public p01icy:"~ineducation, strong federal initiatives guaranteeing funding per child (Fundescola and Fundef); inhealth, the successful combination of the universalization of services (SUS) with focused programs (such as the Programa de Atendimento Bisico and the Aids Program). Inboth cases, a key strategy has been to combine federal instruments with decentralized execution and community participation. 5.14 Theseaccomplishmentsare impressive,but have limited short-term impact onpoverty rates as measured by income. These rates have remainedrelatively stable since the one-off gains '13 SeeBrazil Policy Notes Overview for a discussion of this. Also World Bank, 2001, The Quality of Growth documents how social and other outcomes may diverge considerably for a given economic rate of growth. 69 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth that came from eliminating inflation (Figure 16). Inresponse, the previous administration started to experiment with new forms of social assistance, most notably conditional cash transfers such as the Bolsa Escola and Bolsa Alimentaqiio, which make payments to families below a threshold income level contingent on certain actions (school-age children attending school inthe case of Bolsa Escola, following health andnutritional programs inthe case of Bolsa Alimentaqiio). 5.15 I t is too early to estimate with confidence the effect of theseprograms on income poverty (data arejust now appearing for 2002 and are not yet available for 2003). Initial work does suggests that the federal Bolsa Escola program has had positive effects on school attendance. And preliminary data suggest that despite sluggish growth, poverty actually fell in 2002 (from 33.6 percent to 32.9 percent as measured by the government research institutePEA), with PEA'Sheadcount ratio measure of those inextreme poverty falling even faster, by nearly 9 percent (from 14.6 percent to 13.4 percent). Figure16 PovertyHeadcount(percent,WorldBank measure),1992-2001 By Metropolitan/Urban/Rural Total 5.16 The new government is now building on Brazil's system of socialprograms with its own approach. The government has introducedone income transfer that has to be usedfor food purchases (the cartilo alimentaqilo under the Zero Hunger Program), promoted civil-society and private-sector participation through the Zero Hunger Program, and i s now finishingthe design of an initiative that aims to increase youth employment (Primeiro Emprego or "First Empl~yment")."~Most importantly, the government has reacted to criticism that Brazil's many income transfers are too dispersed and that greater impact could be had with improved coordination of transfers at the family level, by proposing the unification o f all these programs (e.g., Bolsa Escola, Bolsa Alimentaqilo, Cartilo Alimentaqilo, and Vale Gh) into a single "Family Grant" (Bolsa Familia) with improved targeting. By protecting this progresseconomic growth can be expected to be even more pro-poor than inthe past. `14Poverty has taken on a younger, more urban profile recently, rising from 36.6 percent in 1998 to 39.0 percent in 2001 in households headed by someone 24 or younger (while poverty fell among older households). This has resulted in pressing problems of violence in the larger cities, which provide a further imperative to create employment and opportunities through renewed economic growth. 70 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth (iv) Economic Growth: Quantity and Quality? 5.17 Finally, the actionsproposed in the government'sgrowthprogram will have specific pro-poor effects. Increasinginfrastructure access has been found to be one of the most pro-poor growth effects in Brazil, and this i s one of the main areas of focus o f the program. Access to financial services i s also being expanded to the poorer segments o f society. 5.18 Apartfrom directgrowth effects, infrastructure expansion has many directpoverty reduction effects. To use transportation as one example, recent Bank analysis inLatin America and the Caribbean has found that improved transportation can decrease traffic-related health problems, increase access to health care, increase participation in and access to education, and promote S M E development. To use information and communications technology (ICT) as another example, such technology bringsnews, information, culture, and entertainment to populations without previous access, help populations gather information about markets and prices, allowing them to get cheaper goods, and have improved access to better education through distance learning and other tools. ICT may also give the poor greater voice to ask for government services or reform, while allowing government itself to accelerate its proce~ses."~ 5.19 Thegovernmentgrowthprogram also containsspecific measures to increase the access of thepoor tofinancial instruments. The most important of these to date have been the simplification of procedures to open bank accounts, the offering of basic accounts, the offering of loans through payroll deductions, and the founding of new financial institutions dedicated to micro-credit. 5.20 Finally, part of the government growthprogram aims to improve theprocedures leading to environmental licensing of business activities. Apart from reducing redtape, it i s expected that better procedures will also leadto a better reflection of environmental costs inthe licenses granted b y public-sector entities. Since the poor often suffer the most serious consequences of environmental degradation (e.g., through exposure to polluted water sources), any improvement inthe effectiveness of Brazilian environmental licensing can be expected to have highly pro-poor effects. 5.21 There is therefore strong reason to suppose that renewedgrowth would benefit the poor in Brazil. The reforms of recent years, the commitment of the present government, and the microeconomic growth agenda being proposedall point to strong potential poverty reduction in the next few years. This i s not simply wishful thinking: some dividends are already being seen from Brazilian governments' serious approach to social policy and economic management. With this inmind,the next section turns to examine the specifics of the Brazilian Government's move beyond first generation economic reforms to a second generation microeconomic agenda for new growth through investment and productivity. l5Fay, M.(2002), "Linkages between Infrastructure and Poverty Alleviation in Latin America and the Caribbean," World Bank internal memorandum. 71 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 6. THE PROPOSEDLOANAND PROGRAM A. THEPROGIZAMMATIC FRAMEWORK, DESIGN,AND POSSIBLEFUTURE LOAN LOANS (i) The Programmatic Framework 6.1 Theproposed loanforms part of aprogram that encompasses an ambitious set of reforms, addressing an integratedand technically coherent set of microeconomic measures and institutional reforms (the Growth Program) that arejudged both necessary and sufficient to foster economic growth and reduce poverty, while protecting sound macroeconomic policies and avoiding increasing social tensions. Moreover, this loan program i sjustified by the strong overall performance o f the Brazilian administration, as described earlier in this document: strong macroeconomic management, development of participatory democratic institutions, innovative social programs, and commitment to microeconomic reforms for growth. 6.2 The Growth Program initially comprisesfour areas to be developed over the next three years, namely: (i) logistics, (ii) business environment, (iii) financial efficiency and depth, and (iv) innovation. The successful implementation of this program i s not only desirable initself for higher growth, but will also reinforce the government's adherence to sound macroeconomic policies, which itself has incurred non-negligible political costs, and increase resources for poverty reducing social programs. As discussed in Section4-A, the Growth Program as defined above forms a subset of a broader growth agenda, which includes other microeconomic reform areas important for growth (e.g., trade, taxation, labor markets, contract enforcement), which are the subject of Government consultation and policy development, but which are excluded from the present loan. 6.3 Scenarios are described belowfor the second and third loans in theprogram. Long term goals have been identified in all four areas, with an impliedpath of reforms over time. Reform progress i s not expected to occur at uniform speed across components, indeedthis would be unrealistic given their ambition and scope. The Bank would thus support subsets of this reform agenda as the Government progresses in one or more area. The first loan i s based on key prior actions in all four areas. The two main scenarios for subsequent loans are described below insubsection (iii). 6.4 Theprogram supports a balancedset of structural legal and institutional measures. A feature of the growth agenda i s that it consists not only of passing laws (or constitutional amendments, etc.), but also of (a) defining approaches to public-private interactions, (b) strengthening the institutional capacity of agencies to plan and regulate, and (c) enforcing laws and regulations consistently and predictably. This necessitates the exercise ofjudgment in definingthe triggers of loan operations appropriately. There i s a trade-off betweeninsisting on "observables" such as laws or the formation of agencies, and "less tangible" measures such as the definition of an approach ina Government White Paper or the adoption of hiring norms in an agency, which taken together may be more important for economic growth than laws strictu sensu. The present loan contains a balance between these two types of action. The importance of the second type - or the government effort involved - should not be underestimated. 12 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 6.5 Brazil's legislativeprocess dictates aflexible programmaticapproach.Laws and constitutional amendments must pass two stages of voting ineach House of the Legislative Branch, implying uncertainty over the speed of passage of each reform. This also means that the Government does not fully control the pace of reforms. Given the number of fronts contained in Brazil's growth agenda, this imposes a flexible programmatic approach. For the present loan, the passage into law of a few key laws (e.g., Article 192, the formation of the two transport regulators, and the ratification of the Kyoto Protocol) defines prior actions, while for other laws their improvement through redrafting, government sponsorship inthe legislature, or passing in the Lower House (e.g., Bankruptcy Law, Innovation Law, Antitrust) have been included as important achievements, with actual passage of the laws reserved for future operations. (ii) Design of the Proposed First Loan 6.6 Thefirst loan supports Brazil's overalldevelopmentpolicy as assessedin the recent CountryAssistance Strategy. l6The proposed loan will support a series of prior microeconomic measures and institutional reforms undertaken by the Government. The actions supported by the loan fit into the four components already outlined: (i) reducing logistics costs, encompassing multi-modal transport planning, customs, ports, androads; (ii) improving the business environment, including infrastructure regulation, competition policy, barriers to entry, and the framework for corporate insolvency and creditor rights; (iii) enhancing financial system efficiency and depth (including long-term credit, insurance, and venture capital), and (iv) improving Brazil's capacity to transform knowledge into productivity gains (through the innovation system). MacroeconomicManagementand Definition of the Overall GrowthProgram 6.7 Macroeconomicmanagementhas been exemplary.Brazil remains in good standing with the IMF,which recently improved a 15 month extension to Brazil's Stand-By Arrangement. Fiscal surplus targets have been met, inflation continues to fall, external balance has been restored, and debt ratios are falling. 6.8 The Governmenthas also taken key actionsto define and to begin to implementa comprehensive cross-cuttingGrowth Program: Two Government White Papers were issued on the Development Agenda and the Growth Program; Institutions for the implementation of the Growth Program have been revitalized or created (the Economic Policy Committee, Infrastructure Committee, National Council of Science andTechnology, and the Working Group on Capital market^)."^ `16World Bank, Country Assistance Strategy 2003-2007 for the Federative Republic of Brazil: Report No. 27043- BR, November 10,2003. '''OriginalPortuguese: CBmara de Politica EconBmica, CBmara de Infra-Estrutura, Conselho Nacional de CiCncia e Tecnologia, Grupo de Trabalho do Mercado de Capitais. 73 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 6.9 The following sections outline - for each of the four pillars - the main prior actions the Bank supports inthe present operation, important triggers for future operations, and monitorable indicators of progress towards long-term goals relatedto economic growth. Reducing Logistics Costs 6.10 Increase effectiveness ofcustoms: The objective i s to reduce time delays inBrazil's customs and related costs to shippers, which affect the productivity and competitiveness of Brazilian.firms. The Government has approved a strategy to modernize and reform customs. Other actions taken so far are (a) the installation of computer-based customs clearance systems'18; (b) the establishment of inland bondedwarehouses; (c) the agreement within Mercosul for joint customs operations. The implementation of the reform, including the streamlining of clearance procedures, the updating and integration of information and control system, and the revision of staff performance evaluation system and development program are key challenges for the future. The main monitorable indicators of success are gross release times for imports and exports. In 2003, these are 5 days and 2.0 days respectively: these could be expected to fall to 3 days and 1.O days respectively over program duration. 6.11 Reduce port costs and delays. The objective i s to bringcost and transit times closer to international levels. The actions taken to date include (a) concessioning of port terminal operation, and opening of private ports for public use; (b) withdrawal of public dock companies from terminal operation and related staff adjustment; (c) the delegation of five ports to states and municipalities; and (d) deregulation of coastal shipping. The main future challenge i s to increase labor productivity in the ports. The main indicators of progress are average cargo transit times through ports, which are today 13.8 days for imports and 8.4 days for exports. Release times could fall to 10 days for imports and 5 days for exports by the end of the program. 6.12 Reduce road transport costs. The objective i s to improve the condition of the paved federal road network, so as to decrease road transport costs through: improved network maintenance management, further decentralization, and increased private-sector participation. The main actions to date include: (a) the legal restructuring of the federal transport administration through the establishment of DNIT, ANTT and reorganization of the Transport Ministry; (b) the transfer of about 9 percent of the remaining network to the states; (c) the concession and tolling o f about 8 percent of the remaining network; and (d) the use of output- based contracts on about 15 percent of the remaining network. The main next steps include: (a) the strengthening of the management capacity of DNIT; (b) the continuation of the decentralization and private-sector involvement programs, with the objective o f reaching, by the end of the program (i) 25 percent o f the remaining network decentralized, (ii) additional 5 an percent under concession, and (iii) 30 percent under output-based contracts. 6.13 Improving multimodal efficiency: A key objective i s to increase the market share of the more efficient multimodal transport alternative over road transport. Achievements to date include: (i) creation o f the National Council for Integration of Transport Policies (ii) resolution of cross-ownership issues inrailway operators, and the preparation of a geographical restructuring of railway concessions inthe South-East; and (iii) drafting of improvedrailway 11*Siscomex, Redex, andRadar. 74 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth regulations. These are expected to leadto an increase inrailways competitiveness and market share. Next steps include the definition of respective responsibilities, and liabilities, of multimodal transport operators with respect to individual carriers, the adoption of a unified bill of lading, and the establishment of effective conflict resolution mechanisms for multimodal operators. The main monitorable indicator of success inthis area i s the share of non-road transportation, which could be expected to increase by 10 percent within the horizon of the program. Improve the Business Environment 6.14 Improve the regulation of infrastructure. The overall objective i s strengthened independent regulatory institutions to give investors greater clarity and certainty when making risk-taking decisions. Key actions here have been (a) the creation of two new regulatory agencies (ANTT and ANTAQ); (b) the publication of the Government White Paper on Regulation; (c) the creation through a Medida Provisdria of a professionalregulator cadre within the civil service; (d) improvements to the functioning of electricity wholesale markets including the settlement of the backlog intransaction settlements and the establishment of public auctions for distributors' purchases from generators and initiation of the tariff review process for distributors; and (e) the establishment of a PPP unit within the Planning Ministry and the submission of the PPP law to Congress. Future steps are the passing into law of the regulator cadre, the passing of the PPP law, and the establishment of clear regulatory models in all the infrastructure sectors, particularly energy, water, and telecom. The indicator of progress i s total infrastructure investment, although given fiscal constraints total private investments ininfrastructure sectors will be an equally important variable to track. 6.15 Improve Antitrust enforcement. Here the aim i s to increase domestic competition through more effective enforcement of antitrust law and enhanced institutional capacity and division of responsibilities between the main three government entities involved: CADE, SDE (Ministry of Justice), and SEAE (Ministry of Finance). The main achievement to date has been the preparation of amendments to the anti-trust law by an inter-ministerial commission composed by the three bodies involved with antitrust enforcement inBrazil. The future submission and approval of this amendment by Congress i s a key future challenge, combined with the strengthening of the cadre of antitrust regulator within the Government. Measures of progress are the number of "hard core" cartel prosecutions and the adoption of pre-merger notification to control mergers. 6.16 Increase competitionby reducingadministrativecosts to businesses. The objective here i s to simplify procedures and certain taxes, especially for SMEs. Main actions to date are (a) the establishment of the Simples tax registration system for SMEs; (b) the extension of the legislationto the so-called Supersimples law currently in the legislature; (c) elements of the tax reform that will simplify the administrative burden on firms of cascading taxes such as the ICMS, and PISPASEP system, and (d) simplification of the procedures for environmental licensing. The main future challenge lies in achieving a simplification of administrative procedures such as company registration and related procedures across federal, state, and municipal authorities. To complement the passing of the Supersimples law, which should occur soon, the Federal Government could initiate reforms with key states and municipalities to simplify procedures inkey areas. Inpilot municipalities, main indicators for reduction intime 75 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth and cost of procedures should be targeted, such as a halving of the number of days it takes to start a business, currently estimated as greater than 150 days. 6.17 Zmprove corporate insolvency resolution. Insolvency procedures are currently inefficient and inflexible, wholly ineffective at maximizing asset values, protecting creditor rights in liquidation, or salvaging viable distressed businesses. Moreover, the present framework i s a significant disincentive to the expansion of credit, and contributes to Brazil's high spreads. The passing by the Lower House of the new bankruptcy law and the associated amendment to the tax code (governing tax succession) represent the most important reform supported by the proposed loan. Inthe near term the challenge i s to pass the law through the Senate (there i s the possibility that the law will be marginally improved at this second legislative stage). Once passed, the key challenge will be to develop successful application of the spirit of the new law through precedents in case law, which occurs at the state level. Monitorable indicators are the average speed of resolution of bankruptcy cases, the recovery value of firms that file under the new law, and reduced spreads in financial intermediation. Any improvement of these indicators over current values will be a significant achievement. Enhance the Efficiency and Depth of the Financial System 6.18 Fundamental enabling legislation and systemic risk controlfor thefinancial system. A key step forward, which removed an impediment to modern legislation over the banking sector, was the passing of the Amendment to Article 192 of the Constitution. This now allows the banking sector to be governed by multiple laws, and opens the way for other legislation governing key financial institutions and infrastructure, as well as basic laws pertaining to different segments of the financial system. The strengthening of the physical infrastructure of the financial system against systemic risk through the successful installation of the new large value payments system i s also a major achievement. Going forward, the evaluation of residual risks in the payments system and the launching of a second phase of payments system reform, this time for retail and small value payments, i s an important item on the reform agenda. 6.19 Increased Competition through ZmprovedAntitrust Regulation of the Banking Sector. Regular competition policy and antitrust law will, under legal reforms currently before Congress, be extendedto the banking sector subject to initialconsideration by the Central Bank, to determine systemic impact in the case of merger relatedissues. This reform will open the way to increased competition infinancial services inBrazil, but will also create the need for the reinforcement of technical capacity within the competition enforcement agencies, which today lack training and expertise in issues specific to the financial sector. The key next step i s thus the passing of the legislation, while medium-term challenge are the strengthening of staff within the competition agencies. One indicator of progress will be the examination of market conduct issues inthe banking authority; market power indicators for certain financial product segments could also be tracked. Bank administrative costs should fall by 100basis points by 2006. 6.20 Mobilize long-term capital through strengthened marketsfor risk and stronger institutional investors in the insurance sector. With recent rapidgrowth and significant regulatory improvements on asset allocation, eligibility, registration, custody, and audit requirements, the insurance sector represents an opportunity to mobilize long-term saving in Brazil. Specific achievements anticipated include strengthened solvency requirements, 76 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth supervision, and disclosure. Inthe medium term, one of the most important reforms in the sector will be removing the reinsurance monopoly held by the IRB. 6.21 Improved Access to Financial Services. Some of Brazil's recent reforms follow best practices adopted elsewhere, notably with regardto simplification of procedures to open bank accounts, the offering of basic accounts, and the offering of loans through payroll deductions. In parallel, financial institutions dedicated to micro-credit have been established (Banco Popular, a subsidiary of Banco do Brasil). There has also been an easing of establishment requirements for financial cooperatives. Inparallel, a number of additional steps have been taken to expand micro- finance which include the earmarking of resources for the poor and for small enterprises, mostly on concessional terms. An important future step for the sound development of micro-finance and financial access would be the evaluation of the costs to the Government and the financial system of these recently introduced programs, as well as their impact on participating institutions (banks and micro-finance institutions) and their intendedbeneficiaries. There are other measures which could support the sound expansion of access, including further reinforcement of creditor rights through the establishment of small claims courts for creditors, and a strengthening of the physical infrastructure for credit registries. Inthe medium term, private credit to Sh4Es would be easedby the passage of the pending factoring law, enhanced use of positive information for credit registries, and a review of tax write-offs for uncollected small claims, to reduce such write -offs and hence protect incentives for collection. The number of bank account holders should increase by 8 million by 2006. Increasing innovation capacity to transform knowledge intoproductivity gains 6.22 Increase the effectiveness of public R&D. The most important future reform should come with the passing of the new Innovation Law by Congress, which increases the scope for public sector researchers to benefit from their own inventions. This law should also increase the number of technology transfer contracts between public and private entities, for which a reasonable target would be a 20 percent increase. 6.23 Improve the incentiveregimeforprivate R&D. Here one objective i s to increase the return to risk-taking through profitable innovation activities by speeding up the granting of patents and licenses. The main action to date i s the development within the Ministry of Development, Industry and Trade (MDIC) of a proposal for refocusing the activities of INPIon granting and enforcing patents. Private research may also be encouraged by better links between the private sector, public universities andresearch institutes, which will come from a more efficient and transparent system of public R&D grants. Actions to date have been the creation of competitive grant funding under the Fundo Verde-Amarelo. Here a monitorable indicator i s the share of private in total R&D, which could increase by ten percentage points. (iii) Possible Future Loans 6.24 Subject to reform progress, twofurther loans are imagined within thepresent CAS period. Future loans will be based on the key next steps outlined in the previous paragraphs and summarized succinctly in the third and fourth columns of the Bank Matrix inAnnex 2. The next loan will be enabled when the key next steps (triggers) in one or several program areas have been met, and at the same time a critical mass of reform measures from the broader matrix have been 77 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth achieved, such that there i s sufficient confidence in substantial progress towards the development outcomes interms of equitable and sustainable growth. Scenario I Uneven Reform Progress across Pillars (viewed as most likely) - 6.25 The second loan in the series, based on a reasonable estimate of the most likely reform scenario in the comingyear or so, would be primarily based onprogress in the areas of the business environment andfinancial sector reforms, with critical mass coming mostlyfrom the other twopillars. Within the business environment, triggers would be the passing into law of measures that have been launched, most notably the PPP law, the bankruptcy law, and the amendment to the national tax code. A career development plan for regulators would also have passedinto law. The amendment of Article 192 of the Constitution opens up the possibility of significant alterations to financial sector regulation becoming triggers. Inlogistics, critical mass next steps would be further progress incustoms reforms cutting average net release time by 20 percent, the application of output based contracts for the maintenance and rehabilitation of about 30 percent of the federal roadnetwork, and the approximate doubling of the proportion of non- trunk federal highways to state management. 6.26 The third loan would shifl focus to the innovation system. Here the enactment of the new Innovation Law would be a trigger, encouraging greater private innovation and interaction between public-sector research and private-sector development. Similarly, improvements to the sector funds would make their allocation transparent and competitive, and markets incarbon trading could by this stage be functioning on a sustainable basis. Triggers would also come within logistics, where customs clearance systems would have been modernized, port authorities restructured, and the road network classification law approved. These reforms would accompany quantitative targets: customs selectivity levels cut to 20 percent and a further 10percent of federal roads under concession. Over this longer time horizon, critical mass progress would be envisaged inthe financial sector, including the application of antitrust law to banking, the breaking of the reinsurance monopoly by allowing new entrants, and improvements to the laws expanding financial access to the poor and to SMEs. Critical mass inthe business environment would include the present proposed improvements to antitrust law having been passed, andthe final approval of the "Supersimples" proposal. Scenario 11- More Uniform but Slower Progress 6.27 A second scenario would see slowerprogress in thefinancial sector and the business environment compensatedfor byfaster progress in logistics and innovation, andpossibly with key measures coming in new areas, such as trade integration or taxation. Inthe absence of significant alterations to financial sector regulation becoming triggers, progress on either the restructuring of the Sector Funds or the Innovation Law would be trigger actions for which the second loan may wait. The thirdloan would then depend on balanced progress across the pillars of the program. The final set of achievements would be approximately the same as in Scenario I, with the order of triggers through time reflecting more uniform progress. Figure 16 provides a schematic illustration of the two scenarios. 78 - --- ------ Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Figure 16 Scenario IShows Faster InitialProgress on the BusinessEnvironment and the Financial Sector.. . Scenario I1Shows Slower More Balanced Progress and the Introduction of New ReformAreas inLoan 3 --I ' , I Loan 1 2 3 2 3 Logistics I Business En\,ironment I... FinancialSector Innovation Sew Reform .Area I Primary focus or triggers Secondary focus or critical mass (iv) Goals and Expected Outcomes 6.28 The overarching goal is a sustained increase in economicgrowth based on higher investment andproductivity gains, and leading to at least aproportionate rise in the income of thepoor. However, where possible we have also defined monitorable intermediate indicators for the main categories of reform included in the first loan. These are given inthe fifth column of the table inAnnex 2. 6.29 I n logistics, the main targets would be deep cuts inthe through times incustoms and ports (see Annex 5), 50 percent of the main network in good condition, 5 percent decrease in average road costs on the federal network, a 10 percent decrease incontainer handling costs, as well as a 10percent increase inthe share of non-road transport services. Within the business environment, an important target i s to halve the average time taken to register a new business. The number of successful cartelprosecutions would also provide an indication of progress in improving antitrust capacity. The main measures of success infinancial reforms will be falling intermediation spreads (as opposed to base interest rates, which depend primarily on macroeconomic conditions, most notably inflation). I n innovation, the number of technology transfer contracts between public-sector university and the private sector could increase substantially: 20 percent would be a reasonable target. Privately funded R&D should increase as a share of the total: 10percent would represent good progress. And under the Clean Development Mechanism, Brazil could target sale of 20 million tons o f carbon dioxide by 2008, which assuming an average price of US$5 per ton over the period would imply US$lOO million insales. 6.30 Most importantly, concertedprogress in the reform program as defined could be expectedto have a significant impact on Brazil's economic growth rate through reduced private sector costs (inlogistics), increased productivity (through competition and entry), increased infrastructureinvestment (via regulation), decreased spreads and increased financial intermediation, and increased productivity through knowledge and innovation. Economic science i s not precise enough to give reliable estimates of the quantitative effects of reforms, but as an indication, sustained average growth of 4 percent per annum would be expected to make significant inroads into Brazil's poverty headcount. Using a poverty line of about R$120 per month per capita income (at which Brazil's poverty rate i s just over 30 percent), World Bank 79 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth parameter estimates suggest that sustained 4 percent GDP growth could reduce the poverty headcount ratio b yjust under one percent per year. Sustained growth at or above 4 percent per year (with at least similar growth inthe incomes o f the poor) would therefore be viewed as a considerable success. Similarly, sustained equitable growth in the range of 3-4 percent could be viewed as moderate success. 6.31 Economic growth through the measures proposed by theprogram is expected to be sustainable since it would be based on three key principles: .. . Protecting fiscal responsibility and low inflation, both key to sustaining growth rates in the long run; Avoiding vertical industrial policy, which inthe longrunchannels resources to less productive uses; Improvingthe efficiency of use of Brazil's natural resource base, through improved environmental licensing and innovative use of environmental markets, such as carbon trading. 6.32 As explained in Section4, the growthprogram is not expected to increase inequality, and should reinforce the recent tendency of slight decreases inBrazilian inequality, owing to five other key principles: .. Continuing post-Real Plan patterns of low-inflation growth which have on average generated income growth to the poor at rates proportionate to average income growth; ... Avoiding capital subsidies (which favor capital, and therefore the non-poor, over labor, the main asset held by the poor); Avoiding protectionism (trade protection also favors capital over labor and reduces the poverty impact of any ensuing economic growth); Channeling further resources to successful social programs; Increasingfinancial access to poor households and SMEs. B. LINKSWITHTHE CAS, BANKACTIVITIES, AND PARTNERPROGRAMS 6.33 The CountryAssistance Strategy discussed by the Board on Dee. 9,2003, proposes Bank supporttowardsa more equitable, sustainable,and competitiveBrazil, built upon a foundation of good governanceand macroeconomicstability (Figure 17).The proposed loan program forms a key part of this strategy. The main objective of the loan i s to support the establishment of the microeconomic foundations o f sustainable and equitable economic growth inBrazil. It pursues a more competitive Brazilthrough reducedlogistics andfinancial costs, increased investment through better regulation, competition, business andfinancial services, and increased productivity through innovation. Other programmatic loan series are either ongoing or envisaged, so that each pillar of the CAS will be supported by one programmatic loan series. 6.34 Theloan also lends support to the sustainability and equitypillars of the CAS. The loan program strengthens natural-resource management through strengthened environmental licensing 80 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth services, and through innovative market development initiatives such as the Clean Development Mechanism and carbon trading under the Kyoto protocol. In addition, the program pursues more equitable growth through measures to ensure access of the poor to financial services (outlined in Section 4-D). Also relevant for improved equity, Section IV above describes in detail how the program can be expected to contribute to a pro-poor pattern of growth, owing to structural changes inthe Brazilian economy since the Real Plan, improved social policies, and specific measures containedin the program such as increased access to infrastructure services. Figure 17 The Framework of the New CAS - Better water quality and water resource management SUSTAINABLE - Sound- More FOUNDATIONS macroeconomic management and fiscal reforms efficient public sector management - Good govemance 6.35 Finally, renewed economic growth will alsofurther thefoundations laid out in the CAS of sound macroeconomic management andfiscal balance. Notwithstanding Brazil's macroeconomic reforms inthe past decade, economic stabilization i s still threatened by weak growth. As describes in Section IV, there remain three sources of vulnerability - debt, interest rates, and external financing needs - all of which a return to growth would alleviate. 6.36 Theproposedprogram will build on the achievements of the twoprogrammatic financial sector loans. The first of these loans supported financial efficiency and depth, banking system soundness, payments systems, and capital market development. The second loan added new areas on fundamental legislation, public bank reform, and expanded financial access. 6.31 Within thefinancial sector, theproposed loan would support continuedfinancial reforms central to the growth agenda, buildingon the programs established under the previous two operations, with new emphasis on the strengthening of creditor rights and hence the reduction of spreads through reforms in the corporate insolvency framework, as well as added 81 Brazil: Proposed First Programmatic Loanfor Sustainableand Equitable Growth support to new financial ingredients deemed central to higher growth: financial competition, developing markets in venture capital and long term finance - while maintaining an emphasis on the quality o f growth, through the deepening of sound financial access for the poorer segments of society and SMEs. 6.38 Theproposed loan will also complement investment lendingto the transportsector, most notably for the maintenance of federal highways and at the state level in Goiis andRio Grande do Sul. These loans reinforce the road transport policy measures set out throughout this document, by providing catalytic models of private-sector concessions, output based maintenance and rehabilitation contracts, and strengthening the institutional capacity for integrated cost effective planning as well as efficient management of transport infrastructure. 6.39 I n the energy sector, a May 2001 adjustmentloan supported emergency measures to reestablish sufficient energy supply to meet demand.The reform path within the energy sector remains uncertain and for this reason energy sector reforms have not been placed at the center of the present proposal. The Bank continues to offer technical assistance in the energy sector, however, and future support to this sector i s not ruled out, either as part of the present proposed program or using some more focused instrument. 6.40 Theloan would be supported by an accompanyingTechnicalAssistance (TA) operation.TA will be provided to strengthen the capacity of the government entities involvedin the implementation of the Growth Program, in order to facilitate reforms (which could then provide the basis for future phases of programmatic lending). The breadth of the economic agenda implies that a relatively large number of entities (housed inthe Ministries of Finance, Justice, Transport, and Science andTechnology) will be recipients of such assistance. To ensure that this TA can be best support dialogue on economic growth, and to allow flexibility given the scope of the project and the number of recipients, it i s proposedto provide such assistance as a Technical Assistance Program (TAP), to be funded through two Adaptable ProgramLoans. To mitigate implementation risks associated with multiple project beneficiaries, implementation will be carried out ina decentralized fashion, both on the Borrower's and the Bank's side. In addition, annual reviews of implementation performance will allow reallocation of proceeds from lower to higher performing entities. 6.41 Theproposed loan would alsoprovide synergy with IFC activities in Brazil. InFY2003 the IFC focused one-third of its lending inutilities and one quarter inoil, gas, and mining; in 2002 the IFC largest concentration was in finance and insurance (notably trade finance during the difficult external market conditions faced by Brazil that year). IFC aims to increase growth and exports by lending to competitive companies inexporting sectors, which will benefit in particular from the program's focus on logistics and the business environment. IFC port operations (e.g., in Salvador) also support program goals inlogistics. Furthermore, the program focus on infrastructure regulation will support potential IFC lending into energy, road, rail, and water. IFC lendingalso aims to increase S M E access to credit and to support well designed micro-finance initiatives (e.g., Unibanco), both also objectives of the present program. The loan also builds on work for the Brazilian Government completedby the Foreign Investment Advisory Service (FIAS) runjointly by the Bank and IFC and could create synergies with further technical assistanceby FIAS, particularly at the state level. 82 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth 6.42 The ZDB also continuesto invest in the infrastructure sectors in Brazil, notably through its Prodetur family of loans in Northeast Brazil, and lending in the energy sector, the transport sector, and urban upgrading. 6.43 Finally, theproposedprogram is strongly complementary with Brazil's program with the ZMF. Brazil recently agreed a one-year extension to the present Stand-By Arrangement with the MF.As described in Section 4, the measures supported by the proposedprogram both reinforce economic stability, and therefore the objectives of the IMFprogram with Brazil, and receive support form macroeconomic stability, which i s fundamental for private-sector investment and innovation. The Bank will continue to consult with the IMFon areas of the Growth Agenda that are close to the IMFprogram, such as tax reform, financial sector issues, and the efficiency and transparency of public-sector resource use. C. RATIONALEFORBANKINVOLVEMENT 6.44 The rationalefor Bank involvement can be divided intofour levels. Most generally, the loan and the program support a well performing country and administration at a time of need. Second, at the level of the program, the reforms supported represent a coherent set of measures of sufficient breadth and depth to have a significant impact on growth, stability, and poverty reduction. Third, the Bank will add value through technical assistance, knowledge services, and strengthening the long-term strategic framework for complex reforms. Fourth, the financing will increase Brazil's net international reserves and help to cover the external financing needs of the country. 6.45 Brazil is providing an example of how commitment to responsible economic management and socially inclusiveprograms may generate poverty impacts, despitedijfficult circumstances. The Bank has made clear its support to Brazil inthe new Country Assistance Strategy. The year 2003 was demanding both interms of the prevailing economic situation and interms of political resistance to the government's legislative agenda. Inspite of these circumstances, Brazil has regained stability and passed tax and social security reforms, in addition to embarking on the growth agenda described in this document. The Bank's strategy i s thus to support the highest impact initiatives of this administration. Within this strategy, support for sustainable and equitable growth i s pivotal. 6.46 The Growth Program itselfis a sufficient set of measures to establish the microeconomicfoundations of sustainable and equitable growth. Achievements to date clearly signal the Government's commitment to the program. These include important legislative initiatives, such as the new Bankruptcy Law and the creation of regulatory agencies; the strengthening of inter-ministerial institutions such as the Economic Policy and Infrastructure Committees; the issuing of White Papers defining the Growth Program and infrastructure regulatory policy. Even in areas outside the program defined within this document, but within a broader growth agenda, such as the labor code and contract enforcement, the Government has launched initiatives toward achieving meaningful reforms within its mandate. But there can be little doubt that significant and sustained progress in the main areas covered by the proposedloan and program - reduced transport costs; increased infrastructure investment; reducedbarriers to entry and increased competition; reduced financial spreads and increased credit; stronger 83 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth technological innovation - would leadto a significant acceleration ineconomic growth for Brazil. 6.47 The Bank is wellpositioned to add technicaland strategic value to the Government's growthprogram. The assessment inthis document i s based on a solid foundation of technical analysis over recent years, including a growth report, regulatory analysis of infrastructure sectors, a financial access study, and lending operations inthe financial sector, transport, water, energy, and science and technology. The programmatic framework initiated by the proposed loan aims to strengthen the cohesion of a complex set of reforms touching a number of sectors, ministries, and agencies. A companion technical assistanceloan i s under preparation that would provide support in all four areas supported by the proposed first loan. All four are areas where international experience can help strengthen institutions and policies. 6.48 Likelihood of success in the implementation of the Growth Program raise with Bank's support. Brazil's new administration arrived inthe midst of heightened market uncertainty. The market was concerned about Brazil's external financing requirements, high domestic debt and interest rates, and inflationary pressures. Major concerns were also linked to management of sector policies -- such as infrastructure regulation- and Brazil's growth strategy. Inresponse to that, also several initiatives raised market confidence inthe macroeconomic management of the new administration. The Bank's support to the Growth Program will reinforce the markets' perception of the commitment of the new administration to sound economic and sectoral policies. The timing of this operation i s meant to send a strong and visible signal of support duringthis crucial periodof transition from the stabilization efforts to a periodof sustainable growth. Additionally, the operation represents an efficient vehicle for deepening the policy dialogue with the new administration. 6.49 The Bank'sfinancial assistance would help Brazil meet its externalfinancing requirements. Brazil's external financial requirements which in 2004 are estimated at some US$50 billion. This i s essentially made up of medium and long-term debt amortization (about US$45 billion, excluding IMF),since Brazil i s forecast to run a small current account deficit in 2004 (about US$5 billion). Foreign direct investment i s only expected to cover about US$13 billion of these financing needs. The proposedloan would also help meet the federal government's external financing requirements in 2004 and help lengthen the term structure of public sector debts, thus reducing vulnerability. With improved market sentiments vis-a-vis Brazil, sovereign bond spreads have dropped to close to 400bps as of January 2004. But international economic uncertainties mean that emerging market access to commercial external debt financing remains precarious and the cost of alternative debt financing i s high.Finally, the proposed loan would contribute to Net InternationalReserves, and as such would help increase market confidence inBrazil and sustained credit access for the sovereign. D.FINANCIALASSISTANCEAND CONDITIONSFORDISBURSEMENT 6.50 The Bank's assistance under thisprogrammatic lending would comprise thisfirst single-tranche loan and up to two additionalprogrammatic loans subject to satisfactory progress in reform implementation. The first loan, ina proposedamount of EUR$427.20 million (including front-end fee of one percent) would disburse upon effectiveness of the proposed operation, in support of the Government's efforts inimplementing a growth agenda, 84 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth and to reinforce key actions within that agenda: conditions for disbursement are reform actions completed at the time of loan signing, as summarized in Annex 2, including triggers within each of the four dimensions of the growth program. Two further operations for similar amounts could occur within the program inthe case of very good progress. E.ENVIRONMENTAL ISSUES 6.51 Theprogram is expected to havepositive environmentalimpacts. The program will provide support to the strengthening of environmental licensingrules and the capacity to apply themefficiently. Moreover, the loan supports Brazil's participationininnovative environmental markets such as the Clean Development Mechanism and carbon trading under the Kyoto Protocol. These measures are described in detail in Section 4. 6.52 Theproposed loanfocuses on legal, regulatory, institutional, andpolicy reforms, and as such has been classifiedas a StructuralAdjustment Loan without an environmental category and is not subject to an environmentalassessment. As such, the project will provide general budgetary support as opposed to financing specific investments, with the proceeds of the loan to be integratedinto Net International Reserves. Nonetheless, the program of which the proposed loan i s part includes a proposed TA Loan for Sustainable and Equitable Growth and offers an opportunity to strengthen the framework for the mitigation of adverse environmental or social impacts resulting from private-sector activities. F.RISKSANDRISKMITIGATION 6.53 It should be recognizedthat theproposed loan is subject to high risks, which are nonetheless mitigated by complementary operations, technical assistance, due diligence, and the programmatic framework. Inpart because of these risks, the program will generate highreturns inthe case of success. Inrecognizingthe risks to the economic growth impact of the loan, and outlining mitigation strategies, it i s convenient to divide these risks into four categories. 6.54 First, there are well-documentedexternal risks to Brazil's economy. Brazil has high external financing needs coming mainly from medium- and long-term debt amortizations. Brazilian public finance i s hampered by highdebt service payments and rigid spending patterns that reduce the scope for reallocating spendingtoward the most effective programs. Both external financing needs and tight public finances make the Brazilian economy vulnerable to investor perceptions, international and domestic. A downturn inemerging market conditions, for example, increases the cost to Brazil of rolling over (even partially) its debt amortizations. Such downturns are by nature quite unpredictable. And exogenous shocks that affect the public finances (such as changes ininternational risk aversion and its effect on the price of emerging market debt) may also affect domestic investor perceptions about the government's liquidity and capacity to honor its contracts, and therefore the cost of deficit financing. 6.55 While real, these risks should not be overstated and would anyway be largely mitigated by a well-executedgrowthprogram. As described in Section 2 (Recent Economic Developments), Brazil's external financing position has improved considerably against a background of a weaker currency, domestic recession, low international interest rates, and strong 85 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth Brazilian export performance. In2003 Brazil's economy shifted from runningpersistent current account deficits to a current account surplus. Brazil's sovereign spreads have recently fallen to below 450 bps, lower than at any time since 1998. Strong fiscal performance at all levels of government, strict adherence to the Fiscal Responsibility Law by the states, municipalities, and public enterprises, and the passage of social security reform have all increased investor confidence in the sustainability of Brazil's public debt, and thus the Government's ability to honor its own financial contracts. 6.56 Second, the governmentitselffaces social andpolitical pressures, which themselves lead tofurtherfiscal risks. The pursuit of cautious and orthodox fiscal and monetary management by the Lula administration has not come without its own political costs. Parts of public opinion, particularly inthe media and inparts of the governing party coalition, have pressed for various departures from the path chosen so far: a faster lowering of the monetary policy interest rate (SELIC), currency intervention in favor of a weaker real, exemption of public enterprise investments from primary surplus figures to allow faster public sector infrastructure investment (at the expense of fiscal loosening). All would have represented extremely risky economic strategies and all were resisted. The country i s now beginning to see the results, with growth picking up and forecast to accelerate into 2004. Falling unemployment should soon follow. Nonetheless, political pressures may lead not only to fiscal risks but also to program risks of short-temism and measures that compromise long-term growth. This riski s mitigatedby the programmatic framework, since future loans depend on the integrity of the reforms, and accompanyingtechnical assistance. Moreover, the Government itself has demonstrated a high degree of commitment to sound policies through the development of the present Program. 6.57 Part of the Bank's strategy to mitigate this risk has been to broaden its supportto incorporate severalfronts that should garner stronger supportfor the governmentprogram. The Bank is planning to support two of the Government's flagship social initiatives (the unified conditional cash transfer Bolsa Familia and the youth employment program Primeiro Emprego) both financially and technically. Furthermore, a successful growth program may have some immediate impact on investment - and hence growth - though confidence buildingeffects. 6.58 Renewedgrowth itself will mitigate both external andpolitical risks. As argued in Section IV, economic growth simultaneous turns several vicious circles into virtuous ones. Productivity growth and lower administrative costs of doing business both reduce external vulnerability by raising exports. Higher growth improves the arithmetic of debt sustainability through several channels (see section IV-F). And higher growth will reduce unemployment and create greater budget resources for the more visible social initiatives of the Government. The growth program itself thus partially mitigates these risks. 6.59 Third, there is the risk that theprogram as defined has its impact attenuated by limited scope. An example here i s the threat of a second energy shortage. Inenergy, despite progress toward defining the new regulatory structure, its final form remains uncertain, and private sector investors have so far delayed large scale investments innew generating capacity. This leaves open the possibility of energy once again (as in 2001) becoming a bindingconstraint on economic growth inthe near future. The program mitigates this risk as far as possible through due diligence in ensuring that reforms in energy obey basic principles of good practice. The autonomy of the regulator (ANEEL) i s being respected and the Government's proposals are 86 Brazil: Proposed First Programmatic Loanfor Sustainable and Equitable Growth maintaining many elements of good practiced encouraged by the recent Bank adjustment loan to the energy sector during the 2001energy crisis. Technical Assistance from the Bank inthe energy sector further mitigates this risk.For another example, in the public banks, although fiduciary concerns over implicit liabilities are limited by strong government budgetary and accounting regulations, increases in directed lending may corrode financial-sector efficiency: public-sector lending has limitedgrowth effects and by using scarce national savings crowds out potentially more productive lending by the private sector. Technical assistance inthe financial sector i s being usedto mitigate this risk. 6.60 Fourth andfinally, there is the risk of weak implementation of the growthprogramper se. This risk i s probably the greatest, but i s precisely the risk that the programmatic framework aims to reduce. B y creating a financial and strategic framework for a medium-term series of reforms across diverse areas, moving in single-tranche operations from prior actions towards a long-term vision of a country growing through competitive exports andrising domestic productivity and investment, the program for sustainable and equitable growth aims to increase the probability of these reforms being completed. Weak implementation should further be avoidedby concentrated technical assistance provided through a complementary loan (under preparation and due for imminent discussion at the regional level before submission to the Board), touching all four areas of the program. 87 ANNEX 1 LETTERDEVELOPMENT OF POLICY Ministt!rio du Fazendu GABINETE DO MINISTRO Cartang 02 N F Brasilia, 20 dejaneiro de 2004. Mr. James D. Wolfensohn President, The World Bank Washington, DC - USA I PrezadoSenhor, 1. Esta carta retrata a agenda de reformas microecon6micas do Governo' brasileiro, destinada a promover o aumento da produtividade da economia brasileira, por meio de medidas microecon6micase reformas institucionais nas areas de logistica, clima de negbcios, inovagso e intermediaqiiofinanceira. As iniciativasaqui descritas constituem importantes esforqos do Governo, a serem apoiadas pelo Banco Mundial, por intermedio de um emprestimo de ajuste programatico. 2. Alem de apresentar as principais linhas de ag5o a serem seguidas pelo Governo brasileiro com a finalidade de obter ganhos de produtividade que permitam a retomada do crescimento econdmico em bases sustentaveis, esta Carta destaca as medidasque ja foram ou estao sendo implementadaspelo Governo com esse objetivo. CengrioMacroeconBmico 3. No an0 de 2003, a politicaeconbmica implementadapelo Governo enfrentou -diversosindicadorderisco-Brasilatingindopatamarsuperiora2000pontos-base,taxasde desafios. Na esteira da conjuntura econ6mica desfavoravel encontradaem 2002 com o inflaqiio no liltimo trimestre anualizadas de mais de 30% ao ano e taxa de cambio em patamar proximo aos R$ 4,OO por d6lar -o novo Governo fez um grande esforqo para recuperar a confianga na economia brasileira e para assegurar a estabilidade macroecon6mica, de modo a criar as condiqaes para que sejam atendidos dois compromissos cardeais assumidos pelo Presidente Lula: a queda sustentavel das taxas de juros e a retomada do crescimento econbmico. Neste sentido, o Governo assumiu o compromisso de conduziruma politicaecondmica responsavel, apoiada no equilibriofiscal de longo prazo, no sistema de metasde inflaqao e no regime de c2mbioflutuante. 4. A politica fiscal responsavel que vem sendo implementada pelo Governo representa uma nova fase do ajuste fiscal no Brasil. Entre 1995 e 1998, observou-se um significativoaumento da divida liquidado setor pliblico, que n2o pbde ser revertidonos 88 . . . . . .. -*ypF?... . ..........: f?. .................._I d . z ! . ...........-,_. . . . ......... ,. s w I-- I.-.%--"- _r ., , I ' . , . . ( I . . . .. . . . . . . . . . . I , . . . . . ., . . .... . . s seguintes, levando a um acrbsci s 1999houvetambem um aume PIB nesse periodo. Por considerar que o aumento da car jdades produtivase dificultq a retomada da atividade econ6 +velde emprggo e por wnsiderar que o aumento da divida ona uma eleva@o dos prQmios de risw e, dejuros de mercado, o atual espesas e, prindpalmente,na me1 etttttttttttttttttttria"fav0r8velpara a dfvida p6biica, o rgamentii.rias, para2QQ3 e 2094, uma mbt 5. Cumpre destatacar que a res objetivo do Govern0promoverum ajuste solv&nciaintertemporal. Nesse contexto, deve-se r Previd8ncia propclsta pelo Governo e fundamental pqra assegwar tanto o equilibria int para assegumr o direita de todo cidadgo B ap comprometidaem umsist;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;a desequilibrado. 6. queda dos pr&nios de risco - que ago 0 Governo avalia que a at cbnter a tendbcia de aumento da razgodivida liquidado setor alcanpu 57,1696. 4 politica fiscal tambem faadlifou a melhora que chegou a 62,5.l%em setembro de pGblica observ2jda em 2003. De fato, a proporgo de titulpq r pliblica mobiliaria federaj caiu de 40,67% em mbro de 2003. Outra conquista importantefoi o 2003. Dessaforma, ao favorecer o os pr6miosde risco, a politim fiwa . aqueda sustentaveldas taxasdejuros. 7. 0 controlk da infla@o foi fundamental para a monetaria mnduzida pelo Banco Central, paralelamente $I fooi decisiva no combafe B infla@o, que constituiu a primei jnicio de2003. Essa prioridadeera amp1 a confiansa na emnomia brasileira e de evitar que as ca mais pobres ds popula@o, as maisvulnergveis,fossem penalizadascom a volta 8. 0 &xitoda politica monet maio de 2003, quando os principais in arrefeeimento das pressaes inflaciona Destarte, afara pelos primeiros meses previsto, os preps tam saguido a traje um 2004 com 8 infla@o sbb control retomada do wesumento econ6mico 89 , 1 I I IS fontes de pressao do lado da oferta sobre a' inflag do petrbleo e a oferta agrkola. Nesse contexto, as exp i convija para a meta de inflapo de 5,5%,mais ou menos A inflexao da inflar;%opermitiu que a taxa bgsica res iniciasse uma etoria de que&, passando de 26,5% ao ano, em maio de dezembro de 2003. Bastante signifrcativa tamb6m 6 a qu rcado, para a movimento das quais tambem contribuiram continuidade do ajuste fiscal, a aprova@io da Reforma da Nacional. A taxa de juros de mercado para o prazo de 1 (um) comep de 2003 (entre t6% e IT%, em termos reais, desc para o periddo correspondente)para menos de 16% em,dez termos reais). a10.estabilidade do &mbio, em conjunto com os efeitos Essa trajetbria de queda das taxas de juros, a constituem um cen6rio propicio B retomada dt, investimento do crescimento con6miw. A retomada dos niveis de atividade na ecanbmia b nforme demonstram os indicadores de crescimento da p setembm, a indlistria acumulou expansgo de 7,6%. Embdra o c 2003tenha sido pequeno, trata-se de um desempenho melhor que em desenvoivimento que enfrentaram crises de extern0 senlelhantes aquela vivenciada pela Tipicamente, essas economias sofrera, substanciais a n t enquanto no Brasil, a perda de 3% do Pi5 em financia ri$pida ajuste da economia, com amplia@o concentrada na primeira metade de 2003. P e 8 economia brasileira tera um crescimento do PIB de 3,5%, p esempsnho das exporta@es e pela recuperaCao do ombstico. 11. 0 desempenho favoravel das contas merece ser ressaltado. A crise de 2002foi, sob vhrios aspectos, a economia brasileira passou nos cjltimos anos: (i) 0. Pais deixou US$30 bilhdes em recursos externos; (ii) o investimento estrangei segundo semestre de 2002, em rela@o ao segundo semestre de rolagem dos dbbitos externos do setor privado pas 42%, em dezembro de 2002. A politica econbmica conseguiu reverter esse quadro desfavoravel. Os excepcionais: durante o an0 de 2003 foram exportados mais de um superavit comercial de quase US$25 biihbes. Esse resultido manutengo de uma taxa de dmbio de merca fortalecimento da moeda ao long0 de 2003. Ao fint do ano, o deprbciado em cera de 72% na camparaGdo com a taxa m6die mas em mais de 15% em compara@o corn a 90 cdntribuiram para esse resultado a conquista de no comerciais, o aumento do interdmbio comercia1corn a China e a ada das vendas paraa Argentina. 12. Esses resultados v4m contribuind vuherabilidadeexterna da economia brasileira.Ate o balanp de pagamentos acumulou superavit de ue o ano de 2003 dever6 terminar com saldo pos do. A dlmensao o ajuste extern6 realizado pelo atua{ Govern0 pode ser percebi ndo se observa 9 3. Quanto ao nivel de emprego, apesa IBGE nas seis regibes metropolitanaq ter chegado dados do Ministgrio do Tfabalho e Emprego indkama trabalho formais foram criado econdmico. brasileiFo, sem promoveraumento de carga tributaria. ridadesdo Governo para pr consequentemente, para estimular os investime os de logistica. Para isso, o objetivo e promover, nos p ificativasnoscustos envolvidosno despacho aduaneiro, nos sportes rodovlariqferroviario e multimodal. Na area aduaneira, apesar de uma skrie de inovaqje d6s anos 1990, o desempenhodo despacho aduaneiro permane Ii . femacionais, dificuifando0- aumento da padicipaHo do Pais no esse contexto, o aumento da eficlbcia do despachoaduaneir overno brasileiro, mbtivo pelo qual foi elaborado recent isdo estrategica do Governo para as aduanas, iiitagSncomercial e segu a Rbceita Federal,foi enviado ao B lnternacionais deste Minisf&io de tend? que esse$ objetivos de ferrqmentas cop0 a ana tes fiscais em relago a0 Control& prdviosie a fiscali procedimentos %pis para das obrigac$q tfibutdrias, ntiragilidadelogistica a qoniinuidade do process0 d a introdu@ia de s ao longo deste e dos proximos anos, os mo a redug0 de 26% no temp , espera-se uma ra 20%, o que de dos niveisatuais. i 19. 0 esforp do Governo para aumenta comptementado com medidas para assegurar o a iserviqos portu6rios aos padrijes internacionais, o que depende implementa@io da reforma dos portos. Em sua primeira fase, a privatizaeo das operagbes portuarias nos prin 'autoridades partuar4a.s e o inicio da delega responsabilidqdapela administra& dos portos. significativado cyst0 dos servips portuarias.En intern'acionais, epte cusfo ainda e alto, os nfveisde produtividade vdrias enticfadesenvofvidas na sqtor ainda precisa ser clarame regutatbrionedesbita ser completado. Como a redugiiodos custos 6 vital para o `ctyscimento das exportaq6es brasileiras, o Governo , .,. ...... . ...-. *.. . . . . . . . . . . . . . . . . . . . .A,+<.:- .! - . i-- .w_.".-.d I a . , ! . .' . . . . . . . .. .. . . . . . ... . .. . . I 8 plementa@o da reformadospottos, GO r portuario competitivo ao nivel inter dutordo cxescimsnto das exportagijesbrasileiras. 0 Govsr.no tambh est4 atento a necessidadedo rodovias, haja vista que as mesmas s30 responsaveis pela longadist&tciado pais. Estima-se que.amelhorada conserva@o sa signifiealewnomia da ordem de US$500 milhdes por a a de recfu($io nosgastos com a manutengo de veiculos. A eria@o de um novo ambiente institucional p perseguido de diversas formas, ineluindo a extin@o do Dep Estradasde Rodagem (DNERI),sybstftuidopelo Departaqentq Transpartss (DNIT), criado pela Lei n.O 1'0.233, de 05 de si%o,tamb6m se crioutambem a Agi\ncia NacianaldeTramp cujo papel regulat6Fiono setortem aurhentado de forma continua. 22. 0 Governo k"6m permitiu a transfergncia de J Federal remanescente para a tra@o das Estados programa ern que estsadbs men o diretamente maptid apoiofinanceiro da UniBo. Essep deveri continuar, qo 12% da malha em 30.4 e 2005. Albm disso, o Governo tem exp reabilita@o e manutenqgo basqqos em requltados (contrat CREMINHA), que cpbririb 30% de malha rodoviaria Federal. horizontede 3 a 4 anos, o Governo de fazer ooncess6 rodoviariaFederalreinanescentee a a Leido SisfemaNacion 23. Ciente be que o estimulo a outros modos de t rodoviarioe uma condi@o necessariapara uma redu@oforte e transporte no Pais, o Gmerno prefende incentivar o desen multimodal e o maior us0 do transpodeferroviario e aquaviario. o Governo tomou uma sdrie de medidas regulatorias em fa permitindo a solu@o de pend6ncias societdrias e dando maior geografica as concessdes. As m@cfidas consideradaS para fortalecimento da capacidade de planejamento e de estrutura@o privadas dos Ministerios erzvolvidos e a continua@o da reorganiza das concessijes ferroviarias, para que possam se integrar de principaiscorredores de transporte do pais, a eliminasdo gradual d e a conctusSio do marw regulatoriopara o transporte multimodal. de mercadorias transportadas por ferrovias e hidravias (em 'mercadoriastransportaqaspor ano) poderia aumentar 10%nos pr6 il 4 93 i. . I i e infra-estrutura. 4 urante a fase de e; muitas vezes a pos.$ibilida$e de o Lei n." 2546/03, que marc0 regutatbrio estavel, capaz de afastar os riscos de 1 enaminhado ao Congress0 Nacionalno prbximom&sde 28. 0 Grupo de Trabaho concluiu que o modelo das a s autbnomas e independentes 6 o modelo institucional que promove os melhore do bem-estar social, principalmente quando aplicado a regula servips pljblicos concedidos e monopolios naturais, Esse model regras estaveis - essenciais p6ra assegurar um ambiente investimento privado e a redw@o do custo de capital nos setor continuidade da prestag3o dos s$rviqos aos usuarios com p pregos compativeiscom opadrgo de renda da populaF6obrasil agdnciaspela sociedadee pelo pober ptiblico. I 29. I imutavel. Enatural que haja um constante aperfeipamento da reg A estabilidade do marc0 regulat6rionAo significa, contud nesse sentido que o Grupo de Trabalho prop& diversasmedidaspa do modelo de agirncias. Uma primeira recomenda@o do relatdriotra . . / ' ' , . !i g', / . _ _ 94 i <3 1 , portanfo, que nao deve haver conflita ent i 1 1 I I I atual sistema de mqndato dos Conselhsiros e Diretores das coincid4ncia entre mandatos desfes e do Presidents da .dura@o dos mand represents uma i Governopresetva o desenho regulatdrio sofrer alterages que podem interfer 95 1 ser notificado.para que que, a despeitode nao vinculativo, deve ser discutido pelarespecti 0 prbprio SBDC necessita de aperfeiqoamento.As stqs de mudanw 30 sendo elabo por um.Grupode Trabalho Interministe reoentemente,fez' stas de aI2eragBo na Lei no8884/94 das! pel0 Govemo As iniciativas do Govern0 para incrementar o refacionadaao proeesso de registro e legaliza@o de em dia. 0 diagn6stico a esse respeito e de que o processo de empresas no Brasil 6 excessivamenteburocratizado,envplvend esferas de poder Federal, Estadual e Municipal, os quai 0 resulfedo desse processo excessiva urn memo local fisico, d ntudo, essas iniciativas ior densidade tecno16gica, por meio de uma nesse contexto que estgo sendo estudadw, ern pel0 Ministeriodo Desenvolvimento, fnddstria e C o desenvolvimentodd urn sistema integrado de regist principaisintervenientbsnasesferasFederal, Estaduale Municipal. 38. 0 Govemo brasileirote a opera@o das micro e pequenas empresas. Nesse contexto, a acaba de ser aprovdda pelo Senado prevQ, dentre outras co .recolhimento de impostos Federais, Estaduais e Municipais para empresas, o que atendeao principio de simplificagio e racionalisa 39. Outra questso que est4 sendo icipaflio das , empresas brasileiras no com6rcio international. Com o desburocratizaflo das exporiafles, estimulando as cada vez mais, o Govemo mnsolidou 54 portarias da Secretaria d Comgrcio Exterior I 1 1 r 96 -.,,-, rx*4-w-m- - T ____L_ 1 / I I I do Ministbrio do desenvol 3 de setembro de 2003 - P eo), tendo revogado outras 29 portarias do Minister dljstriae ComQrcioExterior. A redu$io do custo do credito tambem e vital p gocios no Pais. No Brasil, as dificuldades em executaras gara 2coqtratap3o de empresthos e a morosidadedos processos nando como um estimulcr Q inadi por elevar o custb do credito, o que 58 feflete nos es de intermedia@ofinanceira. i i 41, fipanceira e de ampliar o awsso ao credito em condiSdes com o objetivo de reduzir os spreads das a empenhou-se, ao longo do ano de 2003, pela aprova$io da no arcabouco falimentar em vigor remonta a primeira metade do obstante tenha sido uma regulamenta@oadequadapara a epoc notbrio que; ela j6 nSo ma& atends aos objetivos inererrtes a ' inoderno.Ali4 sse diagndsticode que a legisia$io falimentar s c imeira proposta de ref0 &os ptocessos falime pinhada ao Csngres .Federal, no ano de a a preri$ncia de consalida@o do pro(;? @io macroeconBmica por rasileira no dem 1'9?3, algumas reformas de caram par alguti ,', ' 42. Rewflheqendaa urgencigde dotar o Pais de u atual Govern0 colocau a sua aproVaMo como uma de suas Ida evolu$k~dQdebate econ8micoe juridic0 refwenteaos arcabougo falimentar modemo, o Execu tq original, $e modo a incorporar avanGo aptados cultum juridiea e empresa montou-se, no infcio de 2003, um grypo de trabalho com te . govemo que, com a colabora@o de agentes privados, cOmo acadhicos, elaborouum wnjunto de sugestdesde alte no Congresso Nac bem como uma proposta d Nacional, as qugjs apresentada$e discutidas em detalhas envolvidoscom o tema. A proposta de reforma do arcabougofaiimentar dimensdes.A primeira diz respeito a integraHo dos trabalhadores e demais cre empresas em dificuldades, mediantea institui@o de urn conjunto de de modo que todos os agentes envolvidos vislumbrem vantager rocesso. A segurida dimensao se refere a criaCBo dos mecanis servago dos ativos das empresas e, dentro do possivet, a manu: mprego, renda e arrecadaHiotributaria. Nesse sentido, permitir-se- . ...... . . 97 ....., . . , . .. .. ... . __ _.-__ ........................................ .......m.7.. 7-7 ', A T - . I ' .. . . . . . . . .- . . . . . - . . -- .I , 'I . ' . ,, . j ' dos ativos, priorizando, quando possivele eco Q em bloco, sem prejuizo, no entanto, da s mens80 se refere predsamenteaos direitos de ecadadosGam QS ativosda empresa. lsso significa definir uma e fazermwm que us recursos que venham a ser arrecadados nte a venda dos distribuidosrigorosamentesegundoessa prioridade. projeto de,lei aprgvado em 2003 pela Chmara d A fim de construIr os incentivos adequados a reestr da concordata pela da rec mbfeia Geral db Credpres e, finalidade B promover e mor 1 1 I I 45. No MSO da inviabilidadeda empresa (inviabilidadee arrecadados corn a venda de ativos da massa falida, o projeto da Lei de FafBncias apresenta uma grande inova@o, que aproxima o novo arcabouqo ntar brasifelroas melhores prbticas,interriacionais. Trata-se do Fisc0 e os credores, com garantia real no process0 de ordenado dos cr6ditos.' A partir da aprova@o da nova Lei, o Fisco e os credor icom garantia real concorm& em igualdadede wndicdes pelosrecursosarrecadados vandade ativos. SistemaFinanceiro 47. A mefa do Governo de promover ao longo dos proxi redu@onos spreadsdas atividadesde intermedia@ofrnanceirad aumento da competi@o bancaria. cam essa finalidade que Congress0 Nacional um projeto de lei que estende a aplica@o parao sebr bancario. Corn isso, dentre os casosdefusBes e aqui financ;eiras, o Banco Centi-a1 ficari encarregado de decidir concentra@o que possam afetar o born funcionamento diredotiandotodbs os demais casos, de irnediato, para as autcri 98 ! j . -_-- I rrencia. A expectativa do Govern0 e que em breve o projeto de lei seja provado pelo Congress0Nacional. Nacional seja feita e eliminandoo teto dejurm reais previstona Co em cargtsr irrev Cust6dia (SELIQ. Na &ea de seguras, a Superintendbcia de S emitiu normas para: a) esclarecer os crit4rios de elegibilidade empresas do setor de seguros, conforme a Resolu@o do Cons 52. Tem sidotamb6m uma preocupa@o do Govemo amp bancirios pela popula@a brasileira. Nesse contexto, o Consefho Banco Central do Brasil regulamentaram diversas a@% e ins ampliaq8o dos mecanismos facilitadores de acesso da popufa@ entre os quais se destacam: a. a edi@o da Medida Proviskia no 122, de 25.06.20 cornpetencia para regulamentar a aplicaGao de parte dos instituiqbesfinbnceiras, incluindo as cooperativasde credit0 e aquelas de livre admissso de associados, em operafles populaMo de baixa renda e a microempreendedores. Com Resolu@io CMN no 3.109, de 24.07.2003, fixou as con Diante da importancia da microfinanGa para estimular o em a pobreza, o Govemo pretende realizar uma avaliaG8o de medidas recem-implantadas, a fim de permitir o aprim existentes; 99 . .* . ..-. ., ' . . . . . . . . de contas especiais de fomecimento de talondrio de cheques e moviment6vei-s so meio eletrrinico, com objetivo est obten@io de crddito, de realiza@o de poupanp CB. um, ano ou na mesma r o fortalecimento das cooperativas de cr6dito no Pais, co , i 100 I 1 - __ c, . . 1' ,. - . . , . .. .. .. .. . . 1 Y ' ,., . ' . . . ! ..I' ... .. , i a@o para desconto de prestagdes de emprestimos, deifinanciamentus e de I arrendamento mercantil em folha de pagamento, p privado dada por intermedia da MP 430, atual Lei 2003. Trata-se de instrumento ufilizado ha alguns ampregador, stutorizado pelo empregado, retBm os finaneeira quando da pagamento dos sal4rios e repas erac6eb &ae$p$cie s80 contratadasa taxas de ju I1 dalidadesdecredit0 pratieadas,j6 que o risco da I I I No Brasil, o apetfeipamento do Sistema Nacional de Ii ria@o das condiG6es para que o conhecimento gerado nos i esquisa possa ser transferido para o setor privado e aplicado coopera@o hoje existente entre o setor prjblico e o se ova@o decorre, em grande medida, de entraves demrrentes do E nesse sentido que tecnicos do Governo, de vari lisando e propondomodificagies ao texto do Projeto de Lei no7. de Inovagbes. A questao central a ser resolvida pela Lei de Ino es para que o conhecimento gerado nas univ quisa -referidas ntificas e tecnal (tCTs) -possa no Projeto de Lei pelo ser transferido, mediQnte setor produtivo. Essa transferencia e essencial para que a socteda dos resuttados dw pesquisasfinanciadas com recursos pljblimk. Em linha corn esse objetivo, o Projeto de Lei proqvra c s ICTs, a fim ds incentiv6-las no pmcesso de transfergwia de rodutivo. Tal flexibifidade est&sendo buscada media ,Jicita@io na transfer$" de tecnologia, ftcencia explora@o de cria@o protegida, sendo os contratos -56. 0 Projeto de Lei estabelece tambem importantes inovaPo nas empresas, como por exemplo: (i) o apoio do se privadas inovadoras; (ii) a cessSo do direito de us0 de infra-est (labaratbriospljblicos que poderiio ser utilizados por empresas a constitui@o defundos mljtuosde investimentoem basetecnol Para estimular us gastos em P&D peio setor privibo e ,a interaGao universidade-empresa, h6 haje o Fundo Verde e Amarelo, cuja t$gulaFenta@o foi abelecida por meio do Decreto no 4.195, de I 1 de abrif de 2$X. Eiintengo do verno promover, acs longo dos prbximos anos, uma avalia@iq da ieficacia dos mecanismosdeoperaflo e gerenciameptodos fundos setoriais e da FbEP. 80 d t6nciaFinanceira 0 Govern0 continuafirmemente comprometidocom o /hgraina de reforma escrito acima e, nesse sentido, propBe a concessgo de um itico. Esse emprestima devera ser o primeiru passo, de e uma rela@o de no futuro, em a0 orqcimenta sustentdvel e equitativode economia mais ampla, que devera incluir outros empr6stimo.s dessa I I Atenciosamgnte, - i ~ AKTONIO PALOGIC1FILHO Ministrode Estado la Fazenda MINISTBRIO DAFAZENDA Brasilia, 20 January, 2004. Mr.JamesD.Wolfensohn President, The World Bank Washington, DC - USA Dear Mr.Wolfensohn, 1. This letter addresses the microeconomic reform agenda of the Brazilian government to promote productivity gains in the Brazilian economy, through microeconomic interventions and institutional reforms in the areas of logistics, investment climate, financial intermediation and innovation. The initiatives described below represent an important effort of the Government to be supported by the World Bank through a Programmatic Adjustment Loan. 2. In addition to describing the main actions to be undertaken by the Brazilian government to reach the objective of increasing productivity, as a mean to allow the resumption of sustainable economic growth, this letter outlines a series of measures which have been or are being implemented by the government toward that objective. Macroeconomic Scenario 3. In 2003, the government's economic policy implemented by the government faced various challenges. The unfavorable economic context -- country risk higher than 2,000 basis points, annualized inflation higher than 30 percent in the last quarter of 2003 and an exchange rate close to R$4/US$ -- demanded a great effort to recover credibility and guarantee macroeconomic stability. This effort was necessary to create the conditions for two important commitments of President Lula: the sustainable reduction o f interest rates and the resumption of economic growth. 4. The government's rigorous fiscal policy represents a new phase in the Brazilian fiscal adjustment process. Between 1995 and 2002, the public sector net debt rose from 30 to 57 percent of GDP. After 1999, the tax burden rose from 28 percent to 36 percent of GDP. Because the tax burden increase penalizes the productive sectors, making more difficult the recovery o f economic activity and employment, and because the increase in public sector net debt leads to the rise of risk premium, makingmore difficult the reduction of market interest rates, the current administration decided to base the fiscal adjustment on expenditure cuts and on improving the quality o f public expenditures. As part of this adjustment effort, the government established in the Budgetary Guidelines Law a primary surplus of 4.25 percent of GDP for the 2003-2004 period. 103 5. It i s important to remark that this austere fiscal policy i s consistent with the objective of promoting a structural adjustment of public finances and guaranteeing its long run solvency. In this respect, it is worth mentioningthat the importance of the Social Security Reform, approved by the National Congress, i s essential not only to ensure the intertemporal equilibrium of public accounts, but also to guarantee access to pension benefits for the retired population in the future, whose sustainability i s negatively affected by an imbalanced system. 6. The government considers that the option for a fiscal adjustment based on expenditure cuts was fundamental for the systematic reduction o f risk premium now lower than 500 basis points -- and to curb the increasingtrend of the public sector net debt-to-GDP ratio, which peaked at 62.5 percent in September 2002 and fell in November to 57.7 percent. Despite an increase of 1.2 percentage points from the December 2002 level, the government made important progress in its management. The share of dollar-indexed bonds in total bond debt fell from 40.7 percent in September 2002 to 24 percent in November. Another good development was the increase in the share of fixed bonds in total bond debt from 1.9 percent in January 2003 to 10 percent in November 2003. With the control of inflationary pressures and the fall in risk premiums, the fiscal policy opened the space for a sustainable reduction of interest rates. 7. The fall in interest rates was possible because inflation was controlled. Simultaneous to the strict fiscal policy, the Central Bank's monetary policy was decisive to keep inflation under control. The government's priority was the macroeconomic stability. This priority i s amply justified because o f the necessity to recover credibility and avoid the negative impacts of inflation on the poorest. 8. The success of the monetary policy was confirmed since May 2003, when inflation indices began to fall, a tendency confirmed in the following months. Except for the early beginning of 2003, when inflation indexes were higher than predicted, inflation followed the tendency established b y Central Bank, indicating that inflation will be under control also in 2004. This expectation i s based on a macroeconomic environment in which economic activity will recover and a positive performance for the three main factors affecting inflation from the supply side are foreseen: exchange rates, oil prices and agricultural prices. Inthis context, we expect inflation to converge to the 5.5 percent plus or minus 2.5 percentage points target established for 2004. 9. Given this favorable context, the basic interest rate began a downward trend, falling from 26.5 percent per year in May 2003 to 16.5 percent per year in December 2003. The market interest rates also experienced a significant reduction, for which the continuity of the fiscal adjustment and the approval of social security reform have contributed. The market interest rate for one year fell from 30 percent (which means a real interest rate of 16 o 17 percent) at the beginning o f the year to less than 16 percent (or a real interest rate of 9.4 percent) in December 2003. 10. The falling trend in interest rates and inflation rates, exchange rate stability and the positive effects o f fiscal discipline build an adequate scenario for the recovery of private investment and economic growth. The recovery o f activity levels in the Brazilian economy has already happened, as demonstrated by the growth of industrial production in July (0.9 percent), August (1.6 percent) and September (4.3 percent). From June to September, industry expanded by 7.6 percent compared to the experiences o f other developing economies that faced similar reductions intheir access to international markets as Brazil didby the end of 2002. While these economies suffered severe recessions, Brazil reacted to a loss o f 3 percent o f GDP in external financing by 104 quickly adjusting its economy and expanding exports. For 2004, the growth rate should be 3.5 percent, due to a continued good export performance and the recovery of domestic investment and consumption levels. 11. The external sector's good performance in 2003 should be noted. During the crisis of 2002 (among the worst in recent years), the country lost about US$ 30 billion of international funds. Foreign direct investment fell 45 percent in the second semester. The rollover rate of private loans fell from 123 percent at the end of 2001 to 24 percent in December 2002. The economic policy adopted by the government reversed this picture. Trade balance performance in 2003 was very positive: forecasts are for exports to close the year at a level of US$73 billion, with a trade surplus of almost US$25 billion. These positive results were achievedinpart due to a pro-export exchange rate, despite the strengthening of the Real during 2003. By the end of the year, the exchange rate was not only 72 percent lower than the average value in 1995-1998 but also 15 percent inferior to the average exchange rate in 1999-2001.Also, the entry innew markets by the achievement of new trade agreement, the increase of commerce with China, and the recovery of trade flows with Argentina. 12. These results have decisively contributed to reducing the external vulnerability of the Brazilian economy. UntilNovember 200, the current account balance accumulated a surplus of US$ 3.8 billion, suggestingthat 2004 may achieve ahigher surplus level. The size of the external adjustment implemented by the government i s reflected in the present year figures compared to the current account deficit in 2001 of US$ 23.2 billion. The good performance of the trade balance, the recovery of foreign investors' confidence in the Brazilian economy and the restoration of external credit lines led to an important recovery of international reserves, which passedfrom US$37.8 billion inDecember 2002 to US$52.7 billion in September 2003. 13. Regarding employment levels, despite an August unemployment rate of 13 percent (as measuredby the Government Statistics Office, IBGE) in the six largest metropolitan areas, data from the Labor and Employment Ministry show the creation of more than 945 thousand new formal jobs for 2003, an increase of 3.03 percent in formal employment. Data for the period November 2002 -November 2003 show that 69.1 percent of the new positions were generated in non- metropolitan areas. This behavior can be explained by the agricultural sector's exceptional 26 percent growth in output of in 2003 as well as by government efforts to increase formal employment in agriculture. Employment prospects for 2004 are favorable, especially because of the resumption of growth. 14. Inparallel to a sound macroeconomic economic policy, whose positive effects are appearing in the main economic indicators, the government has put a great effort in the approval and implementation of structural reforms considered necessary for establishing the microeconomic basis for sustainable growth with social inclusion. Besides social security reform, essential for positive fiscal effects, it is worth mentioning the tax reform, which main objective i s the rationalization of the Brazilian tax system without increasing the tax burden. 15. Other actions of microeconomic nature and directed at increasing productivity and competitiveness are also included among the government's growth-oriented priorities. The following sections describe the main actions that the government will implement during the 2004-2006 period in the areas of logistics, investment climate, financial intermediation and innovation. 105 Logistics 16. Government priorities to foster productivity gains and, in turn, private sector investments, include the reduction of logistics costs, over the medium-term, through significant reductions of costs generatedby customs clearance, port services, and road, rail andmultimodaltransport. 17. Despite the introduction of a number of improvements in the early 199O's, Customs' effectiveness remains low by international standards, andcontinues to be an obstacle to increased participation of Brazil ininternational trade. The increase in Customs' effectiveness is, therefore, a priority for the Brazilian government, which has elaborated recently its strategic vision for Customs, with the twin objectives of trade facilitation and border security. This document, was preparedby the Ministry's Secretaria da Receita Federal, and sent to the Bank by the Ministry's Secretaria de Assuntos Znternacionais on January 2, 2004. The Brazilian government believes that these two objectives are perfectly complementary. The use of tools such as risk analysis to select cargo to be inspected, the introduction of different timings for fiscal controls and customs clearance, increasing and strengthening of advance and post-clearance controls, the simplification of clearanceproceduresfor users that accept specific controls prior to or following Customs' clearance, the integration of Customs and fiscal administration systems, as well as the fostering of cooperation within and between institutions, are actions designed to improve voluntary compliance with customs and fiscal obligations, allow to more efficiently fight frauds, andimprove the logistics of legal trade. 18. The continuation of the modernization and automation of Customs' clearance procedures as well as the introduction of risk management systems is expected to result in the reduction of cargo selectivity levels from 40 percent today to 30 percent over the next few years, and in a 20 percent reduction in net release times. Over the next 3 to 4 years, cargo selectivity levels could be reduced to 20 percent, which should allow to half net releasetimes. 19. The efforts of the government to enhance Customs' effectiveness must be complemented by an alignment of cost and effectiveness of port services to international standards, which requires continuing the implementation of the port reform. Duringthe implementation of its first phase, the reform allowed the privatization of port operations in the main ports of the country, the creation of port authorities, and the beginning of the delegation of port management responsibilities to States and Municipalities. These actions resulted in a significant cost reduction of port services. However, the cost of port services remains still high when compared to international levels. Productivity ratios remain low, the role of the various entities involvedinthe sector should be more clearly defined, and the regulatory framework must be completed. As cost reduction of port services i s essential for export growth, the Government i s developing a plan to complete the implementation of the port reform, with the objective of obtaining, by 2007, an internationally competitive port sector which would foster the growth of Brazilianexports. 20. The government recognizes also the necessity of ensuring the adequate condition of the road network, as it carries most of the long-distance transport in the country. It i s estimated that the improvement of road condition on the main network could generate savings to the private sector inthe order of US$500millionperyear, through reduction of vehicle operational costs. . 21. A new institutionalframework for the management of the road network i s being put inplace, with the closing of the Departamento Nacional de Estradas de Rodagem (DNER), replaced by the DepartamentoNacional de Infra-Estrutura de Transportes (DNZT),as per Law no. 10.233 of 106 June 5, 2001. The same Law also created the Aggncia Nacional de Transportes Terrestres (ANTT), whose role as regulator has beencontinuously increasing over the last 3 years. 22. The Government has also been able, in 2003, to transfer to the States the responsibility for management of 9% of the remaining federal road network, the first phase of a program under which non-trunk roads are managed directly by the States, with financial support from the Federation. The implementation of the program will be pursued over 2004 and 2005, with the transfer of an additional 12% of the remaining federal road network. In addition, the Government i s in the process of expanding the use of output-based contracts for road maintenance and rehabilitation (such as CREMA and CREMINHA contracts) on up to 30% of the federal road network. Finally, within the next 3 to 4 years, the Government intends to concession an additional 5% of the remaining federal road network, and approve the Road Classification Law (Lei do Sistema Nacional de ViagZo). 23. Taking into account that providing incentives to the development of transport modes other than the road mode i s a necessary condition to ensure a marked and sustainable reduction of transport costs in the country, the Government intends to foster the development of multimodal transport and increased use of railway and waterborne transport systems. To that effect, the Government took, in 2003, a series of regulatory measures in the railway sector, allowing the resolution of various shareholding issues and, in turn, improving the economic and spatial coherence of railway concessions. Further initiatives to be undertaken include strengthening of the relevant Ministries's capacity to carry out planning and structure public-private partnerships, the continuation of the geographical restructuring of the railway concessions along the main transport corridors in the country, the gradual elimination of infrastructure bottlenecks, and the completion of the regulatory framework for multimodal transport. It is estimated that the share of rail/waterborne transport modes in goods transportation volumes could be increased 10 percent inthe next 4 years. InvestmentClimate 24. In addition to macroeconomic stabilization, the improvement of the environment for productive investments depends especially on efficient provisionof infrastructure services. 25. The resumption of investments in infrastructure will require - besides fiscal strengthening -- the definition of an appropriate legal environment for public-private partnerships. Public-private partnerships should evolve around two issues. The first one is to provide for means to increase project efficiency -- reducing the public costs, transferring operation of the asset to the constructor and increasing predictability of public funds during the construction phase -- reducing overprice in public biddings for infrastructure projects. The second issue, without abandoning the emphasis on financially self-sustainable projects, i s to open the possibility to use public funds to complement for the revenue obtained from users of public services, in order to guarantee an adequate return to priority projects in which social gains are superior to private returns. 26. For that purpose, the government sent to Congress project law no. 2546/03 in November 2003, which defines general rules for public-private partnerships. The approval by the National Congress is expectedto take place in2004. 107 27. The recovery of the country's infrastructure also depends on the definition of a stable regulatory framework that i s able to mitigate regulatory risks, following the accomplishment of investments with high fixed costs by the private sector. In March 2003 the Brazilian president proposed an inter-ministerial working group to evaluatethe regulatory framework and to propose improvements in the model of independent regulatory agencies. In October, the group presented its findings in a document published by the Casu Civil. The results of this working group are beingconsolidated inon draft bill to be submittedto CongressinFebruary 2004. 28. The working group concluded that the independent agencies model promotes the best results for social welfare, mainly when applied to regulation and supervision of public services and natural monopolies. This model can facilitate stable rules which are essential to ensure an adequate regulatory environment for private investment, to reduce the cost of capital in the infrastructure sectors, and to provide the continuity of services to consumers, with quality standards and prices that are reasonable, considering the of income levels of the Brazilian population, andthe control of regulatory agenciesby the society and the public. 29. The stability of the regulatory framework does not mean, however, that it can't be changed. It i s natural for there to be constant improvements in economic regulation, and for this reason, the working group suggested some measures to enhance the agencies' model of functioning. A first recommendation of the report deals with the needto separate the public sector's policy definition function, to be exercised by the Ministries, from the regulatory function, to be exercised by the agencies. It was concluded that, because these functions are complementary, there should not be any conflict between the Ministries and the agencies. To assure immediate implementation of the process of separation of these functions, it was recommended the transference of the concession contract placement function from energy, telecommunications, oil and transports agencies, to the respective Ministries, without any harm to the existing contracts with the concessionaires. The agencies must remainresponsible for granting authorization contracts, due to their specialization and operational structures. 30. Another important point raised by the working group's report was the need to strengthen the capacity of the Ministries to formulate public sector policy, and to operate and expand planning of regulated sectors. As part of the efforts to strengthen the institutional capacity of regulatory agencies, the government sent to the Congress a draft bill to create the regulator career. Equally important i s the reactivation of policy definition collegiate entities, whose activities are currently reduced (i.e.: Cdmaras do Conselho de Governo; the ConselhoNacional de Politica Energe`tica -CNPE; the ConselhoNacional de Politicas de Transporte-CONIT; and the Conselhode Aviagiio Civil -CONAC). 31. The report published by the Casu Civil also recommended keeping the current system in which the mandate periods of the agencies' Council members and Directors alternate with the President's, with four-years duration and one possible extension. This measure represents an important signal to the market, concessionaires and investors that the Government will maintain the stability of the rules and will respect outstanding contracts. 108 32. Aiming to introduce mechanisms of social control for the agencies, and also recommending that consultations and public audiences be more intensively usedby the agencies when there are issues that could cause impact for specific interest groups or for the society as a whole, the working group recommended the immediate elaboration of the draft bill that obliges the agencies' controllers to send to the National Congress a report of the regulatory and supervisory activities. In addition, the draft bill i s intended to allow the Congress to request the regulatory agencies' controllers to supply informationon previously defined subjects, which will require an amendment to the Constitution. The document also recommended the establishment of performance contracts between the regulatory agencies and the sector ministries, regarding the monitoring of the agencies' performance. However, the management contracts must not affect regulatory independency, meaning that contracts can not restrict the freedom of decision-making or threatenregulators with possible dismissal. 33. The importance of cooperation between the agencies and the entities that belong to the BrazilianCompetitionDefense System (Sistema Brasileiro de Defesa da Concorrzncia- SBDC) was also highlighted. This cooperation was considered essential because technological change can sometimes make competition feasible in previously monopoly markets. Therefore, it was recommended that the government create an inter-agency reporting system to notify the SBDC when changes in regulatory design interfere in the conditions of competition. It also recommended that the SBDC should prepare a report on the notified issue. This report, although not bidding, should be discussedby the notifying regulatory agency. 34. The SBDC itself needs reforms. Recently, an inter-Ministerial working group reviewed the proposals for changes inLaw 8884/94 approved by the former administration. 35. The Government's initiatives to enhance the business environment are not limited to issues concerning investments in infrastructure and improving economic regulation. There are also issues regarding administrative regulation, like the one related to the companies' registration and legalization processes that are also considered as a top priority. The diagnosis i s that the registration and legalization processes in Brazil are excessively bureaucratic, involving Federal, State and Municipal agencies and entities, which are geographically scattered and without communication among them. As a result, the legislation and the norms that drive the registration process usually aim at specific functions of a certain agency, without any concern for the whole process. 36. The result of this bureaucratic and uncoordinated process i s the high cost in terms of time of completing all registration and legalization procedures. This high cost inhibits and delays the formal constitution of companies. Recent data published by the World Bank, included in the assessment "Doing Business in 2004", estimate that it takes 152 days for the complete registration and legalization of a hypothetical standard company. It i s one of the government's priorities inthe coming years to change this situation, makingthe process more agile. 37. During recent years, some initiatives were successfully implemented in some cities, such as Centrais FACIL,that represent the unification of requirementsfor the opening a new business in the same location. However, these initiatives still need to modernize the registration process itself, which i s so far unchanged. They also need to be more widely disseminated around the 109 country. Therefore, measures to allow the development of an integrated system of firm registry, including the main federal, state and municipal intervenient agents, are being studied by the Ministe'rio da Fazenda andMiniste'rio do Desenvolvimento,Indtistria e Come'rcioExterior. 38. The Brazilian Government has undertaken specific measures related to the participation of Brazilian firms in international trade. The Government, looking at reducing red tape and stimulating exports, consolidated 54 portarias from the Secretaria de Come'rcio Exterior (SECEX) into a single Portariafrom the Ministe'rio do Desenvolvimento, Indhstria e Come'rcio Exterior (Portaria no. 12 of September, 3rd 2003 - Portaria Consolidade de ExportaGtlo), and revoked 29portarias from the Ministe'rio do Desenvolvimento,Indhtria e Come'rcioExterior. 39. The reduction of the cost of credit i s also essential to improve the business climate in the country. In Brazil, the difficulties in executing conceded guarantees when the loan process and the slow process of debt recovery act as a stimulant to default. This situation increasesthe cost of credit, which i s reflected inthe highspreads of the financial intermediation activities. 40. During 2003, the government made a large effort to approve the new Bankruptcy Law, aiming at reducing the spreads on financial intermediation and to increase access to credit in more favorable conditions. The current bankruptcy framework was prepared during the first half of the last century and, though it was an adequate regulation for that period, it i s no longer adequate for the modern bankruptcy process. Moreover, the diagnosis of the bankruptcy legislation i s not new, as a first proposal for its reformulation was sent to the National Congress in 1993, by the Federal Executive. However, due to the importance of necessary reforms for macroeconomic stabilization duringthe 1990s, some microeconomic reforms were set aside. 41. The current government has as one of its main priorities, the approval of the Bankruptcy Law. However, due to the evolution of legal and economic discussions regarding the principles that will lead to the definition of a modern bankruptcy framework, the Federal Executive i s reviewing the original proposal to incorporate recent progress and to adapt them to the Brazilian private sector and judicial system. Therefore, in early 2003, a working group was created to prepare a set of suggestions to the Project and propose changes to the National Tax Code. The working group included technicians from many governmental departments, with support from the private sector, such as bankruptcy lawyers and academics. The suggestions were discussedin depthwith membersof Congress involvedinthe subject. 42. The proposal for the bankruptcy framework has three dimensions. The first i s related to the integration of workers andother creditors inthe managementof firms infinancial difficulty, with the correct set of incentives to make all the agents see advantages of participating in the process. The second dimension refers to the creation of mechanisms to guarantee the preservation of the firms' assets and, as much as possible, to maintainproduction, jobs, income and tax payments. It would allow, therefore, new ways to use the company's assets, prioritizing, where possible and economically feasible, the sale of the business as a whole. The third dimension i s related to the property rights of the sold company's assets. This involves defining an order of distribution, by priority, of the funds originatingfrom the sale of the company's assets. 110 43. The Draft Law, which has already been approved by the Congress in the first round, tries to substitute the incentives for bankruptcy with those of recovery, if restructuring is feasible. It i s important to underscore the creation of the Assemble'ia Geral de Credores and, if needed, the Comit8 de Credores, entities whose goals are the promotion and coordination of employees and creditors' participation, making the negotiation process feasible to create a plan allowing an economically viable company to recover. Specifically, for small and micro enterprises, there will be a standard process, similar to the concordata, which may be permitted by a judge when a reasonable request i s made, but without demanding negotiations with creditors, which may be very costly for these enterprises. 44. If the enterprise i s not viable, the priority i s the fast and efficient transfer of its assets. The preference would be to sell off the business in its entirety, thereby maximizing the remaining value, and maintaining the related economic and social benefits. The National Tax Code, approved in the first round by Congress, deals with ending the taxation of the remaining assets duringa sell off, which is abighurdlefor the efficient and quick transfer of assets. 45. With respect to property rights on resources received from the sale of a firm's remaining assets, the new Bankruptcy Law i s extremely innovative, bringing the Brazilian bankruptcy framework close to international best practice. It i s the establishment of a parity between the Internal Revenue Service and the creditors with a pledgein the process of distribution of credits. Following the approval of this law, the Internal Revenue Service and creditors with pledges will havethe same priorities during the distribution of the assets sold. FinancialIntermediation 46. The goal of promoting a considerable reduction in the spreads on financial intermediation during the coming years depends on the increase of competition inthe bankingsector. Therefore, the Government sent to the National Congress a draft law extending the antitrust laws to the bankingsector. As aresult, among the cases of mergers and acquisitions of financial institutions, the Central Bank will be in charge of decisions concerning bank concentration that may affect the financial system, directing all the other cases to the authorities responsible for promoting competition. The Government expects the draft law to be approved soon by the Congress. 47. The government approved, in the first semester of 2003, the Emenda Constitucional no. 40 which changed Art. 192 of the Constitution, allowing the National Financial System to be regulated through many complementary laws and eliminating the interest rate cap defined in the Constitution. This was done because the government believes that the financial system needs enhancements that require legal modifications. 48. In the systemic risk control area, there was a huge leap recently with the introduction of the Sistema de Pagamentos Brasileiros. The transfer of funds among the banks became real time, irrevocable and unconditional. It contributed to the reduction of liquidity risk of interbank transactions, reducing systemic risk. The clearance in real time for every operation began to be used in the operation with federal public securities by the Sistema Especial de Liquidaglio e Custo'ria (SELIC). 111 49. Inthe insurance area, the Superintend8ncia de Seguros Privados (SUSEP) emitted norms: (i) setting the eligibility and asset allocation criteria for companies in the insurance sector, according to the Resolugio do Conselho Nacional de Seguros Privados (CNSP) no. 98, September 30th, 2002, and the Resolu@o do Conselho Monetdrio Nacional (CMN) no. 3,034, October 2gth,2002, b); (ii) enhancingthe procedures of registry and trustee of assets of insurance firms, according to the Circular from the Superintendhcia de Seguros Privados (SUSEP) no. 220, December 13th, 2002, and c); and (iii) defining accounting norms and auditing procedures for insurance companies, according to ResolupTo do Conselho Nacional de Seguros Privados (CNSP) no. 86, August lgth, 2002. 50. In the reinsurance area, the government intends to concede permission for new operators to supply this service, inthe mediumterm. 51. The government i s concerned with the expansion of access to banking services by the Brazilian people. Therefore, the National Monetary Council and the Central Bank of Brazil regulated many actions and tools for this purpose: (i) Provisional Measure (Medida Provisdria) no. 122, of June 25th, 2003, created to broaden access to credit, empowered the National Monetary Council to regulate the application of a percentage of the financial institutions' sight deposits, including those of credit cooperatives for micro entrepreneurs and those with open admission, in micro credit operations for the low income population and micro entrepreneurs. Resolution CMN no3.109, of July 24th, 2003 establishedthe conditions for these operations. Dueto the importance of microfinance to stimulate the entrepreneurship and reduce poverty, the Government intends to evaluate the effectiveness of these measures recently implemented, to enhance these mechanisms. (ii) Permission to open special accounts of sight deposit, without the use of checks, whose management is merely by magnetic cards or other electronic method, aiming at the strategic goal of enhancing conditions for credit, savings and the acquisition of financial products, and as a tool to release resources to people who receive benefits from social programs. This measure was taken by the NationalMonetary Council through Resolution no. 3.104, on June 25th, 2003, with the following main features: a) the average balance must be under R$ 1,000 per month; b) opening an account is very easy and free to the client; c) a tariff i s charged only i f (i) more than four withdrawals are made in a month, (ii) more than 4 printed statements are requested, (iii) more than 4 deposits are made in the month, and (iv) a check i s issued. If the amount in the account surpasses R$ 1,000 twice a year or R$ 3,000 at any given time, it i s blockedfor verification purposes. (iii) Reform and consolidation of norms related to the hiring of correspondents by financial institutions in the country, throu h Resolutions no. 3110, September 31St,2003, and no. 3156, December 17 , 2003, of the National Monetary ,a Council, highlighting that correspondence banking service aims at the 112 democratization of credit and an infrastructure for the dispersion of microcredit, with the goal of reaching the 40 million Brazilians, without access to banking services, who live in the outskirts of big cities. As a result of this action, many competitive advantageswere supplied to them such as the collection and application of credit, the circulation of money inthe city itself, the reduction of distances, the strengthening of internal trade, and assistance to make resources available to the most needy population, under the Zero HungerProgram. (iv) Strengthening of credit cooperatives in the country, enhancing the regulatory facilities, especially with the promulgation of Resolution no 3.106, June 25, 2003 and no. 3,140, November 27, 2003, which expanded the role of central cooperatives and allowed the creation of cooperatives for small microenterpreneurs and open admission cooperatives, changing the previous model, in which cooperatives could only support specific segments of the population. The new rules will allow the organization of populations that currently have low access to financial services, such as those located far from urbancenters, so that they will be able to mobilize andapply resources to their own benefit, stimulating small rural and urban entrepreneurshipsthat generate jobs. Inaddition, concerning the big centers, they will promote an increase to competition in the financial system, becoming part of the measures to reduce banking spreads. (v) Authorization to withdraw loans and leasing payments directly from payroll, for private sector employees, through Provisional Measure 130, currently Law 10,820, of December 17th, 2003. Public sector employees have had access to this tool for alongtime: the employer, authorizedby the employee, retains the amount owed the financial institution and transfers it to the lender. As the risk of the operation i s reduced, interest rates are lower than other credit methods. 52. Another important measure to expand the access to credit i s the permission to create a positive database of credit information that will work complementary to the currently used negative database. The positive database will include the history of credit operations and punctually paid by the borrower, and other information allowing the identification of good borrowers who will benefited from a larger credit supply with a lower cost. Therefore, strengthening the norms of data sharing established by Resolution 2,835, May 30th,2001, allows the increaseof competition inthe financial system. Innovation 53. InBrazil, the enhancement of the National Innovation System encompasses the creation of conditions for public research institutes to transfer knowledge to the private sector for commercial application. The reduced cooperation between the public and private sector concerning innovation i s a consequence of the legal hurdles created by the current legal framework. 113 54. Many technicians of the government, from different ministries, are analyzing and suggesting changes to the Law Project 7.282, known as the Innovation Law. The main issue to be solved by the Innovation Law i s the creation of the necessary conditions for the knowledge generated in public universities and public research institutes to be transferred to the productive sector. This transference is essential for society to receive the benefits from the results of the researches fundedby public resources. 55. The Law Project aims to provide the public universities and public research institutes the flexibility and incentives to transfer technology to the private sector. For the purpose of increasing flexibility, the Law Project should provide for the replacement of tendering processes for the transfer of technology by simple public announcements(chamadapiblica). 56. The Law Project also provides for important measuresto stimulate innovation in firms - that would otherwise conflict with the Brazilian legal system -- as for instance: (i) direct public sector's support to private sector innovation; (ii)permission for the private use of public R&D infrastructure (such as public laboratories that could be rented to private firms) and (iii) incentives for the creation of mutual funds for investment intechnology-intensive enterprises. 57. The Fundo Verde e Amarelo gives stimulus to R&D investments and to improve linkages between the universities and the private sector. Its regulation was established by Decreto no. 4,195, April 11,2002. The Government intends to promote, during the upcoming years, an assessment of effectiveness of operation and management of the sector funds and of FINEP. FinancialAssistance Request 58. The Government maintains its strong commitment to the reform program described above and would be grateful for the concession of a programmatic adjustment loan. We wish to continue working with the Bank in future programmatic loans aimed at sustainableand equitable growth of the BrazilianEconomy. Sincerely, Antonio PallociFilho Ministro de Estadoda Fazenda 114 . .. . 0 . . 115 116 117 118 119 m 120 x I (0 a EE8 s a 8 * 7e $6 O B 121 122 .- 8 6 k L 123 2Y e 124 125 ANNEX 4 TRANSLATEDGOVERNMENTWHITE PAPER "ROADMAP THENEWECONOMICDEVELOPMENT FOR AGENDA" 1. Objectives 1. The formulationof anew development agendamusthave as its first objective the promotion of sustainable economic growth with improvements in social welfare and income distribution. Interestrate reduction inthe context of macroeconomic stabilization i s a necessary butnot sufficient condition for economic growth andexpansion ofjob opportunities. To attain this objective, important microeconomic measuresand institutional reforms that increase productivity and stimulate investment and savings, variables that have achieved low levels inthe last decades. 2. Inthe case of Brazil, the secondmainobjective of the development agendamustbean increaseinthe country's foreign exchange, through, above all, increasesincompetitiveness and productivity. This expansionwill have positive consequencesinthe reduction of the economy's vulnerability to external shocks and the relaxation of external constraints to economic growth. Special emphasis must be given to export growth. 2. Priorities of the DevelopmentAgenda 3. The priority for public action i s the investment inthe expansion and improvement of infrastructure, which is essential for the resumption of economic growth and its impact on the "Custo Brasil." Industrial, technology andforeign trade policies should also focus on increasing the productivity, capacity for innovation andexport expansion of Brazilian companies. These priorities, properly ordered, should be the basis for an increasedparticipation ininternational trade, stimulating the sectors where the country has the greatestcapacity to develop comparative advantages, and ways for the exploitation of the existing opportunities inthe sectors with the most dynamic international trade flows. This agenda is complemented by the government's coordinated action inthe social sectors, especially ineducation and health, with aconsequent positiveimpact inthe quality and capacity of the work force. Infrastructure 4. The government's commitment i s fundamental for the establishment of transparent regulatory models, well-defined and specific for eachof the infrastructure sectors (energy, transport, andbasic sanitation), reducing regulatory uncertainty and stimulating private sector participation. 5. The establishment of clear rules for the partnershipbetween the public andprivate sectors i s an important action for the promotionand expansion of investments ininfrastructure. 126 6. The capacity of public investment ininfrastructure mustbe expanded. Inmany cases, it i s necessary to make public investments that generate significant externalities for private investment . 7. Inthe transport sector, the concessionsof the mainroadandrailroads, with the appropriate tariff policies, will be fundamental to reducing the "Custo Brasil" and financing of investment inthe remaining landtransport network. Inthe case of railroads, it will be necessary to facilitate access to the essentialfacilities of the network, for each concessionaire.Inthe case of the ports, it will be necessary to resolve pendingproblems inthe regulatory framework, includingthat referringto the hiring of workers, and to improve the administrative requirements applied by the Receita Federal incustoms. 8. Intheelectricity sector,wherehydroelectric generationwillcontinuetohavea preponderant role, it i s necessary to improve the regulatory framework and gradually eliminate the cross-subsidiesto promote tariff alignment. 9. Inthe gas sector,whosedevelopmentcanhaveasignificant effect onindustrial productivity gains, reducing costs and allowing the introduction of technologies that improve production quality, as well as the enforcement of a more competitive regulatory structure will have important roles. A policy that corrects the extreme emphasis on the use of thermoelectrial resourcesshould have a prominent role inthe development of the 2004-2007 agenda. For the GLPthere should be guaranteesof accessbasedon households' capacity to pay. 10. Inthewater andsanitationsector,theresolutionoftheregulatory framework thatrefers to the determination of the power concessioni s essentialto reducing some of the deterioration in the sector and diminished capacity of investment. Inparticular, it i s necessaryto define rules for partnershipwith the private sector, inthe states andthe municipalities that want to enable investment expansion, but at the same time preventing the creation of fiscal liabilities. 11. Intheoilsector,regulationmustbedirectedattheeliminationofsomeimpedimentsfrom the post-monopoly period. The full functioning of the market inthe formulation of prices i s necessary for Petrobrds to identify viable strategic investments, to expand domestic sales, to attract institutionalinvestors inthe stock market, and to guarantee greater integration of the production chain. As much as appropriate, the government will need to focus on the evolution of the stock-holders inthe sector, to increasethe attractivenessof the investment. Industrial, technologicaland international trade policies 12. Focus on the productionof commercialized goods andthe most dynamic sectors of the economy, that promote the growth of exports, the generation, absorption and diffusion of technology and the creation ofjob opportunities. 13. Development of partnerships between the public and private sectors as a starting point to stimulate the capacity of national companies to innovate. Inthis context, it would be appropriate to rationalize the use of the public laboratories, andpermitthe access of small and mediumfirms. 127 14. Greater transparency inthe selectionprocess of lines of researchto be financed by the sectoral funds createdto promote technological development. 15. Special emphasis on basic industrial technology (metrology, standardization, copyright and technological management), that, among other things, makes it possible to leverage the local production of capital goods. 16. Adoption of instrumentsto promote economic efficiency and the volume of foreign trade inBrazil, leading to the aggregationof value to the exports, andto an increaseinthe exports of services. 17. Industrialpolicies must seek to increaseinternational trade volume. Inthis context, the following elements will be central: (i) efforts to increasethe number of export companies, specially small andmediumfirms, as well as to support the entrance innew markets of existing exporting companies; (ii) elaboration of a strategic planfor exports that develops Brazil's comparative advantages and signals the government's commitment inthe mediumandthe long termto promote this activity andthe creation ofjobs; (iii) reevaluatethe effective Brazilian to protection system, inparticular, inview of the tax reform, to reducethe existing distortions, with impacts on the productive structure. 18. Brazil should seek the diffusion of technologies inindustries where Brazil possesses comparative advantages not completely explored (e.g. pavement, marble, coffee, furniture, machines) besides continuing to stimulate the efficiency gains of the agro-business sector. 19. Moreover, without damaging successfulpolicies, and oriented towards the development of proper technology, a new agendaof technological policies must emphasize the absorption and dissemination of new technologies, that, insome cases, occur through the import of capital goods. 20. International trade policies will needto reducethe existing tariffs andco-ordinate the operation, planning and evaluation of export promotionpolicies. 21. Equally important i s the diversification of foreign markets, which will reduce export volatility. The policies with this objective mustbe centered, therefore, on the combination of a product and its geographic market, and respond to the existing trends in overall international trade as identified by trade statistics. Promotion of strategic sectors 22. Public policies must give special attention to the sectors where the country has a demonstratedpotential for international trade expansion, still leveraging Brazil's response capacity inthe sectors inwhich international trade has beenthe most dynamic. 23. The policies mustsupport asubstantial analysis of the costs andbenefits of the programs and, especially, their contributionto the increaseof the international competitiveness of Brazilian products. 128 24. These policies hold, inthe case of the strategic sectors, the development of afocused and efficient incentive regime for researchand development. Policies should favor the generation, absorption and diffusion of technology. A permanentchallenge, which must also be a performance criterion, i s the country's capacity to generate patents, which has practically stagnatedduring the past two decades. 25. Strategically, biotechnology andnanotechnology are the sectors where the country has conducted basic research.But it must soon correct the difficulties that it historicallyhas had in utilizingbasic scienceinapplied research. A solution i s to redefine the institutionalrole of the public researchinstitutes, in view of performance goals, with professional administration that would render services and proper development funding. Particular attention mustbe paidto the registration laws for patents, copyright and metrology. 3. Criteria of Election of Policies 26. Inthe formulationof industrialandtechnology policies, supplementalinstrumentsto the traditionally usedfiscal and financial subsidies must be sought. 27. The starting point for the formulation of policies must be to identify the inefficient sectors, the eventual and existing bottlenecks and the causes of inefficiency. This must take along the entire production chain. Having identifiedthe sources of inefficiency along the production chain, preliminary evaluation would consider what policy choices could correct the problem, andthe necessary costs to attain the desired results. 28. The choice of policies must be basedon the net gains obtained by society, giving greater weight to those policies that promote greater inter-temporal social welfare. To measurethese gains, the implementation of any policy must be precededby adynamic analysis of the expected costs andbenefits. The evaluation of the cost mustinclude the measurement of the volume of subsidiesand/or reduction of the public collection, taking into considerationthe probable increasesinprices of specific products due to the imposition of competitive restrictions. The calculation of the benefits must consider the (productive andeconomic) efficiency gains 29. Inparticular, the analysis mustalways consider costs incurredbyfinal or industrial consumers. For the downstream sectors, these costs can include the purchase of less efficient or more expensive goods or services and should be included inthe cost and benefit analysis that should occur before the implementation of sectoral programs. 30. An important variable to beconsidered inthe selection of policies is the potential for exploitation of opportunities inthe external market. Inthis case, the goal must prioritize average performance inthe external sector in a specified period, with prospectsfor strengthening the country's volume of trade. 129 4. Applicable rules for governmentalsupport 31. The implemented policies must be transparent. The study that does the comparison of the present value of the costs andthe long-term benefits should be available to public scrutiny. The rendering of accounts and the annual statements of the development programs must be equally accessible. 32. The implemented policies must stipulate goals andobligations by the private sector, as well as the statedperiodfor the fulfillment of goals. The policies must be rigidon the possibility of extension of the incentives. They must have, therefore, pre-determined and non extendable duration. It also serves to define punishmentor reduction of the benefits incases where the goals will not be fulfilled within the stipulated period. 33. The concessionof benefits must take into consideration the public sector's capacity to finance and guarantee the strength of the development agencies and the public banks. 5. Procedures 34. A coordinating body mustbe createdto develop initiativesaimed at increasingthe efficiency of the productive sectors and the strengthening of the external sector. 35. The structure of existing benefits must be evaluated, including the tax incentives, subsidies and incentives. The analysis of the internal incentives to the development of the productive structure must include identificationof the existing tariffs and non-tariff restrictions to Brazilianproducts inexternal markets. 36. Moreover, Brazil's existing structure of effective protection should be evaluated to reduce the existing incentive distortions indifferent productive sectors, includingterms of incentives for private investments. This evaluation should incorporate the possible effects of the government's tax reformproposal, with the objective of preparing an adequate strategy to adjust the tariff structure to the new tax system that will emerge from the reform. 37. Also, equal importance should be given to market characteristics, the incentive policies and mechanismsthat were utilizedfor technological development indifferent sectorsinthe past and evaluatethe success achievedto design an institutionalframework more adequateto the efficient development of these activities. 38. Development policies must keepinmindthe specific characteristics and sectoral challenges, and the sources of inefficiency. The sector mapping and elaboration of development policies should be complemented with an analysis of the relative impact of the proposals and their costs to society, to guaranteethe greatesteffectiveness inthe use of the public resources, and to satisfy the criterionof transparency. It should include pre-established periods for the benefits concessions andperformance goals reflected inthe criteria for policy choices established beforehand.Also, it should include the public sector's ability to provide financing and the strength of the promotion agencies andthe public banks. 130 39. The coordinating body will beresponsiblefor the analysisof the existing subsidies and tax-breaks as well as of the effective protection as well as for the mapping of the sources of inefficiency inthe productive structure. It will also be the responsibility of the coordinating body the presentation of aproposalfor the re-design of the promotionpolicies, to specify the criteria to be adopted for the diverse promotion andmonitoring agencies and of the fulfillment of the establishedobjectives. 40. Satisfying these conditions, the resultingpolicies will need to contribute in adecisive way to increase the efficiency of the productive sector and the participation of the country inthe international trade, with the acceleration of investment, the creation ofjobs, and greater social inclusion, giving form to the government's main objectives. 131 ANNEX 5 LOGISTICS 1. The highcostsoflogisticsinthe CustoBrasil 1. Logistics costs are now the biggest component of the cost of doing business inBrazil- the so-called CustoBrasil. With globalization andthe reorganization of production and distribution chains, logistics andrelatedinfrastructure services are becoming a key determinant of the investment climate and of firms' location decisions. 2. Manyinteracting factors contribute to the ongoing reorganization of the production and distribution chains andto globalization. Consumer demandfor customized products contributes to the expansion of to-order andjust-in-time production anddirect-delivery distribution technologies. The liberalization of trade andcapital flows andthe rising education levels inlow- income countries contribute to the relocation of production processes, leading to complex global manufacturing chains. Facilitating andpromoting these changes are improvements in informationtechnology andthe greater speed andreliability of freight transport services, which allow muchlower inventory levels. 3. Globalization is leading to increasedworld trade, which has doubled over the past 15 years while global output has risenby only about 50 percent.More important, international trade flows are changing rapidly. Many developing countries, like Brazil, which usedto supply mostly raw materials to industrialcountries, are now exporting rapidly growing volumes of manufactured products or components. But these new trade flows are also more volatile, since production processescanbe quickly moved to more competitive locations. Indeciding on the location of production units, firms increasingly conside:rtradeoffs between the costs of production andthe costs of stockholding, transport, anddistribution-that is, logistics costs. Figure1: LoglaticsCOSY as a share of GDP 4. A recentBank study estimates logistics costs inBrazil at about 20 percentof GDP, almost twice the Per" level in OECD countries (figure l).' same study The AigenhM estimates that logistics costs account for an average B&l MdCO 35 percent of industry operating costs inLatin Germany America, ranging from 11percent for textiles to 60 TdWa" percent in some food industries. B y contrast, logistics Portugal costs account for only 20 percent of manufacturing Canada JBPB" costs in OECD countries, varying from less than 15 MY percentinthe automotive industry to about 30 percent UK infoodindustries.Thus, there seems to be ample USA scope for reducing the costs and improving the 0 5 10 15 20 25 30 Per~enlolGDP reliability of logistics systems in the region, 'J.Luis Guasch, ongoing work on logistics inLatinAmerica. 132 particularlyinBrazil. 5. Inventoryand warehousing costs are the largest component of logistics costs, accounting for almost 40 percent inthe region. Inventory costs are obviously proportional to interest rates, which have remained highinthe region, particularly inBrazil. But aWorld Bank study shows that inventory levels inBrazil and many other developing countries are typically twice as highfor final products and three times as highfor raw materials as inthe UnitedStates, Figure 2: Ratio of Inventory levels where inventories are estimated at about 15 to U.S. inventory levels percent of GDP (figure 2).2The cost to the Brazil Brazilianeconomy of the additional inventory Mexico holdings i s huge, exceeding four percent of GDP at a 15 percent interest rate.3The study concludes Chile that the low quality andreliability of logistics Colombia services, particularly transport and customs, i s the Vermzwla maincause of the highinventory levels in Peru developing countries. Bolivia 6. Transport and transshipment costs Ecuador represent about a third of logistics costs inLatin America. Brazil's domestic freight transport C6 Ci raw materials Wfinal goods market has inrecent decades been dominated by the trucking industry, which accountsfor almost 80 percent of the demandfor transport and i s essentially unregulated. There are many informal businesses offering low-quality services, a high incidence of cargo theft, and evidence of overcapacity, with a large share of empty return trips andtruckers unable to cover their fixed costs. Moreover, the poor conditionof roadnetworks reduces the efficiency andreliability of trucking services, increasing operating costs by 10-30 percent and affecting delivery schedules. A World Bank report estimates the additional cost to the economy at about two percent of GDP.4 7. Followingtheir recent restructuring and privatization, railways have been increasing their share of traditional markets (particularly the grain market), boosting productivity, and improving service q ~ a l i t yBut with a few exceptions, railways have beenunable to compete with truckers . ~ inthe morelucrative generalcargobusinessor inthe long-distance segment. Shippinglines too are increasing their participation inthe bulk market along the coast, following the deregulation of the industry and the reform of the ports. But their participation inthe general cargo market remains marginal. 8. The ongoing reform of the ports system has already ledto significant reductions inport costs andtariffs. Between 1997 and 2000 port tariffs were reducedby about 50-70 percent in Guasch and Kogan 2000. Newton de Castro 2001. World Bank, "Brazil: FederalHighway Rehabilitation andDecentralization Project."l997. World Bank, "Brazil: FederalRailways Restructuring and Privatization Project," 1996. 133 U.S. dollar terms (including the effect of the Realdevaluation).6And private operators have improvedtheir performance. But labor costs inmany Brazilianports remainsubstantially higher than those inother ports inthe region and elsewhere, and administrative processesand documentation requirements remain cumbersome. 9. Resolving these issues inthe transport systemwould do much to remove the impediments to providingefficient, reliable multimodal transport services, substantially reducing logistics costs for Brazilianfirms. But following the recent waves of privatization inthe transport sector, the main issues now relate to government policies and the regulatory framework, which could do more to encourage private operations and investment intransport. There are also some issues specific to multimodal transport, and these too relate to inadequateregulation as well as to a lack of effective arbitration mechanisms.A conservative estimateputsthe avoidable logistics costs relatedto multimodal transport issues inBrazil at more than US$3.2 billion a year.7 10. Customsand administration costs,including losses andinsurance, Figure3: Structureof logisticscosts account for the remaining 30 percent in LatinAmerica of firms' logistics costs inthe-region (figure 3). InOECD countries there is 18.7% a clear trendtoward contracting out 10.0% .Transport (ports) logistics to third parties and even 0Warehousing entering into long-term strategic alliances with logistics service W Customs providers, reducing firms' administra- involvedinforeign trade, customs represent amajor cost, more than 10percent of operating costs on average. Brazil's outdated customs procedures and practices have anegative impact on the firms' competitiveness, on international trade and on regional integration. Insufficient progress hasbeenmade inimplementing the decisions of the MERCOSUL Council to facilitate regional trade, including agreementsto harmonize procedures, standardizeforms, andultimately developjoint customs operations. 11. Interviews conducted with private businesses with marketsabroadreveal that some of the logistic costs components are also perceived as the main impediments to export growth inBrazil (figure below). 8 GeipotandWorldBank, A ReformaPortuariaBrasileira", 2001. WorldBank, "Brazil: MultimodalFreightTransport: Selected RegulatoryIssues", 1997. Os ProblemasdaEmpresaExportadoraBrasileira,CNI, 2002 134 Entraves B Expanshodas Exportapiies 0% 5% 10% 15% 20% 25% 30% 35% W e 1 12. Clearly, there i s ample scope for improving the efficiency and reliability of logistics systems inBrazil. Such improvements could boost competitiveness substantially, since even a relatively small reduction in a product's final price and more reliable delivery schedules can lead to substantial gains in a firm's market share. A modest reduction inlogistics costs of, say, 15 percent could reduce firms' costs by about five percent on average, which could have a substantial impact on Brazil's economic growth. Because of the large inefficiencies at ports and border crossings, the impact on external trade and regional integration could be even greater. Finally, improvements inthe logistics systems and rural infrastructure services inthe country's more remote andless developed regions, particularly the North and the Northeast, could substantially increase investment and growth opportunities inthese regions and thus help reduce poverty and regional disparities. 2. IncreasingEfficiency of Customs' Clearance 13. This section summarizes the results of a diagnostic of the effectiveness of Brazil's Customs infacilitating trade (FullReport inProject Files), and the measures which the Government intends to take to increase effectiveness. The diagnostic i s based on a series o f meetings with members of the Brazilian trade community, including importers, exporters, customs brokers, port andwarehouse operators, major trade associations, and with Government officials from Customs, Receitu Federal, and the ForeignTrade Ministry. 14. The main theme echoed by the business community throughout the interviews, which confirm various studies o f the competitiveness of Brazil inthe global economy, i s that customs procedures represent one of the major hurdles companies have to overcome ininternational trade. Since timing i s of the essence, particularly withjust-in-time production anddelivery processes, complex customs procedures and overextended and unpredictablecargo release times at ports are a major disadvantage for Brazilian companies trying to compete inthe international 135 markets. Brazil's tax system, illegal payments, port costs, and other government agencies' operations are also cited as issueswhich add to the cost of importing and exporting. 15. The Customs Departmenthas beenworking at addressingthese issues, and it did obtain some results interms of reducing selectivity levels and releasetimes. Customs releasesare now processedwith the helpof a computerized system, SISCOMEX, and another system, RADAR, collects company profiles. But the two systems are not yet linked, and since there i s no adequate riskanalysis, selectivity levels remainhigh. Inaddition, SISCOMEX was developed on the old, complex import andexport procedures, which needmuch simplification. A cargo control system (SISCOMEX-CARGA) i s also being developed. But Customs i s facing numerous difficulties anddelays with the development andmaintenanceof its systems. 16. Some special programs have beenintroduced, such as the BlueLane, which considerably speeds up the clearance process for companies which facilitate Customs' access to companies' records, but import andexport requirementsare such that only 14multinationals participate. And even this facilitated processcan only start after cargo has arrived at port, since there i s no advance release system. 17. Customs StrategicPZan. The Government recently approved a general strategy for the reform andmodernization of Customs. Trade facilitation has now become a major objective in Customs' mission. For this purpose, Customs will simplify its clearance procedures for both imports and exports, and update and integrate its computerized operations information systems accordingly. The new procedures will seek to fully implementthe MERCOSUL agreement for joint customs operations, and incorporate the security controls requiredby certain countries. Customs will also revise their staff performance evaluation criteria and provide themwith adequatetraining. 18. Customs will, inthe short term, prepare a detailedstrategic plan inline with the above strategic guidelines. The strategic planwill include specific action programs inthe areas which are discussed inthe following paragraphs, as well as detailedperformance targets. It i s expected that inthe mediumterm, with the proposed changes, average cargo releasetimes couldbe halved from their presentlevels, for bothimports andexports. 19. Re-engineeringof Procedures and System Modernization. The strategic plan will include a detailed action planfor re-engineering import and export clearance procedures with a view to substantially simplify them, but also to incorporate the new security controls that the United States and other countries are now requiringfrom exporting countries, and to implement the MERCOSUL agreement. It will also include aparallel action planto modernize and develop Customs' operations information andcontrol systems on the basis of the new procedures, addressingthe integration issues, both internally and, to the extent possible, with the systems of other partners inthe trade logistics chain. 20. Short term improvements are expectedto include: acontinuous operation of SISCOMEX and its integration with the RADAR system; an expandedBlueLane regime, with reduced import and export requirements; simplified export procedures; and advance release for air shipments; improved security checks for exports to the UnitedStates at Santos; andpilotjoint customs operations with a MERCOSUL country. With these improvements, Customs i s 136 expectedto reduce its selectivity levels for document review and cargo inspection from 40 to 30 percent inthe short term. 21. Inthe mediumterm, an appropriateriskmanagementsystemwouldbe inplace, together with an advance release system; SISCOMEX andother systems would have beenupdated accordingly and integrated with a cargo control system, also integrated with the ports systems and Merchant Marine's ship control system. Improvedsecurity checks for exports to the United States would be inplace inthe major ports. And the MERCOSULjoint customs agreement would be substantially implemented. Customs would then be expectedto reducetheir selectivity ratios for inspections to less than 20 percent inthe mediumterm. 22. Staff Redeployment and Development. The above organizational changes, in order to be effective, will be accompaniedby acomprehensiveaction plan for staff redeployment and development. Inthe short term, internal procedures will be implemented in order to review workload issues, and some re-assignments will take place to correct major imbalances. The staff performance evaluation systemwill be revised to emphasizethe new trade facilitation objective, and an internalunit and appropriate procedures will be establishedto overseepersonnel integrity. A comprehensive staff development program addressingthe changesinproceduresand systems, andpromotinga new culture consistent with Customs' new mission, will be developed inthe short term and implemented inthe medium term. 3. Further ReducingPort Costs and Delays through Completion of the Port Reform 23. The reformof the port sector was initiatedwith the Port Modernization Law of 1993, which defined a new institutionalframework emphasizing privatizationof operations, competition, and decentralization. But it is only inthe late 1990sthat significant progresswas made, particularly with the concessionning of the major terminals to private operators, the opening of many private (own account) terminals for public use, andthe establishment of local Port Authority Councils (CAPS), and Labor Management Organizations (OGMOs), to help rationalize labor use. 24. These changes have resulted in substantially reduced port costs. For example, inSantos, which was the costliest port inLatin America, container handlingcosts have dropped from well over US$300 in 1997 to US$180 in2000. But the costs still remain muchhigher than those in Europeanports like Rotterdam (US$lOO) and even Buenos Aires (US$120). 25. Some important aspects of the reform still remain incomplete. Fully realizing the expectedbenefits of the reform, particularly interms of facilitating trade, would require resolving outstanding issuesregarding the institutionalandcompetitiodregulatoryframework, port administration andmonitoring, labor redundancies, trade-related operations control systems, and environmental managementinthe sector (see MT/Geipot and World Bankjoint report, A Reforma Portuaria Brasileira, September 2001). 137 26. ConsolidatingtheInstitutional and Regulatory Framework. The reform of the ports sector has somewhat stalled becauseof the absence of clear policies and guidelines neededto implement the institutional and regulatory framework broadly definedby the Port Modernization Law and the Transport Sector Restructuring Law. Inparticular, eachpublic dock company has leasedterminals independently, on somewhat differingterms and without concern for potential inter-port competition issues. CAPs have been establishedinmost ports, but the respective roles and responsibilities of the CAPs, the Port Authorities (APs) or dock companies still controlled by the Federal Government, andthe regulatory agencyAgZncia Nucional de TrasportesAquavidrios (ANTAQ), are not clearly defined. MinistCrio dosTransporteshas delegatedfive ports to states or municipalities, but the roles andresponsibilities of each parties have not been clearly defined either. 27. Before proceeding with the reform, the Government has set up a working group to review the present institutionalandregulatory framework for ports, andto formulate policy recommendations on delegations, competition and regulation, and guidelines and norms for port administrations (CAPs andAPs). On this basis, it i s hopedthat inthe mediumterm, the major ports, particularlySantos andRio de Janeiro, would be effectively delegatedto the respective states and/or municipalities, that an appropriate regulatory framework would be inplace, andthat competition issueswould havebeen addressed. 28. StrengtheningPort Administration and Monitoring. The public dock companies, which have withdrawn from directly operating ports, have reducedtheir own staff by 70% to a total of about 3,500 (inmany instancesby allowing their longshoremen tojoin the pool of for-hire stevedores). But they have not yet reorganized to carry out the port authority functions, including an effective supervision of the leasecontracts. Besides the lack of clear guidelines on the issues raisedinthe preceding section, a major obstacle for this reorganization is their financial situation. Most of themhave debt obligations which are well beyondtheir financial capacities. And the lack of reliable data on port terminal operations makes it difficult, if not impossible, to monitor the performance of the ports system. 29. The above-mentioned working group, incollaboration with ANTAQ, will develop and establish a set of norms and performance standardsfor port authorities and an action plan for the financial restructuring of the dock companies, so that they could, inthe mediumterm, be reorganized and strengthenedto effectively carry out their port authority functions. Inaddition, ANTAQ, which has already started the development of a port performance monitoring and evaluation system, will support the establishment of the system intwo pilot portsinthe short term, andinthe mainport inthe mediumterm. 30. Adjusting Port Labor. Port labor is responsible for a large portion of the highcosts of cargo handling inBrazil's ports. It has not yet been fully adjustedto account for the mechanization of the ports; of the total workforce of about 35,000 stevedores, at least 20,000 may be redundant. Insomeports, the Labor Management Organizations have made progress in reducing gang sizes andlabor costs, but others workers retain excessive advantages inwork conditions and compensation (about 65-70 stevedores are paid on afull-container ship at Santos, compared with 15-20 at Buenos Aires and 7-8 at Antwerp). The impact on Brazil's competitiveness and trade i s major-far greater thanthe cost of retraining and redeploying redundant stevedores to other, more productive activities. 138 31. With little competition among ports or terminals, private port operators and labor unions lack the incentive to resolve the labor issue. Thus an important priority for the government i s to facilitate negotiations between operators and labor unions for adjusting port labor, and contribute to settingup a program for retraining and redeploying excess port labor. Initial steps have been taken with the establishment of the Camara Setorial,which will be the forum for negotiating this and other port-relatedissues between representatives of the operators, labor unions and the government. The Government expects to reach agreement on adequate compensation conditions and on a labor redeployment plan inthe short term, so that the number of registeredstevedores could be reduced from the current 35,000 to below 25,000 in the medium term. 32. Integrating Trade Logistics OperationsZnformations Systems. Private terminal operators have established computerizedterminal operations informations and control systems of various sorts. The public dock companies have various types of informations systems. Customs i s implementing, on a pilot basis, a cargo tracking system, SISCOMEX-Carga, and the Merchant Marine Department i s implementing a ship control system, which, ultimately, would be in operation in all ports. Unfortunately, there has been little effort to coordinate or integrate these systems. International experience shows that the integration of the operations information and control systems of all the participants inthe trade logistics chain can bring very substantial gains inefficiency andcompetitiveness. 33. Inorder to promote the development and integration of these systems, the Government has established an interministerial working group, with responsibility for recommending appropriate technological norms and standards for data interchange and system integration, and an action plan to promote the systems' development andintegration. It i s expected that the above-mentioned basic systems inthe major ports could be integratedinthe medium term. 34. Enforcing Environmental Regulations at Ports. Brazil has adequate legislation and regulations for environmental protection, including for the protection of coastal areas, consistent with the international agreements such as MARPOL, which Brazil has signed. But in general the dock companies, which are to become the port authorities (APs) do not have the technical capacity needed to effectively implement and enforce the legislation and regulations inthe ports. 35. The Ministry of Transport i s committed to develop an action plan to support appropriate organizational arrangements in the port administrations (CAPSand APs), and training programs for their staff, in order to strengthen their capacity to effectively implement the environmental regulations in their activities, and to enforce them with the terminal operators which they regulate and supervise. 4. DecreaseRoad Transport Costs by Restoring and Maintaining the Condition of the Highway Network 36. Brazil's federal highway network, totaling about 58,000 kilometers (km),was built from the 1950s to the 1970s and represents a total asset of nearly US$10 billion. It carries most of the country's long-distance traffic. Maintenance has been inadequate for many years, with about 25- 30 percent of the network rated in poor condition. The network's poor condition leads road users 139 to spendan annual amount equivalent to about three times replacement value to operate their vehicles. 37. The fiscal reformof 1988andthe elimination of the roadfund substantially reducedthe funding for maintenance.And the national highway agency (DNER) proved unable to effectively implementa strategy for network rehabilitation andmaintenanceinline with the available funding.Moreover, its maintenancepolicy-contracting out the engineering designs, rehabilitation and other works, andmaintenanceandsupervision services through traditional, input-based contracts-proved ineffective, with procurement andimplementation delays leading to numerous design changes, cost increases, and contract modifications. As the agency's management has consisted increasingly of political appointees with little relevant experience, andsubject to rapidturnover andto politicalinfluence inevery operational decision, DNERhas seen its execution capacity deteriorate and has been unable to implementthe changes needed. 38. The Highway Reform A broadpolicy and institutional reformwas initiated to address these funding, policy, and managementissues.The reformhad severalaims: To reclassify the highway network with a view to maintaining under federal jurisdiction only the main interregional and interstate highways of national interest (about 45,000 km),transferring to statejurisdictions highways of mainlylocalinterest (about 20,000 w 0 To transfer highway sections with sufficient traffic to private concessionaires, and recover all or part of the costs of operation, maintenance, and upgrading directly from road users through tolls (about 15,000 km) 0 To contract out rehabilitation works and maintenanceservices combined on entire routes of the remaining network through long-term (five-year) output-basedRehabilitation and Maintenance Contracts (CREMA), with the contractors responsible for achieving specified levels of service (about 30,OOOkm). 39. The transport sector administration was restructured, terminating DNER andestablishing anew national department of transport infrastructure (DNIT)responsible for executing public sector programs, a national agency for landtransport (ANTT) responsible for regulating and supervising highway and railway concessions and landtransport services, and anational agency for water transport (ANTAQ) responsible for regulating private infrastructure and transport services inthat subsector. 40. Highway Management. DNIT was gradually established over the past two years, essentially by transferring the staff from DNER (which i s still inthe process of closing down) and from other departmentsof MT, the relevant contracts and most administrative procedures and systems. As a result, DNITinheritedthe organization andculture of DNER and i s not yet effectively performingthe planning, management, supervision and monitoring and evaluation functions for which it was created. 41. The Government therefore establisheda special task force to effectively coordinate the implementation of its highway strategy, including the establishment and strengthening of the necessaryplanning, management, supervision andcontrol systems within DNIT,as well as 140 appropriate program monitoringand evaluation systems inM T and SEPLANEPI. DNIT systems, with adequately trained staff in sufficient numbers, are expectedto be operational inthe short term. The multi-year highway expenditure program included inthe PPA would be updated each year, as part of the PPA review process, and the Government would make the funds available to the highway programin atimely manner. 42. ANTT was establishedmore rapidly andis now basically operational inits regulatory and supervision functions, includingfor highway concessions. However, like a number of other regulatory agencies, ANTT does not yet have adequateinformation andcontrol systems to effectively perform its functions. But it has an appropriate action plan to establish such systems. 43, Decentralization. Decentralization agreementshave been signedwith 14 states which, if implemented, would transfer up to about 14,000 kmfrom Federal to Statejurisdictions by 2006. Butthe proposedlaw which wouldreclassify the highway networks andprovide the legal basis for fully implementing the decentralization agreements, the so-called NationalTransport Infrastructure System (SNV) law, has stalled inCongress on issues that are unrelatedto the reclassification and havebeenresolvedwith the law for restructuring the sector administration. The Government will therefore revise the proposed SNV law and actively seek its approval in the short term, and, on this basis, restart negotiations with the States to proceedwith the decentralization program. With the SNV law approved, the initial target of transferring about 20,000 kmto the States couldbe achieved inthe mediumterm. 44. Concessions. Federal highways totaling about 5,000 km(of which 3,000 kmare delegatedto states) and Sao Paul0 State highways totaling about 2,500 kmhave been under concessionfor several years, androad users have generally been satisfied. But optimistic traffic forecasts (and relatedinvestment obligations) and generous contract renegotiation rules have led to many contract modifications that may have transferred commercial risks to road users and have resulted into substantial tariff increases.As a result, the secondphase of the federal program, for about 2,500 km, has beenstalled for several years by intense questioning from Government auditors. 45. The Government therefore undertook a comprehensive review of the concession bidding andcontract documents, inlight of the Brazilianand international experience, andis preparing to update the feasibility studies to correct the main shortcomings before proceeding with a new phase of the concessionprogram, The new highway concessionmodelwould also incorporate the public-private partnershipconcept, which the Government is developing separately, and which could turn more highway concessions feasible while keepingtoll tariffs acceptableby users. Dependingon Brazil's investment rating and Government funding support available, a total of 10,000 to 15,000 kmof federal highways could beunderconcessioninthe medium term. 46. Performance Contracts. DNIThas five-year rehabilitation and maintenance (CREMA) performance contracts ineffect on more than 4,000 km, and similar, two-year maintenance (CONSERVAR) contracts on about 8,000 km. Experience with these recently-introduced contracts has been mixedbecause of inadequatefunding from Treasury and inadequate supervision from DNIT. Appropriate measures are beingtaken to strengthenDNIT contract supervision capacity (see Highway Management section above). And the Government i s 141 committed to makingavailable the funds necessaryto these programs, on a timely basis in accordancewith a timetable agreed at the beginning of eachyear. 47. With appropriate funding, managementand supervision, the CREMA program would, in the short term, be successfulinrestoring andmaintainingthe highways in adequatecondition in a cost-effective manner. It couldtherefore be extended, inthe mediumterm, to the entire remaining, non-concessionned,network (about 30,000 km). The service levels required fromthe contractors would be determined on the basis of the resourcesmade available to the sector. But a feasible, recommended annual fundingof US$300 million over four years would allow to practically eliminate the severe maintenancebacklog accumulatedduring the previous decades and to maintainthis 30,000 kmnetwork ingood condition, reducingvehicle operating costsby more thanUS$500millionannually. 5. RestoringCapacity for Infrastructure Planning, Financingand Monitoringand Evaluation 48. The PPA 2004-2007, which was recently presentedto the Congress, includes infrastructure investment programs (including transport, energy and telecommunications) estimated at about US$31billion equivalent. And it is hopedthat the private sector could mobilize up to 30 percent of the resourcesneeded, Le. about US$9 billion. 49. Investment priorities inthe various sectorshave been definedthrough abroad consultation process, which involved state and local administrations and civil society. However, many of these programs or projects lack adequatepre-investment studies to provide satisfactory assessment of their economic and financial feasibility, includingtheir impacts on the environment or on disadvantagedpeople or communities. 50. Sectoral policy formulation and planning capacities essentially disappearedduringthe period of highinflation. With some exceptions, including the Eixos study which has influenced the preparationof the PPA, the allocation of public resourceshas largely been determined-or at least largely influenced-by politicalconsiderations. Moreover, because of the lack of cost- benefit analysis and project finance experience, there i s little incentive for involving the private sector and many obstacles to doing so. And poor project concept or design and inefficient administrative processesextend the project development period, leading to commercial and noncommercial project risks and often makingprojects unviable for private financing. 5 1. Policy Formulationand Planning Capacities. The Government has already taken important steps to rebuildpolicy formulation andplanning capacities inthe infrastructure sectors, with a view to promote broader private involvement inthese sectors. An inter-ministerial committee for infrastructure policies (Camara de Infra-estrutura) has been established. The Government also intends to reactivate various interministerial committees to improve policy decision makingincluding CONIT, for integration of transport policies. A proposal i s being finalized, andi s expectedto be presented to the Congress shortly, to define and regulate government support to privateprojects through public- private partnerships (PPP), and to establish a PPPunit inMPOG/SPI to promote such PPPs inthe infrastructure sectors. 142 52. The PPP legislation i s expectedto be approvedby the Congress inthe short term. If this i s the case, the Government would, also inthe short term, establish the proposedPPP unit in MPOG, as well as counterpart PPPunitsinthe infrastructure ministries. These new units, as well as the policy formulationand planning departments or units of the infrastructure ministries (particularly transport, energy and telecommunications) will gradually be strengthenedwith adequately-trained staff, includingspecialists inpublic policies and inproject finance. 53. The PPP unitswill be responsiblefor developing a pipelineof infrastructure projects which can be financed by the private sector with the minimumpublic support necessary. It i s expectedthat each sector unit would first identify and analyse one (or more) pilot projects inthe short term, andhave them structured and initiatedinthe mediumterm. 54. Infrastructure finance instruments to leverageprivatefunding. The NationalEconomic and Social Development Bank (BNDES)i s the primary lender for infrastructure investments in Brazil, providing about US$5-7 billion inloans annually. BNDES has been financing at least part of projects debt on very favorable terms, makingit difficult for project sponsors to attract private bank financing. Insome cases cofinancing with the International Finance Corporation or Inter-AmericanDevelopment Bank has helpedbring syndicate private bank loans (B loans) to close the transactions. Such direct financing has been necessary given the volatile macroeconomic conditions, the government's lack of experience in structuringprojects for private financing, and the nascent legal and regulatory framework. 55. With the recentprogressinaddressingthese constraints, however, the government could develop a strategy to gradually move from direct financingto indirect financing and to promote the development of the domestic capital market and private investment ininfrastructure. The maindomestic source for long-term investment funds i s pension fund reserves, almost half of which i s invested inshort-term, fixed income public sec~rities.~ With interestrates falling, a large share of these resourcescould gradually move to variable income and private securities, especially if the rules governing pension fund investment were phasedout and replaced by a more general "prudent professional" rule. And with the ongoing reduction inthe perceived country risk, some of the enormous pension fund reserves abroadcould be shiftedto profitable long-term investments inBrazil, including ininfrastructure. 56. The Government and BNDES intendto test various instrumentsor financing facilities to promote private investment ininfrastructure.lo instrumentswould include government These guarantees and securitization of public assets or cash flows. After beingtested inpilot projects and implemented caseby case, suchinstrumentscouldbe mainstreamedthrough special-purpose financing facilities offeringbothcredit-enhancing guarantees and direct loans where needed to close atransaction. Appropriate contingency planning andbudgeting would beput inplace for these instruments,which would be gradually phasedout as domestic capital markets become stronger. MPOG, Secretariat of Planning and Strategic Investments, "Long-Term FundinginBrazil: The Infrastructure Case." lo Dailami and Klein 1998;Darche 2000. 143 57. Monitoring and Evaluation of Public Expenditure Programs. The Government is preparing to establish a comprehensive systemto monitor the implementation and to evaluatethe results of public expenditure programs, including the infrastructure programs. This system would become the basis for carrying out the annual reviews of the PPA and for proposing eventual revisions to the Congress. MPOG/SPI, which coordinates the preparation and the implementation of the PPA, i s responsible for the design and implementation of the monitoring and evaluation system. It i s expected, however, that sectoral ministries would, with guidance from MPOG/SPI, establish or strengthen appropriate monitoring and evaluation systems for their own programs, which would form a solid foundation for the PPA monitoring and evaluation system. 58. MPOG/SPI will, inthe short term, prepare a design and an implementation plan for the monitoring and evaluation system. Discussions are ongoing between the Government and the Bank to define a cooperation agendato support MPOGindeveloping such system. The transport ministryhas already manifested its interest for pilotingthe development and implementation of the monitoring and evaluation system at the sectoral level. The Government expects to have the MPOG/SPIand at least the MT systems inoperation inthe mediumterm. 6. Strengtheningthe Regulatory Framework for Infrastructure Services 59. Brazilhas made rapidprogress inbringingthe private sector into the provisionof infrastructure services. But much remains to be accomplished. The main challenges lie in deepening and sustaining reforms, resolvingfinancing issues for the less attractive concessions, buildinga soundregulatory framework andeffective regulatory agencies, and implementing a consistent, sustainable strategy for improvingpoor people's access to infrastructure services. 60. The legal and regulatory framework for infrastructure has a numberof weaknesses. In general, the law gives too muchpower and discretion to public authorities. The interpretation of severalkey legal conceptsremains ambiguous, prolongingcontract negotiations and increasing transaction costs. Regulatory arrangements are neither transparent nor consistent across sectors and are vulnerable to political interference, leading to numerousdisputes and contract renegotiations and wasteful rent seeking. And there i s little scope for resolvingdisputes other than through slow, cumbersome, andunpredictablejudicial processes.These weaknesses raise concerns about the stability and credibility of regulations and contracts, substantially reduce private sector interest, andjeopardize the feasibility of many projects. 61. Regulations can be effective only if implemented andenforced by effective institutions. Effective, independent regulatory institutions can reduce actual and perceived investor risks by increasing the transparency, credibility, andpredictabilityof regulations andby helpingto settle disputes. They can reduce the likelihood of capture by operators or politicians. They can foster technical, allocative, and dynamic efficiency by safeguarding against monopolistic practices. Andthey can ensure the sustainability of tariff regimes andconcessioncontracts. 62. Regulatory Governance. The Government has recently publisheda White Paper on the role of regulatory agencies, which provides a clear diagnostic of the mainissues of regulatory governance and recommendations for improvements, including: (i) clearly reallocating policy 144 formulation and concessionbiddingand contracting responsibilities to sector ministries; (ii) improvingthe accountability of regulatory agencies towards the congress; (iii) increasing the transparencyof their decision-making processes; (iv) improvingcoordination with the anti-trust entities; and (v) resolving the agencies' staffing issues and formalizing the regulators' carrier stream. 63. The Government expects that draft legislation addressingthe above issues and recommendations could bepresentedto the Congressinthe short term, and, if approved, substantially implemented inthe mediumterm. The Government also intendsto shortly reactivate the debate inthe Congress on the proposal for the creation of a regulatory agency civil aviation, including airports (ANAC), which, if approved, would enable the Government to establish ANAC inthe mediumterm, and with this agency to complete the systemof regulatory agencies for infrastructure services. 64. GeneralRegulations.The Government is also preparingto address the mainregulatory issues, which cut across sectors, and are essentially relatedto tariffs. The general pricing principle i s to rely on a two-part tariff, the variable partbeing set close to the marginal cost of producing services, the fixed part being set to ensure financial viability, basedon appropriate benchmarking. Inorder to meet the Government's equity objectives, the fixed part could also vary according to the ability to pay. Procedures, criteria and methodologies for adjusting and revising tariffs will beclarified, and the use of benchmarking and comparative efficiency analyses will be expanded. The informationto be provided by the concessionaireswill be clarified accordingly, andpenalties for non-compliance will be clearly specified incontracts. 65. Inparticular, the Government will clarifythe conditions, criteria andmethodologies for applying the financial equilibrium clause of the concessioncontracts. That clause requiredby the ConcessionLaw is currently applied inconsistently across sectors, sometimes in a manner which provides an across-the-boardrate of return guaranteeand i s a disincentive to productivity increases. The Government intendsto issue such regulations and guidelines for regulatory agencies inthe short term, so that they canbe substantially implementedinthe mediumterm. 66. TransportRegulations. The Government andthe regulatory agencies for land(ANTT) andwater transport (ANTAQ) have madeprogressinaddressingsome sector-specific regulatory issues. Inparticular, a set of regulations has been preparedfor railways, which clarify the conditions, criteria and methodologies for applying the general regulations on railways captive shipper rates,joint andinterchange traffic, access pricing andbranch line abandonment, which are included inthe railways regulation decree and inthe concessioncontracts. 67. These railway regulatory improvements have beenprepared inparallelwith a geographical restructuring of the railway concessions inthe Southeast region, inorder to bring them inline with the natural transport corridors, which was not possible at the time of concession biddingbecauseof the delays inresolving the situation of the Sao Paulo (ex-FEPASA) railways. However, a decision i s still neededon how to resolve the critical railway connectivity bottlenecks inthe Sao Paulo metropolitan region (which are due to increasing commuter train services) andin accessingthe port of Santos. The Government i s expectedto take a decision on boththe regulatory and the restructuring proposals inthe short term, so that ANTT can implement theminthe mediumterm. The Government will also, inthe short term, seek 145 agreement with the state of Sao Paulo on a planfor improving freight train traffic inthe metropolitan regionof Sao Paulo. 68. The Government also intendsto define and enforce rules for effective multimodal transport operations, and to facilitate the selection of formats for electronic data interchanges, commodity certification, and for the standardization of intermodal equipment. The rules will in particular clearly define the responsibilities of the multimodaltransport operator (OTM) with respectto individual carriers or partnersinthe intermodal logistics chains, and establish effective conflict resolution mechanisms. They will also resolve some insurance and tax-related issues, and promote the use of a standard, unifiedbill of lading. These rules and an action plan for facilitating the definitionof formats are expectedto be approved inthe short term and implemented inthe mediumterm. 69. The proposedimproved regulation of transport services, and establishment of formats or standardsfor electronic data interchange, commodity certification, and equipmentexchange, i s expected to lead to a gradual integration of the transport andother logistics services and operations information and control systems. Such integration, together with the other actions described above, will substantially reducethe costs of logistics inBrazil, possibly from 20 percent to less than 15 percent of GDP inthe medium term. Itwill also allow the development, by third parties, of quality logistics services, which will substantially increasethe productivity and competitiveness of Brazilianfirms, and inturn contribute to the recovery of sustainable growth. 146 ANNEX 6 THEBUSINESSENVIRONMENT 1. A sustainedincreaseineconomic growth is achievedby apermanentincreasein investment ratios or inproductivity growth. InBrazil, investment ratios have declined over the last two decades and TFP improvements have been modest. Investment levels and productivity gains have beennegatively affectedby the deterioration of the business environment duringthe 1980s andpart of the 199Os,reducingthe marginal productivityof capital. Three factors, among others, negatively affected the businessenvironment inBrazilduringthe 1990s:(i) the infrastructure regulatory framework; (ii) the competitive environment; and (iii) lack of a the coherent businessdevelopment services. Each of these elements -or rather the lack of it - reduced the attractivenessfor the private allocation of resources(either financial resourcesor entrepreneurship) inthe Brazilian economy, contributing to the a lower economic growth during the period. Inthis Annex, we will discuss the main issues associatedto each of these components, the recent achievements of the government as well as the future challenges Brazil might face. 1. InfrastructureRegulation Background and Issues 2. Inthe 1990s,Brazilcarriedout major reformprograms inthe infrastructure sectors with very limitedresults interms of investment expansion.Reforms were built around privatization, the unbundling of telecom and electricity companies, and the establishment of new regulatory frameworks. Followinginternational practice, regulatory reform involvedthe separationof commercial, regulatory, andpolicy activities. Telecom, port, railways, and the energy legal frameworks also put significant emphasis on the role of competition. Private ownership and competition were expectedto raise efficiency and private investments in infrastructure services. But, while infrastructure reforms have reduced fiscal burden and improvedthe operational performance of utilities, the results interms of increasedinvestment have-with the exception of telecom-been disappointing (see Table 1). Infact, the expansion of services inkey sectors such as roads and electricity have not been enough to reduce the gap between Brazil and most of it international competitors inthe provision of such services (see Table 2). 147 Table 1:Gross Fixed CapitalFormation(as % of GDP) 0.53 0.69 0.89 0.77 0.67 Total 23.50 18.00 14.90 17.00 16.35 16.45 16.10 16.50 Source: Based on Bielchovsky et a1(2002) "Investimento e Reformasno B r a d-Ind6stria e Infra-estrutura nos anos 1990". IPEA: Brasilia, DF. andWDI. Table 2: Infrastructure ServicesinBrazil and Selected Countries 1994-1999 Roads, paved Telephone Electric power (% of total roads) mainlines (per consumption 1,000 people) (kwh per capita) 9.6 19% 79.8 148.7 86% 1538.8 1817.1 Source: WDI 3. The poor investment performance of infrastructure sectors is intimately linkedto a poor regulatory framework. As macroeconomic stabilization imposes limitations on public investments and private capital becomesthe main source for the expansion of infrastructure capital stock, the regulatory environment becomes an essentialconditionfor the expansion of infrastructure. Becauseof the inherently highsunk-costs, privateinvestors are concerned with regulatory opportunism and the incentive to appropriate rents once investments are made. Uncertain regulations increase the risk of regulatory opportunism andthereby the premium 148 charged for investments ininfrastructure sectors. Dependingon the country and sector, such regulatory risks can addtwo to six percentto the cost of capital, which inturn may add more than 25 percent to the final tariffs.' Estimatedcapital costs inBrazil remain highininfrastructure sectors andhave increasedmarkedly inthe last few years, despiteregulatory reforms (See Table 3). Water 12.0 17.2 13.3 Telecom 14.0 18.5 16.0 Source: Guasch, J. L.(2003) "Concessions: Bust or Boom?An Empirical Analysis of Fifteen Years of Experience inConcessions inLatinAmerica and Caribbean." The World Bank Institute, Washington, DC. 4. InBrazil, one component ofthe regulatory risk is the poor concessiondesign. Ill- defined property rights and liabilities inconcessioncontracts stimulate opportunistic behavior by both signatory parties, generatingrecurrent conflicts, which increasecost and harmperformance. Poor concessiondesigns introduce further difficulties when profitable state-ownedinfrastructure assets are transferred to the private sector, leavingthe government with the responsibility to cover costs and risks of the remaining weaker operations. Unbalanced outcomes, intheir turn, tend to lead to calls for renegotiation of contracts. The issue is then how best to leverage scarce public funds for the most pressing infrastructure investments. External vulnerabilities impose further complexities. For example, contracts should ideally specify contingent actions to mitigate currency risks, but most contracts provide no guidance and appropriate financial products are often not even available. Many existing concessions inwater, roads, and energy contain weaknesses stemmingfrom the award processor from features of the concessioncontracts. Recent examples of problems exist inwater (the city of Limeira), toll roads (the state of Parand) andelectricity (the state ofMinas Gerais). 5. Another component of regulatory risk is the incompleteness of the legal environment. With the exception of telecommunications, the major infrastructure sectors- transport (logistics) and electricity-present major limitations. Progressinwater & sanitation has been very little. 6. The least developed regulatory framework i s inwater & sanitation services, where distributinglegal rights among different municipalities and states remains the central problem. Legal conflicts have emergedbecause article 30(v) of the Constitution allocatesto municipalities the rights over the provisionof local services inthe case of pre-existing natural (water) and economic (water and sewage companies) resources, where geographic or political boundaries do not provide an easy mapping. Several privatizationattempts have been blockedby thirdparty court actions. The SupremeCourt has decided preliminarilyinthree cases, with final decisions World Bank (1999), ReportNo. 19568-BR. 149 still pending.2The Government i s sponsoring one Legal Bill (PL 41047/2001) to regulate this subject . 7. Inthepower sector, the 2001 energycrisis highlighted reformfailures relatedto regulation and pricingdistortions. Underthe previous contracting structure, incentives hadbeen absent for generators or distributors to ensure reliable supply to end-users and distributors hadno way of covering the costs of supply margins. Insome cases, generators could benefit financially from rationing. Under such regulation, new merchant plants hadno incentive to enter the market. At the beginning of 2003, Brazil's electricity sector found itself inan awkward intermediate positionbetween a state-controlled and a private-led market: wholesale market mechanismswere inadequate, while firm-handed central planning was also absent. In2003, the Government has initiateda wide debate with private sector and civil society actors about future directions. 8. For the transport infrastructure, the legal framework has major weaknesses. Ingeneral, the law gives too muchpower anddiscretion to public authorities. The interpretation of several key legal conceptsremains ambiguous, prolongingcontract negotiations and increasing transaction costs. The concessionlaw restrains substantially the array of options available to structure specific PPPprojects. Regulatory arrangementsare neithertransparent nor consistent across sectors, and are vulnerable to political interference, leading to numerous disputes and contract renegotiations and wasteful rent seeking. Enforcement of regulation i s difficult, with regulatory agencies set up only last year, andunclear provisions inconcession contracts with respect to information disclosure requirements. And there i s little scope for resolving disputes other than through slow, cumbersome, and unpredictable judicial processes. These weaknesses raise concerns about the stability and credibility of regulations and contracts, substantially reduce private sector interest andjeopardize the feasibility of many projects. Regulatory issues remain inthe logistics sector. 9. A third componentof regulatory riskis regulatory governance.InBrazil, regulatory laws within infrastructure have not been precise enough indefiningaccountability and transparencymechanisms. Beyondtheir formal independence, it i s essential for the regulatory agenciesto articulate the rationale underlyingtheir decisions, infull consideration of all evidence presented.Eventhe agencies that are well-thought-of (by formal standards), such as ANEEL, have receivedcriticism inthis regard: whether the rationale and deliberative processesbehind decisions has beenclearly explained. Furthermore, judicial review of regulatory decisions takes place at the first levelof thejudiciary, which lacks relevant expertise and training inthe topic. 10. Funding and staffing policies are also essential. The funding of regulatory agencies i s central to their credibility-government discretion over resourcescan constitute an effective means of subverting regulatory independence, quite apart from the direct performance impacts of funding cuts. Although absolute financial stability may be difficult inthe current fiscal circumstances, agencies may be runon a fiscally neutral basis and their budgetsmay be small in * ADI-1746-6, AD1 1842-5, and AD1 2077-3. Jurisprudence so far provides little guidance as cases have given contradictory findings on the rights over water and sewage services. 150 relationto the overall b~dget.~Independentregulators differ from most other government agencies owing to the highnecessityof knowledge, staff continuity, and hence salaries competitive with the private sector. Expertise improves the quality of regulatory intervention, staff continuity increasespredictability, andcompetitive wages reduce "revolving door" staff losses to the private sector, where regulatory expertise i s inhighdemand. InBrazil, the regulatory agencies have not been allowed to establishtheir own hiringmechanisms, compensation, or career policies. Agencies are today fully staffedby temporarily assigned employees, many originally employed by former regulatory bodies or by the former state-owned firms. Personnel from regulated companies often continue to draw compensation from and hold career positions within these companies. Retaining staff i s reported to be a problem. 11. Finally, good governancerequires the appropriate definition of boundaries between regulators andthe executive. An important issue is the extent of the power delegatedto regulatory agencies. Ambiguity currently stems from: (i) the proliferationof "executive" agencies to bypass rigidities inthe public administration; (ii)poor definition of important policy issues by the executive or legislature, creating "self-legislation" by infrastructure agencies (e.g., asset price evaluation inthe electricity ~ector)~; the involvement of agencies inissues outside (iii) their conceptual mandate (e.g., universal services, granting concessions, conducting auction^)^; and (iv) the lack of appropriate planning by the executive body.6 Inaddition, the judicial review of regulatory decisions by the first level of thejudiciary, which usually lacks expertise and training inthe topic, may increaseregulatory risk. RecentAchievements and Future Challenges 12. One important achievement i s the preparation of a draft Public Private Partnership (PPP) Law. While Brazil has a well developed concession-law, the PPP-law, once approved, will introduce more flexibility for the development of infrastructure projects by at least two main improvements of the existing concessionframework: (i) allowing for the use of public funds as a Sector laws provide for the financial independence of regulators. For example, ANEEL is supposed to receive 0.5 percent of revenues collected in itsjurisdictional market, reasonable by international standards. Intransport, funding of ANTT and ANTAQ consists of allocations from the general budget and revenues from authorization fees and from supervision fees and penalties from concessionaires. Agencies must comply with public expenditure rules and oversight requirements and are accountable for the use of public funds. Despite practical fiscal difficulties, funding for Brazil's regulatory agencies is provided for by law. For example, unlike other countries, neither Brazil's electricity law nor its secondary legislation defines the methodology to be used in the valuation of distributors' assets for tariff setting, creating incentives for both sides to act opportunistically. A similar problem i s faced by ANATEL in setting tariff for fixed-phone services. According to the Telecommunications Law, ANATEL is also accountable for the "universalisation" of telecommunication services; ANEEL released its own universalization program last May. Regulators' primary objective is generally the enforcement of rules conducive to efficiency. Today in Brazil, ANEEL, ANP, ANATEL, and ANTT are responsible for granting concessions respectively on new energy supplies, on new rights of upstream exploration in the oil market, on new spectrum frequencies, and on roads. Because bidder and regulator may have conflicting objectives - over which the regulator may later have to arbitrate - and because the concession-granting function can be performed well by other institutions, it i s generally advised that regulatory agencies avoid this task. For example, CNPE - the national council for energy policy - has not yet defined the rules for the sector. As a consequence, ANP and ANEEL have been the actual policy-makers in their sectors to complement the oil and electricity regulatory frameworks, granting themselves considerable discretionary power. 151 complement to private resources; and (ii) the concession criteria more flexible to better making fit the particularities of eachproject. The government hastaken clear steps for the development of a PPP-unit within the Ministry of Planning(MPOG), with the aim of identifying"bankable" projects and structuring project financing. Inthis area, the Government i s discussing with the IMF,through ongoing negotiations onthe next Stand-by Agreement, anincreaseinits fiscal space for investments ininfrastructure. 13. Significant improvements are neededin areas such as: (i) clarification of the financial equilibriumclause; (ii) definingcriteria for the use of scarce public resources in specific projects and the amount of resources (tariff affordability); (ii) the definition of a pipeline of bankable infrastructure projects; (iv) and the development of PPP-pilots. A related issue will be how to induce or increasethe likelihoodthat both signatory parties to a concessioncontract, the government andthe private operator, will comply with the terms of the contract andthat opportunistic behavior by bothparties i s dissuaded. Remedies to reduce exposition to external shocks will be pending. The Government should also look for innovative arrangements to leverage existing public resources, through, for example, securitization of public assets or cash flows. 14. After five months of broadconsultation with the private sector andcivil society, in September 2003, the government issued alandmark "White Paper" on reg~lation.~ This document should significantly reduceuncertainty by setting out the current administration's overall "regulatory policy". The document reinforces the role of the independent regulatory agencies ininfrastructure. It reassuresthe importance of the regulatory agencies ininfrastructure andthat the mandateof regulatory agencies' managementshould not coincide with presidential election cycle. The document also identifies the necessity of improvingtechnical capacity and creating a permanentcareer within the regulators andrecommendsreforms inorder to improve transparency, accountability, and definitionthejurisdiction between of the executive and the regulatory agencies. 15. The White Paper also recommends the restoration of planning capacity ingovernment. As one consequence, Casu Civil has preparedone draft law transferringback to the executive the granting of concessionsand the conduct of auctions, and another establishing performance contracts (contrutos de gestzo) as the maininstrumentsfor the public control of regulatory agencies. A key challenge i s to define the appropriate mechanism to make the performance contracts as effective as possible while preserving regulatory independence. Another consequenceof the recommendations will be the definitionof a career for regulators applicable to all federal infrastructure regulators: a draft law i s beingpreparedby the Ministry of Planning. A further challenge will bethe commitment of stable budgetary finances for the regulatory agencies. Overall, regulatory agencies still lack the skills, information andregulatory instruments to pursueoversight functions such as reviewing tariff structures and monitoring compliance with standards. Itwill be necessary to develop regulatory accounting and information standards; cost andfinancial models; and efficiency andproductivity measures. '"Analysis and Evaluation of the Role of Regulatory Agencies under Current Institutional Arrangements in Brazil" (Andlise e Avalia@o do Papel das AgCncias Reguladoras no Atual Arranjo Institucional Brasileiro) - issuedjointly by Casa Civil, the Cdmarade Infra-Estrutrua and the Cdmarade Politica Econo'mica. 152 16. Much work remains to develop a stable regulatory framework inelectricity and inwater andsanitation. Inthe electricity sector, the government is planning to sendits reformproject to Congressin 2003. Inwater andsanitation the government intends to pass a new law by early 2004. Secondary legislation will also be needed. The legal andregulatory framework for transport infrastructure has significantly improved. The reorganization of the Federal Transport Administration has been approvedby law, and implemented, with the creation of two independentregulatory agencies-the landtransport and waterborne transport agencies (respectively ANTT and ANTAQ)-and the reorganization of the Transport Ministry. The creation of the regulatory agencies filled an institutional void with respectto monitoringand oversight of concessions. The reorganization of the Transport Ministry will gradually refocus the role of the Ministry on two of its core tasks: planningof infrastructure maintenance and development anddefinition of policies. Overall, an amendment of the constitution may be required to provide for the revision of regulatory decisions by the secondlevel of thejudiciary. 2. The Competitive Environment Background and Issues 17. Long periods of price controls, and entry and exit regulationlessened competition inthe Brazilianmanufacturing industry. Product marketcompetition increasesefficiency and productivity (and productivity growth) by providing incentives for managers to reduce costs, innovate and reducewaste.' Inthe presenceof competition, firms adjust operations to raise efficiency andthus maintain profitability, while less efficient firms exit the industry. InBrazil, however, entry andexit were controlled by the Conselho de Desenvolvimento Zndustrial (CDZ) for more than 20 years, reducing market mobility. Price competition was eliminated by price controls imposed by Conselho Znteministerial de Pregos (CIP), through mechanisms that institutionalized price-leaders andprice-formulas, facilitatingcollusion. Although CDIhas been long extinguished andprice controls intradable goods have beenpractically abolished, market dynamics in several segmentsof Brazilianmanufacturing are still deeply influenced by incumbents' behaviors. These firms benefit from natural protections granted by market segmentationmainly due to hightransport costs or product differentiation; economies of scale andinformationasymmetry. Inthis environment, collusion, abuse of dominance and anticompetitive mergersthreatencompetition, consumer welfare and discourage investments in new plants. * See Baily, Martin Neil and Gersbach, Hans (1995): "Efficiency in Manufacturing and the Need for Global Competition". Brookings Papers on Economic Activity Microeconomics 1995: 307-47. Djankov, Simeon and Murrell,Peter (Forthcoming): "Enterprise Restructuring inTransition: A Quantitative Survey", Journal of Economic Literature. Geroski, P.A. (1990): "Innovation, Technological Opportunity, and Market Structure", Oxford Economic Papers 42 (3); 586-602. Nickell, Stephen J. (1996): "Competition and Corporate Performance", Journal of Political Economy 104 (4): 724-46. Nickell, Stephen J. (1997): "What makes firm perform well?", European Economic Review 41 (3-5): 783-96; among others. 153 18. Competition problems are even more relevant inthe non-tradable sectors, particularly inthe infrastructure industries. Ininfrastructure industries,structural reforms were conceived to encouragecompetition-where feasible-aiming at increasing consumer gains, innovation and private participation. Inindustries where sunk-coststend to behigh, local demand i s relatively small and incumbents might have cost-advantages,competition does not occur naturally after privatization. Competition depends on the impact and the extent and design of reforms on the new market structure. Competition "for" the market may also be a good substitute for competition "in" the market innaturally monopolistic segments. In fact, empirical evidence suggeststhat the performance of infrastructure industries,inparticular, i s highly affected by the extent to which competition i s introduced in (for) the market.gInBrazil, where vertical separation of assets occurred inthe electricity industry, horizontal break-upshappenedin electricity andintelecommunications. Petrobris still has a defacto monopoly over oil refining but competition increasedinthe upstreamanduntilrecently separateaccounts were kept between the firm and Transpetro (a subsidiary of Petrobris owner of the gas pipelines).Yet, fiscal considerations dominated competition concerns in several privatizations andmerger control enforcement faced institutional and political limitations. As aresult, CompanhiaValedo Rio Doce (CVRD) might control (directly or indirectly) the whole railway system, inwhich case railway privatizationhadbasically transferred a state-ownedmonopoly for the private sector. Two large terminals inSantos andRio de Janeiro were privatized to the same controller groups, reducing incentives for inter-port competition. Yet, the constitution of CCR-a joint-venture of some of the largest construction firms operating inBrazil-jeopardizes bidcompetition for transport contracts (either concessionsor maintenance). Cross-participation inelectricity generators coupled with apredominant shares of Eletrobris-over half of the generation capacity i s still controlled by Eletrobrh subsidiaries-diminish competition in electricity generation. The lack of competition has also been pointed out as one of the sources of high spreads inthe Brazilian financial sector. 19. Competition law enforcement, part of the competitive environment, is gradually evolving inBrazil. Brazil's 1994competition law (Law 8,884/94) broadly resembles competition laws inother countries. The law provides for repression of anticompetitive behavior, including the abuse of dominance, and for the control of mergers.It also grants formal independence-through fixed-term mandatesfor its commissioners-to CADE (Conselho Administrativo de Defesa Econdmica), the body rendering final decisions on antitrust cases. It also extended to SEAE (Secretaria deAcompanhamento EconBmico) at the Ministry of Finance, advisory roles, before restricted to SDE (Secretaria de Direito Econdmico) at the Ministry of Justice, which is also responsible for carrying on preliminary investigation and handling administrative proceduresbefore submitting the file to CADE. lo Despite certain operational complexities, the enforcement of the competition law made reasonableprogress, not only in See Bouin, 0. and Michalet, C.A. (1991), "Rebalancing the Public and Private Sectors: Developing Country Experience", OECD, Paris. Kwoka, J.E. (1996), "Power Structure, Ownership, Integration and Competition in the U S Electricity Industry", Boston: Kluwer. Kleit, A.K. and Terrell, D. (2001), "Measuring Potential Efficiency Gains from Deregulation of Electricity Generation: a Bayesian Approach', Review of Economics and Statistics", 83(3), 523-530. Zhang et a1 (2002). "Electricity Sector ReformIn Developing Countries: An Econometric Assessment Of The Effects Of Privatisation, Competition And Regulation". Aston University. PaperNo 31. lo Clark, J. (2000) Competition Policy and Regulatory Reform in Brazil: A Progress Report.OECD Competition Policy Review, vol2 No.3.; and OECD (2001). Brazil -0ECD Economic Surveys. Paris: OECD. 154 terms of the number of cases ruledby CADEbut also interms of "advocacy" roles, a function increasingly played by SEAEandSDE. 20. Nevertheless,two remaining weaknessesare the small number of hard-core cartel cases condemnedand the complex enforcement of merger control provisions. In contrast to the growing emphasis on anti-cartel enforcement adoptedby other antitrust agencies and with the condemnation of more than 15 international cartels since the mid-l990's, CADE had successfully prosecutedonly one domestic cartel case between 1994-2000. Poor activity interms of hard-core cartel prosecution was partially causedby limitedinvestigative powers and by the increaseinthe number of mergers submittedfor review: merger reviews grew from 46 cases in 1997to 226 in 1999and 584 in 2002. Delays inthe enforcement of merger control were partly causedby the multiplicity of agencies involved and a possibly excessively low threshold for the submission of merger cases." Uncertainties for the private sector were also raisedby the interpretation of the deadline for the submission of the merger, 15 days after its "occurrence." As the systemworks through post-merger notification, the private sector andthe authority have repeatedly disagreedover the legal definition of occurrence and CADE has been particularly aggressive on imposing fines for the non-compliance with the 15-daysdeadline. Inaddition, post-merger notificationalso makes it more difficult for the authority to adopt structural remedies for anticompetitive mergers.Not surprisingly, most of remedies adopted so far have beenbehavioral, which international experiencehas shown to be much less effective to protect competition and consumer welfare. 21. Yet, institutional fragmentation and the lack of a stable corpsof qualified professionalsare probably the most immediate institutional obstaclesfor the strengthening of competition law enforcement inBrazil. The Brazilian systemi s unique inthat three government bodies are involvedinthe enforcement of competition law within an unclear division of legal authority. Competition law enforcement is then weakened by the fragmentation of actions and high transaction costs necessaryto achievecoherence incase handling and to avoid duplication of tasks. Institutionalfragmentation also causes loss of synergies among personnel with complementary backgrounds.l2 Currently, SDEhas only six professionals dedicated to merger enforcement while SEAEhas more than 50. SDE assigns 17 professionals for cases of anti-competitive practices while SEAEdesignates eight. SEAE i s mainly composed of economists (63 percent of technical staff) while lawyers constitute the majority of technical staff at SDE (54 percent). CADE does not assign separatestaff and its technical personel are mainly lawyers (46 percent). Among the three institutions, the Brazilian government assigns 398 employees to the enforcement of the competition law (of which, 42 percent are at technical level).13CADE commissioners are appointed for a two-year mandate (extendable for one more term), but all other professionals may be dismissed any time. Salaries are not competitive with Both SEAE (Secretariade Acompanhamento EconBmico) at the Ministry of Finance and SDE (Secretaria de Direito EconBmico)at the Ministry of Justice have to issue non-biding technical opinions. Article 54 provides for the submission of merger or acquisitions involving firms from economic conglomerates whose worldwide sales were equal or grater than RS$400 million (roughly US$ 1333 million). 12Not surprisingly, the Global Competition Report has ranked Brazilian antitrust next to last among more than 50 countries surveyed for two consecutive years (2001and 2002). l3BrazilianReport on Competition Policy - 2002. Available at www.fazenda.gov.br/Seae 155 the private sector but an annualbudget of the three institutions-more thanUS$ 10million excluding salaries-is not smallby Brazilian standards. 22. Law reformmay also improve governanceand efficiency. Decisions over merger cases have raised concerns, domestically and internationally, of CADE's independence. Disputes over large and controversial cases are not uncommon, but the risk of politicization may be reducedby changing the appointment mechanism for the commissioners (for example, limiting commissioners' appointments to a longer but single term), Law reform might also provide for a better distribution of legal authority, coupled with better accountability mechanisms, to enhance authorities' incentives to successfully prosecute anti-competitive behavior. Revision of CADE's decisions by "first-level" courts may alsojeopardize the effectiveness of competition enforcement. Pre-merger notificationmight also reduceconflict between the private sector and the authorities while better defined merger thresholds might reduce the number of mergersto be reviewed by the authorities. 23. Poor competition innon-tradable sectors industries is partially causedby weak enforcement of pro-competition regulation, including the competition law. Competition does not occur automatically with privatization, but rather depends on appropriate design andon the enforcement of pro-competition regulation and competition laws. Sector laws intelecom, electricity andports have clear provisions for the adoption of competition as a key organizing principle of the regulation as well as akey objective for the potentially competitive segmentsof the industry. Nevertheless it is still unclear how these provisions are going to be implemented. For example, there i s no institutionalmechanism to solve potential conflicts betweenpromoting competition and other possible objectives of regulation. Also, despite several agreements between regulators and competition authorities, inthe enforcement of the competition law, SDE and SEAE roles intelecom cases are replacedby Anatel. Sector laws also provide for the open- access of the bottleneck segmentsbut the implementation of such provisionhas beenuneven between sectors. Inthe gas industry, for example, negotiations for access to Petrobriis pipelines took over one year and hadto be ruledon by the regulator. Enforcing well definedopen-access regimes i s usually a complex task even indeveloped economies. Several agreements aimed at improvingcoordination of the enforcement of competition law ininfrastructure industrieshave been put inplace during recent years. Yet, the role of SDE and SEAEon antitrust cases in competition cases i s unsettled.An Attorney General's decision blocked CADE, SDE and SEAE from applying the antitrust law to the banking industry, representing inpractice an exemption to the antitrust legislation. 24. The competitive environment in,Brazilis also deteriorated by the government-generated entry barriers and operational requirements, such as unduly complicated business registration processes, costly and time-consuming labor regulations, restrictive standards registrations procedures, anddifficulties in acquiring anddeveloping land or receiving environmental licensing. These costs of doing business inBrazil deter investment and the formalization of new firms with clear negative impacts on training, education and acquisition of new machinery and 156 equipments.l4Four aspects are of major relevance: the registration process ,environmental licensing, tax collection and export procedures.l5 25. Registration is not expensive but takes too long. Evidence on entry costs comes from two main sources: the World Bank "Doing Business" database and SEBRAE (Sewigo Brasileiro de Apoio Bs Pequenas e Mkdias Empresas).16According to bothdatasets, Brazil does not have excessivepecuniary costs of firmregistry ($33 1)compared to other countries. Nor does the number of proceduresto register appear amajor concern, although with 15 procedures, Brazil i s higher thancomparators such as Korea (12) Costa Rica (1l), (10) and Mexico (7).17The Chile costs interms of time are very high inBrazil, however. The average time to complete all requiredproceduresand establisha new businessinBrazil(about 152days) is the secondhighest inLatinAmerica (Figure 1).Brazilrankswellbehindother largeeconomieslikeMexico (51 days) andtakes more than five times as long as Chile (28 days). The comparison i s much starker ifwe include someof the moreimportant OECDcountries (Figure 2). Brazilis significantly higherthan comparators suchas Mexico, Korea or Chile which approachthe OECD averageof just over 30 days. However inmany of the most innovative countries, with highrates of both investment andproductivity growth such as Ireland, Australia, andthe UnitedStates, time to register a company i s below twenty days and inmost below ten days. Time Needed to Register a Company - Latin America Comparison Figure 1: 200 180 160 140 120 100 80 60 40 20 0 I Source: The DoingBusinessDatabase l4 See the World Bank (2003): "Doing Business in 2004 -Understanding Regulation". World Bank and OUP: Washington DC. l5Highstart up costs inhibit investment and entry by making it less likely that new firms become formal and hence access services that can help them grow. Lack of entry can also reduce productivity: new firms have been found to exhibit both higher and faster growing TFP. See World Bank (2002): "Brazil: The New Growth Agenda," Report NO.22950-BR. l6Both datasets use similar methodologies, though there appear to be significant variation in estimates for some of the steps inthe processand therefore in overall time and cost to register. l7World Bank, (2003) Doing Businessdatabase. 157 Figure 2: Time needed to register a company OECD comparison - 140 120 100 2 80 VI 60 40 20 0 Source: The Doing Business Database 26. Partof the explanation for the length of this processinBrazil is the lack of unificationbetweenFederal, State and Municipal registrationprocesses:there i s a great deal of duplication inprocessesacrossthe threejurisdictions. For example, a firm must register with allthree tax registries, which takes about 25 dayson average. By comparison, afirmcan complete all registration requirements inhalf that time (12 days) inIreland. Some processes, such as the needto be a member of a trade association, appear to be vestiges of the past with little value to government.18According to the DoingBusiness database the bulk of time needed to register i s taken up at the municipal level, which accounts for 120 of the 158 days (76 percent of the total time). According to extensive work carried out by SEBRAE, there is significant variation across regional administrations inthe time taken to grant a municipal operating permit (AZavar6defuncionamento). In 17 states the permittakes between one and five days, but inthe other states, it cantake between eight and 30 days. The costs vary between R$2.60 andR$300. This variation of the registration experiencehas beenconfirmed by arecent study inSiio Paul0 state, which found large variations intime and costs for micro-entrepreneurs opening apparel production facilities among the state's different municipalities. These data point to the possibility of discretion on the part of localbureaucraciesrationing entry, whether inpursuitof rents or simply to comply with outdated norms that artificially curtail competition. Additionally, informalityreduces incentives bothemployee and employer have to invest inlabor training therefore affecting labor productivity andthe quality of growth. The variability of experience is quite wide. SEBRAE, using expert interviews in 2000, catalogued the variation in requirements, time, and cost to register in each state in Brazil. O f the twenty-six possible forms that a firm could be asked to produce in order to register with the state tax authority, only one (the "declaration of individual firm") was required by all states. Mirroring this heterogeneity, the minimum time to process a request once all forms are submitted ranges from 1to 15 days and the costs from R$2.18 inMaranhao to R$103.5 in RondBnia. 158 27. Initialregistrationis simply the first step toward a functioningfirm: there is a myriad of permits and licenses needed at the state and particularly the municipal level to begin production legally. These range from municipal health andfire inspections to bureaucratic requirements needed to acquire and develop land for an industrialsite and meet environmental licensing requirements. These processes show similar levels of variation inthe time and cost to complete. Inmany cases, as SEBRAE show, the same information and even copies of the same forms are required by multiple agencies. The lack o f information sharing (or even the use o f a single registration number, as practicedinmany countries) obliges the firm to present the same information to multiple agencies. The cumulative effect of these bureaucratic requirements can remove small investors' incentive to register their business formally. This may lead to a vicious cycle of informality which steadily erodes the tax base, hence government's ability to provide public goods, further reducingthe attraction of operating formally. 1 ::I 100 - 14 T O 2 BO B so 40 10 20 10 0 1. Check company name 10. Get receiptdinvoices approved b y the 2. P a y registration fees Munlclpal Taxpayers' Reglstry 3 Register With the Commercial Board 11. Register with the Municipality 4. Rsgister for federal tax 12. Receive inspection from the Municipal 5. Reelstel employees with the INSS authorities 6 Get company invoices with CGC and 13. Get the employee registry book C G F numbers from 'egistry approved 7. Register for state taxes e. Register with the Municipal Taxpayers' 14. Open a FGTS account 15 Register the employees in ths social Registry integration p'og'am 9. Pay TLlF to the Municipal Taxpayers' 16. Notify the Ministry the employment of Registry workers Source: Doing Business Database 28. Environmental Licensing. Brazil i s probably the developing country with the oldest and most consolidated environmental licensing system, launched inthe early 1970swhen industrial growth andthe proliferation of cars inRio de Janeiro and S2o Paul0 began to generate significant urban pollution. Two state environmental agencies (FEEMA and CETESB) equipped and trained personnel, anticipating actions by the federal government, which later started to focus on natural resources problems such as biodiversity, soils, forests, water, coastal zone management. Even today, the State o f SZo Paul0 drives the national pollution management agenda. 29. Government now recognize the need to mainstream environmental management into its broader economic agendas. Brazil i s something of an exception among developing countries on environmental licensing. Ithas qualified personnel and environmental licensing procedures, including more complex environmental impact assessments, and standardized and 159 widely disseminated procedures to seek government approval. The systemincludes all states in Brazil and municipal governments are now beginning to play a role inlicensing. The fact that the system i s consolidated anddisseminated has produced an undesirable rigidity. Although the system achieved progress towards social participation and transparency, it has not become sufficiently flexible to address the specific needs of economic sectors. Inmost cases capacity i s reasonable, but the system has become bureaucratic, adversarial, andincreasingly divorced from mainstream economic development. 30. While environmental agenciesare responsible for this scenario, many private interests and government sectors have had a role inperpetuating it. They often perceive environmental enforcement as politically andtechnically weak: the risk o f being caught or fined for non-compliance i s minimal. This i s becoming less frequent due to public awareness, social pressure, andthe work of the Ministe`rio Pu'blico and environmental agencies. Yet, most government policies either disregard environmental issues or treat them as an externality to be treated ex post outside the planningprocess. This promotes confrontation and litigation and increases costs. For example, environmental impact assessmentshave become costly compendia of information with rare consideration of more sustainable alternative projects. 31. Inlargeinfrastructureprojects, the issuesthat mustbe licensed remainunclear. Since environmental issues are not incorporatedupstream inproject design, IBAMA has been forced to assume a policing role for regulations and norms. Since sector policies are often unclear about the environment, most projects tend to leave environmental issues for consideration late inpreparation, when an environmental license i s requested. A troublesome consequence i s that IBAMA must negotiate, with sector agencies, policies which are the responsibility o f the Ministry of Environment. For example, the indirect impacts of roadbuilding infrontier areas (particularly inthe Amazon region) are far more important than the direct impacts. But while many of these indirect impacts may be of an environmental nature-such as increased deforestation-many are more diffuse and not necessarily under the domain of IBAMA-such as effects on indigenous communities, population growth, and the general consequences of increased economic activity. Inthe absence of other actors, IBAMA has inflated its mandate to license many economic activities. 32. Another bottleneck is the lack of coordination among tiers of government. Article 23 o f the FederalConstitution-which establishes the complementary roles of Federal, State and municipal governments inenvironmental management-has not yet been "regularized," so that the three tiers often overlap or conflict, complicating the environment for entrepreneurs. Also important are institutional gaps for overseeing environmental problems. Box 1illustrates the implications for the environmental licensing of the hydroelectric power plant at Itumirim, inthe state of Goia`s.The case illustrates a common problem: the licensing system was originally conceived for larger industrialactivities, where even today it operates well, under the leadership o f state environmental agencies. Large infrastructure projects, however, are still subject to a great deal of uncertainty, confrontation, and delays by environmental authorities. 160 Boxl-Environmental Licensing of Hydropower Plant of Ztumirim The National Electric Energy Agency - ANEEL - offered the hydroelectric power plant of Itumirimfor bidding based on its 50MW potential in 1999. Companhia Energktica do Itumirim won the bidding offering seven times the reserve price. The plant is expected to be built on the River Corrente, the confluence of the Formoso and Jacuba Rivers, which have sources inside the Emas National Park. The dam will flood a small part o f the Park and most of an important ecological corridor, home to many endangered animals (such as the cervo do pantanal, oya-pintada, lobo-guard, and tamandud- bandeira). Because the River Corrente i s a state river, the company submitted its environmental license to the state environmental agency. But because of the effects on a National Park and on endangered species, the Ministe`rio Pu'blicotogether with IBAMA launched a legal action against the state license. This case was upheld and the environmental licensing was transferred to IBAMA, which in 2001 deemed the enterprise unfeasible. The entrepreneur then requested a license for a new plant, which would lower from 680 to 678 meters the dam's level (with an operational level of 675 meters). In February 2002 IBAMA issued a final decision denying the construction of the plant even under the new proposed conditions. 33. A final problem is the disconnect between licensing and enforcement. Entrepreneurs and environmental agencies alike regard the environmental license as the end o f the process. Three types of licenses are required at different stages-prior, installation, and operation. Even though operation licenses have to be renewedat regular intervals, there i s rarely follow-up to conditions imposed on licenses. This i s largely a consequence of small budgets and enforcement capacity, but also stems from a system design that relies on capacity to monitor, follow-up andto enforce license agreements, activities which inturn are often carried out independently by different departments within the same agency. 34. Tax collection and export procedures. It i s widely recognized that Brazil has a complex tax system that not only introduces important economic inefficiencies but is also burdensome for the private sector. A foreign investor, for example, faced approximately 52 separate taxes, imposts, duties, compulsory loans and other charges imposedby the different levels of administration in 2000.'9Each state sets its own Impost0 sobre Cirulaga`o de Mercadorias e Sewigos,resultingin a chaotic situation with currently 44 disparate rates inthe country and a permanent incentive to engage infiscal-wars. Similar problems apply to the municipal tax on services (ISS). 2oFor exporting firms, export procedures are one major impediment to international competitiveness. A recent survey with 460 exporting firms has shown that 43.5 percent o f the firms found bureaucratic requirements for exports the major difficulty inthe exporting activity.21 Export regulations were provided by several different legal documents (59 See FIAS (2001): Brazil-Legal, Policy and Administrative Barriers to Investment in Brazil. Volume I.FIAS- IFC/World Bank: Washington DC. 2o World Bank (2003), Report No. 25880-BR, pp-27. 21 See Veiga, P.M. (2002): "0 ViBs Anti-Exportador: Mais AlBm da Politica Comercial". In Pinheiro, A.C, R. Markwald and L.V. Pereira: "0 Desafio das ExportaCBes". BNDES: Rio de Janeiro. 161 inMDIC). Exports of more than2250 products -- roughly 23 percent of the total-were until recently subject to previous authorization by eleven different bodies of the Braziliangovernment. RecentAchievements and Future Challenges 35. Antitwst enforcement. Since 2001, important progresshas been achieved inthe enforcement of the competition law inBrazil. An important improvement hasbeen the increasing emphasis on cartel investigations. In2002, CADE condemnedtwo instancesof collusion between gasoline stations inFlorian6polis (SC) and Goidnia (GO). InSeptember 2002, 260 cartel investigations in 30 differentindustries hadbeen started by SDE. Several institutional measureshave beentaken, includingthe launching of a "Leniency Program" and the signingof an agreement with Policia Federal both aimed at improving investigative techniques. Stepshave also been taken to harmonize merger analysis by SEAE and SDE and to speed up their investigation on cases that may cause no harmto competition, as for example by issuingjoint SEAE-SDE horizontal merger guidelines in 2001. The government i s preparing a draft law for the rationalization of work between SEAE and SDE as well as further amending the current antitrust legislation. A differentpiece of legislation i s supposedto be sent before the end of 2003 allowing for the hiringof permanent personnel by CADE. Inmarch 2003, a cooperation agreement between the Brazilian and U.S antitrust authorities was ratifiedby the Brazilian Congress. Finally, a cooperation agreementbetween Brazilianand Argentinean authorities was signed in 2003 to facilitate the implementation of the Fortaleza Protocol-a 1996 agreement among Mercosur countries on common competition policy principles. Futurechallenges for government authorities inthe competition enforcement area are: (i) the rationalizing the system of competition law enforcement; (ii) establishing a corps of stable well paidqualified professionals; (iii)the passing of a new law improving governanceand efficiency inthe enforcement of the competition law; (iv) amending the constitution to provide for revision of antitrust decisions at the second-level of thejudiciary. 36. Non-tradable sectors. Inthe non-tradable sectors, the most important achievementswere the overall principle related to competition andregulation, the definition of the methodology for interconnection tariffs intelecom andthe submission to Congress of a draft law extending antitrust law to the bankingsystem. Several agreementsaiming at improvingcoordination of the enforcement of competition law ininfrastructure industries have been put inplace over the last two years by regulatory agencies andthe competition authorities. This year, the "White Paper" on regulatory policies proposes the adoption of a notification systembetween the regulatory agencies and the competition authorities when regulatory changes will affect competition conditions inregulated industries.By its turn, the interconnection tariffs for fixed line services will be basedon long-runmarginal cost. Ifproperly enforced, this regulation may improve competition intelecommunications even further. Future challenges are the adoption of the above mentioned notification system and abetter definition of the interface between competition and regulatory issues, andthe role competitive mechanisms should play inorganizing the industry and serving the consumer. The role of SDE and SEAE on antitrust cases inthe telecom sector should be clarified. The implementation of the long-runmarginal cost principle will require a large effort by ANATEL. The appropriate definition of open-access inthe natural gas industry is still pending. Preliminary negotiations indicated an undesired outcome with the new regulation granting a de facto monopoly to Petrobrh over most local markets (with perhaps the exception of Comgas).Even when the legal environment of open-access i s present, its timely 162 implementation has shown to be an important challenge for regulators inBrazil. Increasing timely enforcement of open-accesswill be a challenge for the future. 37. Registration, tax collection and export procedures.There have been some attempts to reduce the time neededto register a company, such as the "Sistema Fdcil" introduced by the Departamento Nacional de Registro Comercial (DNRC) ina few selected states, but they have yet to be assessedrigorously. Although SistemaFdcil unifies all the start-up requirements inone single place (one-stop-window), the processesare still fragmented in operational terms, imposing limits in terms of reducing time. The tax reformbill sent to Congress in 2003 contains an important effort to simplify tax collection for micro, small and mediumenterprisesthrough "Super-Simples." On the export side, a simplificationprocess was undertaken during the first nine months of the new administration, culminating with the following, among other initiatives, by MDIC: (i) the consolidation of 59 Secex-Portarias inonly one legal document (Portaria Consolidada de ExportaGdo); (ii) the elimination of 29 Portarias from MDIC that imposed unnecessaryexport requirements; (iii) the further reduction inthe number of products for which exports require authorization by the government; (iv) the eliminationof the US$50 limit per product for the grouping of products with different values and characteristics but with the same code number inthe registration of exports; and'(v) the elimination of sales registries (Registro the Venda) for coffee, aluminumand cocoa. 38. Environmental licensing. The NationalEnvironmental Council (CONAMA) has long established a technical committee to review the licensing system, although the mainfocus has beentechnical, following the specific demands of Siio Paulo, Rio de Janeiro, and other states with pollutionproblems. The current federal administration i s addressingsome of the problems through dialogue with the economic sectors inan attempt to mainstreamenvironmental issues into sector policies. Since infrastructure projects and programs are the most pertinent, the Ministry of Environment (MMA)has been focusing on the energy and transport sectors, with lBAMA dealing at the more operational levelwith counterpartssuch as the NationalPetroleum Agency (ANP), NationalElectric Energy Agency (ANEEL), NationalWater Agency (ANA), and National Transport Infrastructure Department (DNIT).Efforts have been made to establish clearer guidelinesfor regulating specific activities, and for mainstreaming environmental issues andincorporating them upstreaminproject design.Withinthe nationalenvironmental system, the government has made efforts to regulate authority and integrate the activities of the three tiers of government (e.g., efforts are beinglaunchedto regulate Article 23 of the Constitution). 39. Many problems of the national environmental management system and of licensing remain beyond the domain of the environmental agencies themselves. Regulating and controlling small and mediumenterprises remain a formidable task in a country where about half the economy i s informaland largely outside government control (labor, tax, social security, safety, environment, etc.). This i s particularly serious inspecific highpolluting sectors typically carried out by small-scale operators. Itmay also be difficult to makethe systemmuch more flexible. Environmental laws and regulations inBrazil are stringent, comparable to OECD countries. Even ifenforcement is lax, authorities have noway of giving licenseto activities outside the norms and regulations. The Ministe`rio Pdblico has been playinga major role inensuring compliance with the legislation, to some extent supervising the performance by environmental authorities. While this i s good to ensure an effective performance by the Executive, it prevents 163 environmental agencies from being more flexible with environmental licensing. This is not a problemspecific to the environment sector. 3. BusinessDevelopment Services (BDS)for Micro, Small andMediumEnterprises (MSME) Background and Issues 40. S M E Sector Overview. The crucial importance of micro, small and mediumbusinesses (SME)to the Brazilianeconomy is illustratedby their share inemployment (62 percent) andof the country's firms (98 percent) in 2000.22Micro-firms inparticular correspond to one-third of employment and 97 percent of the firms. Employment generatedby micro-firms increasedby 5.4 percent on average between 1996-2000 against 1.5 percent in large firms. Between 1997-2000, birthratesof micro-enterprises exceededmortalityrates, resultinginan annual net expansion rate of 6.7 percent inthe number of micro-firms. Significant growth (measuredby changein size classification) was not significant between 19991997 and larger firms presentedhigher probability of surviving.23MSMEs are represented in an array of activities, but commerce and services clearly dominate, with "trade, repair of vehicles and, personal andhousehold goods" accounting for more than 50 percent of the numberof enterprises and44 percent of the employment among all micro-firms with manufacturing representing small shares for both variables. The importance of manufacturing increaseshowever as size increases: it represents31 (28) percent of the firms and 31 (28) percent of the employment for small firms. 41. Why is M S M E Productivity so low? One strikingcharacteristic of the MSMEs' performance i s low productivity levels: depending on the measureused(value addedor value of shipments per employee), productivity of large firms can be 6.2 times higher than micro- enterprise^.^^ Productivitydifferentials are inpart causedby informality, which deepens known failures incredit, information and technology markets.As formality is at least inpart voluntary, highcosts of formality constitute further obstaclesto the adoption of new technology and Businessregistration andtaxes inBrazilare two important obstacles to formality. 42. As inmost countries, technology performance of MSMEs is inferior to that of large firms. During1998-2000,2.2 (1.2) percentof micro-firms inBrazilreportedto have introduced products (processes) that are new to the Brazilian market, against 35 (56) percent of large firms.26Smallfirms' performance was relatively better (five andthree percent claimed to have 22Guimarbs, E. (2003) "AvaliaqBo das Micro, Pequenas e Mtdias Empresas no Brasil" Background Paper for the Project. Mimeo. 23 Najberg, Sheila, Puga, Fernando and Oliveira, Paulo (2000). ``CriaGZio e Fechamento de Firmas no Brasi: Dez. 1995Dez. 1997". Textos paraDiscuss5o79.BNDES: Rio de Janeiro. 24GuimarHes, E. (2003) "AvaliaqBo das Micro, Pequenas e Mtdias Empresas no Brasil" Background Paper for the Project. Mimeo. 25 Parente, S. and Prescott, E. C. (2000) "Barrier to Riches", Mimeo, University of Minnesota; and Djankov, Simeon, La Porta, Rafael, Lopez de Silanes, Florencio and Shleifer, Andrei, (2000) "The Regulation of Entry" NBER Working Paper No. W7892. 26 IBGE (2000) "Pesquisa Industrial InovaqgoTecnol6gica". Departamento de Inddstria. IBGE: Rio de Janeiro. 164 introduced roducts and processes). Those are not necessarily low, however, for international standards?`New products introduced by MSMEs are predominantly developed internally (for at least 71 percent) but new processesare acquired from other firms or institutes (for at least 82 percent). This i s consistent with the fact that the single most frequent innovative activity implementedby SMEs is the acquisition of capital goods, for 35,24 and 17 percent of medium, smallandmicro-firms, respectively. 43. The importance of capital goods for MSMEs is striking. During 1998-2000, at least 63 percent of MSMEsexpenditureson technology were related to the acquisition of capital goods, against 50 percent of the averagefirm.Micro-firms' expenditures correspondedto 77 percent (roughly RS$ 110,000 on average) compared to 43 percent of large firms.28Large firms spent on R&D, training andindustrialprojects almost as muchas inacquisition of capital goods, while MSMEs'expenditures inthese activities was lessthanhalfthe expenditure of capital goods (in the case of mediumfirms) and inferior to one quarter inthe case of micro-firms. An additional difference between MSMEsand large firms i s related to training activities. During 1998-2000, while half of large firms reported to have executed training activities, roughly 20 percent of medium and six percent of micro-firms reportedto have done so. Expenditure on training i s smallandsimilar regardlessfirm size.29Inaddition, the lack of cooperation between firms, firms and researchinstitutes seems to be greater for MSMEsthan for large firms. During 1998-2000, almost 20 percent of large firms reported to have cooperatedwith other firms or research institutes to develop new products (22 percent for new processes) against 10percent of medium firms (five percent for new processes) and less than sevenpercent for micro-firms (less than four percent for new processes). 44. The number of exporting MSMEsgrew from 12,650 to 15,680 firms between 1997- 2001-r roughly 1.3 percent annual growth. However MSMEs' share inthe value of exports fell from 35.2 to 30.7 percent of the total. Consequently, the value of exports per enterprise within the MSMEs roup decreasedmore than five (7) percent annually inthe case of micro (small) enterprises?' Evidence indicates that exit from export activity i s highamong micro and smallexporting firms.31Preliminary data also suggest however that export growthis not strictly related to firm size: during 1997-2001, size distribution among firms with higher export growth (at least 8 percent per year) is quite similar to those firms with negative export MSME exporting firms seemto be more numerous inindustries where the country has natural *' See Empreendedorismo no Brasil. Relat6rio Global. Global Entrepreneurship Monitor Reports 2002. In this report only 926 out of 9,615 interviewed entrepreneurialfirms (regardlessthe size) in 37 developed and developing countries were classified as highly innovative. 28IBGE (2000) "Pesquisa Industrial Inova@o Tecnol6gica". Departamento de 1nddstria.IBGE:Rio de Janeiro. 29See IBGE(2000) "Pesquisa Industrial Inova@o Tecnol6gica". Departamento de Indbstria. IBGE :Rio de Janeiro. IBGE suggeststhis last result might be related to measurementproblems. 30 In 2001, 64 percent of micro and 47 percent of small firms exported no more than US$ 50,000, while only 6 percentof large firms exported no more than that amount. 31GuimarHes, E. (2003) "Avaliaqgo das Pequenas e MBdias Empresas no Brasil" Background Paper for the Project. Mimeo. 32See Markwald, R. and F. P. Puga (2000). "Size nevertheless affects the probability of exports". Mimeo, Funcex: Rio de Janeiro. 165 comparative advantages (such as tropical fruit, wood products and furniture and footwear). MSMEs reported bureaucratic impediments (mainly customs requirements), port costs and access to information regardingmarketing opportunities as the main obstacles for MSME's exports. Information about access rules related to product andprocess quality seems to be another important obstacle. MSMEs claim that complying with quality standards and establishin external partnerships with local distributions are the two most effective export strategies.35 45. BDS policies. Since the 1990swith the establishment of SewiCo deApoio 2s Pequenas e Mkdias Empresas (SEBRAE), the Brazilian government has tried to support MSMEs development. Several institutions have implemented pro-MSME policies at the federal, state and municipal levels. Federal programs and instruments are mainly implementedby six institutions: SEBRAE, Apex (Aggncia de Promo@o de Exportapjes),BNDES (Banco Nacional de Desenvolvimento Econbmico e Social), Banco do Brasil, andFinep (Financiadora de Estudos e Projetos), representing three ministries (MDIC, MFandMCT) and one semi-autonomous institution (SEBRAE). There are more than 30 federally funded programs inthe areas of credit access, business development services (BDS), access to technology and export promotion. 46. Two important sources of credit to MSMEs are Banco do Brasiland BNDES: in 2002, the two institutionsprovided R$lO.7billion or approximately (0.8 % of GDP). BNDES programs-such as Finame, Finem, BNDES-Automdtico and BNDES-Exim-are not specific to MSMEsbut rather lines of credit available to any firm regardless of its size. Lines of credit are provided to MSMEs under more favorable conditions. Banco do B r a d administers at least two credit programs targeted to SMEs (Proger Urbano Empresarial andMIPEM Investimento). Three guarantee funds administered by BNDES (Fundo de Garantiapara a Promo@o da Competitividade), SEBRAE (Fampe) and the Ministry of Labor (Funproger)- with resources from the National Treasury, SEBRAE's budget andFundo de Amparo ao Trabalhador (FAT)respectively-have disbursed between 1998-2002approximately R$2.7 billion. BNDES disbursed 90 percent o f the money. 47. BDS is provided at the federal level by SEBRAE. In2003, SEBRAE spent approximately RS$ 1,l billion (60 percent of its budget) on six different types of BDS programs, including access to technology and innovation (12 percent) and training (15 percent) and market access (10 percent). SEBRAE i s partially funded by 87.5 percent of the social contribution tax (a 0.3 percent tax over payroll)-which represents an estimate of RS$677 million in 2003, slightly lower than the 2000-2002average (RS$712million)-while payment per services corresponds to less than 10percent.34The institution i s managed by three directors appointed by the Directive Board which i s composed by five institutionsfromthe federal government and eight business associations. Activity i s highly decentralized and state-level SEBRAE offices have a highdegree o f autonomy. 33 See Tinoco, Galeno and Ribeiro, Fernando (2002) "Um levantamento de atividades relacionadas atividade exportadora das empresas brasileiras: resultados de pesquisa de campo junto a 460 empresas exportadoras". In Pinheiro, A.C, R. Markwald and L.V. Pereira: "0Desafio das ExportaGdes". BNDES: Rio de Janeiro. 34In2003,47 percent of the budget correspond to carry-overs. 166 48. Technology-related support by means of financing is also provided by Finep, mainly by meansof the Forum Brasil de Znova@ies and theApoio a Arranjos Produtivos Locais. Since 2002, Finep and SEBRAE arejointly implementing the Programa deApoio Direto a Inovaglio with the objective of improving technological performance of MSMEsand funds of roughly RS$80 million. Apex i s the Brazilianexport-promotion agency also responsible for supporting MSMEs exports. It i s fundedby 12.5 percent of the social contribution tax andi s administered by the federal government. Through matching grants (normally up to 50 percent of the cost), Apex provides support to different activities such as marketing research; business training; product andprocessescompliance (IS0 certification included) and other related services. UntilJuly 2003, Apex had supported368 export programs, 200 of which are still in place, at atotal cost of roughly RS$386million. Two-thirds of the programs are targetedto specific sectors or productivity chains most of them on industries where Brazil presents international comparative advantage(such as agribusiness; leather andfootwear). 49. Apex policies. Apex was createdin 1997as part of SEBRAEwith a limitedbudgetof RS$50 million and the mission of implementing export promotion activities. As part of SEBRAE, its initiativeswere first restricted to MSMEsbutlater extendedto other enterprises providedthat the specific initiative would have a clear impact on SMES. Overall, Apex works with a broad concept of export promotion, includingthe development of "exporting firms" through grants and matching grants with a sector-specific approach (as opposite to firm- specific).35By 2001, Apex hadconcluded 76 projects with 121inoperation (totaling roughly US$ 130million) mainly concentratedin sectors inwhich the country has revealed comparative ininternationaltrade fairs, commercial visits andinternational publication^.^^ advantages- such as food, footwear andtextiles - supporting activities such as the participation 50. Export credit. The major export financing program, PROEX (Programa de Financiamento its ExportagGes)has beenoperating since the early 1990sprovidingdirect financing to the exporter (with resourcesprovided from the NationalTreasury); and equalization of interest and servicing charges with those prevailingininternational markets.The share of Brazil's total exports benefiting from PROEX financing was roughly 15percent. The implicit subsidy for 2002 was roughly US$125million. To provide for export credit insurance, SBCE (SeguradoraBrasileira de Crkdito h Exportaglio) was establishedin 1998 andhas since been supplementedby resourcesfrom the federal government budget. Its monopoly positioninthe Brazilian market i s no longer guaranteedby law. 35That has led Apex to emphasize sector-approaches, dealing with a broad range of sector specific obstacles to export - from the compliance with international standards to the development of the appropriate design. Horizontal programs have applied only 23% of Apex's funds in 2001. 36See Veiga, P.M. and R.M. Iglesias (2002): A Institucionalidade da Politica Brasileira de Comkrcio Exterior. In Pinheiro, A.C, R. Markwald and L.V. Pereira: "0Desafio das Exportaq6es". BNDES: Rio de Janeiro. 167 RecentAchievements and Future challenges 51. InJune 2003, the new administration announceda set of measuresto expandmicro-credit and facilitate access to bank servicesby the poor. Among others measures, the Brazilian government: (i) substantially reducedthe amount of bureaucratic/legal requirements to open bank accountswith less than RS$ 1,000 monthly deposits; and (ii) basedon the Medida Provisdria 122 of July 25, 2003 and through the ConselhoMonetario Nacional, establishedthat two percent of the cashdeposits must be allocated to smallloans (less than RS$500 or RS$ 1,000) to poor individuals (individuals with balance accounts of less than RS$1,000 or as defined by Law 111of July 6 2001) and micro-entrepreneurs (defined as those that couldapply for loans underconditions establishedby Resolution 2874, de 26 of July 2001) under special conditions (mainly atwo percent monthly rate cap).37It i s also expectedthat Banco do Brasil will be allowedto create a subsidiary fully dedicated to micro-credit and that RS$ 1.3 billionfrom Fundo de Amparo ao Trabalhador will be allocated to Banco do Brasil and Caixa EconSmica Federal to expand credit for the poor at lower rates for the acquisition of construction material. 52. Despite the expansion inthe number of programs and instruments,federally funded programs to support MSMEs development lack coherence, clear targets andtransparency: (i)lackofcoherenceisevident,forexample,intheemphasisoncreditmeasurestothe detriment of BDS and technology-related services, against international experience that suggeststhat the probability of success of credits increase as they are combined with BDS (andtechnology related services). (ii) ofcleartargets:althoughfinancialandtechnologicaltargetsareprovided,feware lack specifically tailored to MSMEs.BDS providedby SEBRAE and export services provided by Apex are more focused to SMEs but lack clear objectives and measures. (iii)lack of transparency appears in several aspects: although with a sound reputation inthe business sector, SEBRAEis afederally funded institutionthat is not runby the government nor provides clear mechanismsfor monitoring the effectiveness of its programs. 53. Overall, measuresand programs to support SMEs lack governance and effectiveness. They needto be articulated ina set of initiatives that could be defined as a comprehensive federally fundedpolicy for SME development. 54. InFebruary 2003, Decree4,584 (of February 5th)provides for more political autonomy of Apex. Emphasis on sectors where the country has shown comparative advantages and on initiativeswhere there might be market failures (such as commercial missions andbroad marketing initiatives) are promisingdirections but sector focus to the detriment of horizontal measuresmight be counter-productive. Apex has recently sponsored an evaluation of the impact 37 Although this intent to direct credit to small entrepreneur might have a large direct impact, as predicted by the government, it may also have an indirect negative effect on the spreads and on the overall efficiency of the financial intermediation. 168 of its programs, an initiative that should be continued. Overall, export promotionprograms in Brazil may benefit from further focusing, tailoring and do~nsizing.~' 38See Markwald, R. and F.P. Puga (2002): "Focando a Politica de PromoqBo de Exportaqdes". InPinheiro, A.C, R. Markwald and L.V. Pereira: "0 Desafio das Exportaqdes". BNDES:Rio de Janeiro. 169 ANNEX 7 CORPORATE INSOLVENCY LAW 1. The availability and cost of capital in Brazil has been significantly affected by its weak framework for creditor rights. Difficulties associatedwithjudicial debt collection processes weaken creditor's rights and rendercredit ultimately more expensive.' This note discusses a centerpiece of Brazil's legal framework for creditor rights, embodied inits law for corporate insolvency. The first part provides an overview of the present legal framework and describes the processwhich has ledto the submission to Congress of a bill for a new legal framework. The secondpart provides specific details of the drawbacks of the current insolvency framework. Part 3 critically evaluatesthe proposed new legislation, and Part 4 compares it to the present system, and to international norms of good practice. The final part points out some areas which are still to be addressed, either through complementary additional legal or regulatory measures, or through attention to the practical application of the new legal framework 1. The Current LegalFrameworkfor Corporate Insolvency An Overview - 2. Brazil's current legalframework for corporate insolvency is largely out of date, fragmented and unresponsiveto the needs of modern business, lacking theflexibility required for modern corporate restructuringor closure.The central piece of legislation for bankruptcy proceedings for commercial entities was enactedin 1945 (Lei de FuZ2ncius - Decree Law 7661 of June 21, 1945).2 Though the Lei de FuZ2nciusprovides for both abankruptcy liquidation proceeding and an insolvency and reorganization proceeding intendedto prevent or avoid liquidation of enterprises, inpractice the insolvency (concordutu)processhas proven to be wholly ineffective at maximizing asset values and protecting creditor rights inliquidation, or at salvaging viable distressedbusinesses. Cases are sluggish and routinely take from three to eight years; longer periods are reported. The process has led to an informal use of the system (concordutu bluncu) to promote consensualworkouts by taking advantage of the moratoriumand suspensionof proceedings to negotiate a settlement. Workouts are also hamperedby an Discussed extensively in Brazil: Access to Financial Services (World Bank, 2003 - Draft); based on inputs from Armando Castelar Pinheiro, and from Pinheiro and Cabral (2001) "Credit Markets in Brazil: The Role of the Judiciary and Other Institutions" inM.Pagano (ed), "Defusing Default: Incentives and Institutions", Inter-American Development Bank, Washington D.C. Several additional laws govern specific insolvency cases, namely: (a) the Civil Code and the Code of Civil Procedure rule Civil Insolvency Proceedings of natural persons and legal entities not encompassed by the term "merchant"; (b) Law 6404/76 with the modifications introduced by Law 10.303 rules a judicial or extra-judicial liquidation of corporations but i s restricted to cases in which assets outweigh liabilities; (c) Law 6024/74 applicable for the intervention or extra-judicial liquidation of financial institutions; (d) Decree Law 73/66 applicable for liquidationof insurancecompanies; (e) Law 5764/71for liquidation of cooperatives; (0Law 9656/98 for liquidation of private health insurance companies; (g) the Aviation Code Law 7565/86 for liquidation of airlines companies. State-owned corporations and private-public joint-stock companies (sociedades de economia mista, Le., legal entities incorporated in part with government capital) pursuant to Article 242 of Law 6.404/76, as amendedby Law 9.457/97, were also excluded from bankruptcy proceedings, until 31 October 2001, when law 10.303 (the new CorporateLaw) modifiedthis rule, allowing the bankruptcy of private publicjoint stock companies. 170 insufficient legislative framework. The processof disposing of assets i s slow due to court and procedural inefficiency and lack of transparency. The law does not provide for an independent and qualified court-appointed admini~trator.~The so calledproblemu du sucessa`o; Le.; the transfer of liabilities, notably tax and labor liabilities, to the buyer of property soldinliquidation, leads to deterioration inthe market value of the assets of an insolvent company. The preference given to labor and tax claims inpractice eliminates any protection to other creditors. 3. Provisionsregarding treatment of contractualobligationsare also outmoded. Upon declaration of bankruptcy: (i) debtor forfeits the right to dispose of his or her assets; (ii) the any unadjudicated or pendingcreditor actions or collection suits with regard to rights and interests in the bankrupt estate are suspended; and (iii) on debt outstanding i s suspended. interest Notwithstanding these generalrules, several exceptions are so broadthat they render the rule nearly irrelevant. Usually, assets of the estate remain unuseduntiltheir sale. Ifthe trustee considers usage of assets to be inthe best interest of the estate, he may use these assets with court approval. Assets are usually sold in a public auction. While the law allows the debtor to continue operating under independentmanagement, inpractice this rarely occurs. Short of continuing operation during the bankruptcy, bilateral contracts previously entered into by the bankrupt entity are not automatically suspended or rescinded, and may be performed by the bankruptcy trustee, with thejudge's approval, if their performance i s deemedto be inthe interest of the estate. There is no comprehensive list of assignable contracts. 4. Weakprotection of creditor rights leads to low credit volumeand upwardpressure on interestrates. The lack of effective mechanismsto support corporate restructuring result in disproportionately highdefault rates of potentially viable companies. And the costs of exit of non-viable companies are high. 5. Brazil's main efforts to update its corporate insolvency legislationstarted with the drafting of thefirst versionof the "Biolchi Project" in 1993 (Projeto de Lei No. 4.376, de 1993, supported by Senator OswaldoBiolchi). Since then, the original Project has experiencedseveralamendmentsuntil the House of Deputies approvedthe latest version on October 15,2003. Its considerationby the Senate i s expectedto take place soon. The Lower House of Congress also approved amendmentsto Brazil's 1966Tax Code (Cddigo Tributdrio Nucionul - CTN) simultaneously with the new Bankruptcy Law addressingseveral issuesof great importance ininsolvency proceedings. Frommid2001 to mid2002, the World Bank assessed the Brazilianinsolvency and creditor rights systems pursuant to ajoint IMF-World Bank initiativeon observanceof standards andcodes ("ROSC"). The review was carried out in collaboration with the Central Bank, basedon the World Bank Principles and Guidelines for Creditors, among whom the judge shall appoint a trustee (sindico or comissa`rio), almost never accept the designation. In consequence, judges generally appoint a lawyer to perform the role of administrator. Brazilian insolvency law does not establish committees o f creditors. Untilliquidationis complete, the trustee will manage the bankrupt estateunder the supervision of the Court, assistedby the Public Attorney's office. (SubemendaAglutinativa Global 2s Emendas de Plena'rio ao Substitutivo Adotado pela Comissa`o Especial ao Projeto de Lei No. 4.376-BA993 (PLno. 205, de 1995,apensado). 171 Effective Insolvency and Creditor RightsSystems principle^").^ An added objective of the assessment was to provide technical assistanceto the Brazilian authorities inconnection with the ongoing Project to amendthe bankruptcy law. Inaddition, the World Bank team reviewed the thenlatest versions of the 1993Project of Law 4.376, includingthe May 22,2002 proposalthat incorporated recommendations by the Central Bank.6 Dialogue with Brazilian authorities has been highly constructive. Moreover, the current Bill, approved by the Lower House (October 2003) reflects several suggestions of the ROSC Report submittedinJanuary 2003. 2. Limitations of the Current Framework 6. Rights of secured creditorsare impaired by theprecedencegiven to labor and tax claims. Inbankruptcy proceedings @zZe^nciu),the classification of credits inthe current framework i s a matter of public interest and not subject to modification or extension by private arrangement. Secured interests rank below several other claims, in accordance with the following order of priority: (1) claims for compensation arising from work-related accidents; (2) other labor and social security claims; (3) tax credits; (4) costs of administering the bankrupt estate, includingprofessional fees; (5) securedclaims; (6) personal claims enjoying special privilege; (7) personal claims enjoying generalprivilege; (8) unsecuredclaims; (9) subordinated debt (debzntures subordinadus). Once the long anddrawn-out bankruptcy proceedings have been concluded, and all the top-tier creditors are paid, there are few, if any, funds left over to be distributed, even among the securedcreditors. 7. The concordataonlyprovidesfor a moratorium on the terms of payment or a discount on the credit owed, so as to enable a debtor to meet its obligationsand avoid or suspend bankruptcy and liquidation. As such, the concordatai s arigidand inefficient mechanismfor rehabilitation of viable businesses. Notably, itjust encompassesunsecuredcreditors, but there are no provisions allowingparties (debtorkreditors) to negotiate a plan. Write-offs and rescheduling of debts are rigidly prescribed by the law, which does not permit other negotiated mechanismsfor reorganization of the business. There are no special regulations regarding borrowing and obtaining of credit while under the Brazilian concordata. Duringthe concordutu, the entity may not dispose of real property or give securedguarantees without authorization from the court. The concordutu might thus be considered a legal moratoriumgranted by a court at the request of an insolvent debtor. The `concordutu preventiva' provides a mechanism for insolvent debtors before reachingbankruptcy. Debtors retain the right to continue their business (debtor in World Bank, Principles and Guidelines for Effective Insolvency and Creditor Rights Systems (April 2002), http://www.worldbank.org/ifa/rosc-icr.html. In addition to the review of legislation, regulations and related information, the conclusions in the ROSC assessment were based on a wide range of interviews with public and private sector stakeholders, including, among others, with: (a) senior officials and staff members of the Ministries of Economy, Finance (Tax Department) and Justice; (b) bankruptcy and commercial court judges; (c) representatives of the registry office, BRADESCO and credit agencies; (d) members of the drafting commission for the preparation of the Project; and (e) various professionals serving as trustees, executors, lawyers, accountants, and debt recovery specialists. Finally, the assessment team participated in several roundtable discussions and a two day Experts workshop on insolvency conducted in October 2001, attended by numerous public and private sector experts to discuss issuesrelated to the assessmentand the Project. Subemenda Aglutinativa Global ds Emendas de Plendrio ao Substitutivo Adotado pela Comiss6o Especial ao Projeto de Lei No. 4.376,de 1993(Vers6o22 de Maio de 2002 -BACEN). 172 possession) under the supervision of a commissioner. The `concordutu suspensivu' allows an insolvent debtor who has been declaredbankruptto exit from bankruptcy inthe case of recovery prospects, provided the debtor pays at least 35 percent of unsecuredcreditors' claims.7 8. There is no specific regulatorypameworkfor qualifyingparticipants, such as administrators, liquidators andinsolvency practitioners. This leads to low or non-existent entry level requirements for professionals chargedwith handling administration of the process. This leads to significant disparitiesinthe quality and reliability of the system. There i s no provision for an independent andqualifiedcourt-appointed administrator. Creditors from whom thejudge must appoint atrustee (sindico or commisa`rio)rarely accept the designation. Inconsequence, judges generally appoint a lawyer to performthe role of administrator. Brazilianinsolvency law does not establish committees of creditors. 9. Thejudicialframework for insolvency is also a weakpart of the existingsystem. Brazilianstate courts, which are overburdenedin mostjurisdictions, are competent to deal with all kindsof corporate insolvency proceedings. Slowness of thejudiciary i s a major problem as well as the non-uniform quality of the judiciary acrossBrazil's 27 states. Nevertheless there i s some experience with specialized insolvency courts in a few jurisdictions such as Rio de Janeiro, Port0Alegre and Belo Horizonte. 10. Non-judicial proceedingscorrespondingto the internal commercialpolicies and actions taken by a business to block the liquidationprocess are not covered by current legislation, Brazilianbanks have attemptedto reach negotiated agreements out of court. However, successes have beenlimited.Some users of the systemrefer to workouts as "quite rare" while others mention demandsfor better guarantees or the enhancement of collateral as preconditions to start informalnegotiation.* 'In a preventive concordutu, the insolvent entity must offer creditors payment o f at least 50 percent of their claims on sight, or it must offer payment of 60, 75, 90 or 100 percent of their claims within 6, 12, 18 or 24 months respectively. Additionally, in the case of an 18 or 24-month preventive concordutu, at least 40 percent o f the debt must be discharged in the first year. In a suspensive concordutu, the entity must offer its unsecured creditors payment of at least 35 percent of their claims on sight, or 50 percent within a maximum period of two years, and at least 40 percent of the debt must be discharged in the first year. In either kind of concordutu, the interest rate applicable to credits subject to the concordutu can be up to 12 percent, assessed beginning on the date on which the concordutu is granted. It should be noted that in the majority of cases, judges have applied the maximum rate of 12 percent, as well as the frequent use of inflation adjustments. In some recent cases, the Court has ordered lower interest rates, compatible with low inflation. * Several obstacles to informal workouts (some of them also common to formal restructuring proceedings) were reported, including: (a) Succession issues and uncertainty in respect of potential lender liability when introducing advisors and/or new management into a troubled customer; (b) Lack of trust and collaboration amongst creditors; (c) Low quality and reliability o f information (in some cases several sets o f accounts and/or potential cash leakage issues); (d) Current provisioning rules would be acting as a disincentive to lenders to support prolonged restructuring; (e) Lack of tax incentives; (0Uncertainties in the formal proceedings, thus turning informed decision- making difficult (outdated bankruptcy law; lack of consistency in courts decisions and time to deliver judgments); and, (g) Priorities of government and labor claims in insolvency proceedings. 173 3. The ProposedNew Insolvency Law Areas of Improvement - 11. The proposed new Billrepresents a major improvement on existing legislation, integrated with Brazil's broader legal and commercial systems. It strikes a reasonablebalance between liquidation and reorganization and provides an option to reorganize in or out of court (Arts.45- SO>. The insolvency framework would significantly be improvedby the Bill, as it: (a) allows the conversion to recuperationproceeding (recuperagiiojudicial) inliquidation (falgncia) (Arts.79- 80); (b) permits the debtor to apply for rehabilitation duringthe procedural term afforded to respond inthe liquidation proceedingfiled against him(Art. 81, Q 2); and, (c) introduces a new extra-judicial reorganization system (recuperagiio extrajudicial)for prepackagedrestructuring plans (Art. 73-78). 12. Participation of stakeholders in insolvencyproceedings will be enhancedthroughthe newly designed RecuperationCommittee(Comitt?de Recuperapio). The Billprovides for a Comitt?de Recupera@o, which presents the possibilityof increasedcreditor and employee participation (Arts. 64-72). Upon commencement of the reorganization proceeding, the judge should call the creditors to a generalmeetinginorder to designate their representativesto the RecuperationCommittee. It will be composedof the following members: (a) one employee representative; (c) one representativefrom the class of securedcreditors; (d) one representative from the class of unsecuredcreditors. Inaddition, two substitutesor acting representativesof each of these classes should also be appointed. The Committee would have competenceto present an alternative rehabilitation plan should the debtor's proposal prove non-viable, to supervise the administration of the debtor duringthe recuperation process, to evaluate creditor claims, andto request judicial authorization for encumbering or selling assets of the debtor (outside the ordinary course of business) where necessary for the continuation of the enterprise activity during the periodprior to the approval of the restructuring plan. 13. TheBillprovidesfor a standstill on enforcement actions of both secured and unsecured creditors,aprovision wellsuited to maximizethe valueof asset recoveries in FalZncia and tofacilitate corporaterestructuringin RecuperagiioJudicial. Tax claims not rescheduledinaccordancewith the CTN's provisions are exceptions to the standstill (Art. 7, Q 8"). Inreorganization proceedings, the standstill period should be limited to that which i s necessaryfor the approval (by the creditors) and confirmation (by thejudge) of the restructuring plan.Inany event, the maximumstandstill term is 180days, extendable by thejudge to other 90 days if requested by the Creditors Committee. 14. Flexibleand modernjudicial and extra-judicial restructuringproceedingsestablished by theBill will replacethe highly ineffective existingconcordata.Options available inthe recuperation processwill be increased, including delay of payment or partial debt forgiveness; division, incorporation, merger or assignmentof shares or stock; partial or total substitution of the administration; increaseincapital stock; leasing of assets; collective labor agreementsto reduce salaries, increasedor decreasedscheduledhours of employment; accord and satisfaction or novation of liabilities; incorporation of creditors; partial sale of assets; andjoint administration among others (Art. 50). 15. Mostfeatures of the recuperationprocess are in line with internationally recognized bestpractices,namely: 174 The Bill does require a debtor petitioning for judicial recuperation to submit to the court a recuperationplan with the time period estimated for its completion, not subject to a fixed or maximum duration, a report elaborating the reasons for the company's indebtedness, and documentation of the estate's assets, debts, and financial transactions (Art. 51). The judge then appoints a Judicial Administrator to evaluate the petition and notifies potential creditors of the proposed plan by publication so they may take their decision in a Creditors General Meeting (Art. 52-1). The Bill's primary achievement inthe area ofjudicial recuperation i s the addition of the Comit2 de Recuperaglio (Rehabilitation Committee) andthe Assemble'ia Geral de Credores (Creditors General Meeting). The Committee has competence to present an alternative rehabilitationplan should the debtor's proposal prove unviable, to supervise the administration of the debtor duringthe recuperationprocess, and to evaluate creditor claims among others. The Creditors General Meeting has the authority to approve or to reject the plan proposed by the debtor (Arts. 43-44), as well as to propose an alternative plan(Art.55 9 1").The lack of approvalof a plan by the Creditors General Meeting causes liquidation (Arts. 55 9 4"). Claims arising from valid transactions performed duringthe recuperation process (e.g., loans made to the reorganizing corporation) are considered as expenses of the estate not subject to bankruptcy rules (despesas extraconcursais). Incase of liquidation, those claims will therefore be paidbefore any pre-filing credits, which i s an important incentive for extending credit to insolvent companies under reorganization proceedings. Planformulation, considerationand votingis also consistent with bestpractice: It does not fix the nature of the Plan, even when it describes several means, as examples, for the recuperationPlan; (Art. 50) Classification of creditors for voting purposes i s well defined (Arts. 40-42); Voting rights are determinedby amount of claim (Art 38); The restructuring plan has to be approved by all classes of creditors. Ineach class, the plan should be approved by the majority of creditors attending the General Meeting who, inaddition, represent more than 50 percent of the class claims (Art. 43). The Court may, however, allow a plan if holders o f 50 percent o f the credits o f two classes and 33 percent of the thirdclass approve the plan, altogether representing more than 50 percent of the total amount o f the debtor's liabilities (Art. 44); The voting rights o f insiders are limited (Art. 41). The Bill's provisions on thestages of implementationof the restructuringplan and dischargeof debts encompassed by theplan are sound: 175 0 Duringthe recuperationprocess,the debtor has to makeamonthly report on the state of the business (Art. 59); 0 A plancouldbereviewedandmodifiedby the Creditors GeneralMeetingwhen there is a substantialchange inthe economic and financial situation of the debtor (Art. 62); 0 Termination of the plani s possible in several circumstances, which brings about the liquidation of the debtor (e.g.: when decided by the General Assembly of Creditors, when the plan i s not approvedby the creditors, or when the plan i s not accomplished). (Art. 79) 0 There i s a provisionfor following the discharge of debts encompassedby a plan. (Art.48 9 2) 18. TheRecuperapioExtrajudicial is an important advance which establishesa legal frameworkfor corporateworkouts and restructuring, andpermits the conversionof a non- judicial recuperationplan into aprepackagedjudicial recuperationplanfor the enterprise. The Billestablishes an out-of-court proceeding (RecuperaGlio Extrajudicial) (Arts. 73-78) by which the debtor may call hiscreditors, or some classesof creditors (with the exclusion of tax andlabor creditors) (Art.74 0 1") andproposeto them anon-judicialplanof recuperationfor the enterprise. This call to the creditors i s not considered an act of bankruptcy. The planhas to be approved by all classes of creditors; ineach class, the planshould be approved by a majority of creditors attending the meeting who, in addition, represent more than 50 percent of their class claims. It may thenbe submittedto the judge to obtain judicial confirmation. Creditors who did not vote infavor may object to the agreement (Art. 76) and thejudge shall decide whether to approve or not approve the plan. Once the plan isjudicially confirmed (homoZoga@o),its provisions are bindingon all creditors (of the same class or classes) even when they didnot vote infavor of the plan.g 19. As regards liquidation (falgncia),the Bill incorporatesseveral importantinnovations, andpartially solves someflaws of the existingsystem. The Billimproves the current treatment of contractual obligations (Art. 48 and Arts. 115-131). Notably, it provides for the offsetting of debts andcredits ininsolvency proceedings (Art. 8 andArt. 118-VIII). As for the avoidance of fraudulent or preferential transactionsperformed during the time when the enterprise was insolvent ("suspect period"), the Billshortens this period, contributing to a reduction inthe disruption of normalcommercial and credit relationships. It also introduces a significant rule protecting legitimate deals and asset sales when undertakenas part of a recovery plan approved . inareorganization (Art. 1320 1"). 20. TheBill and theamended CTNaddress one of theprincipal existingproblems of insolvency in Brazil the difJicultissues concerningtax credits. The Billprovides for the sale - of the assets at the outset of the liquidation proceedings and, whenever possible, as a going concern. Inaccordancewith the revised CTN, the buyer of these assets, bundledtogether, will not be liable for past tax and social security liabilities and therefore the assets will be worth more, becausethe buyer will be able to take over the bankruptbusiness without assuming hidden liabilities inthese areas. Also referred to as the 'cramdown' provision. 176 21. I n addition, secured creditors will share, on equal terms, thepreference in the distributionof the estate,just after labor claims, which would continueto have toppreference. The amended CTN also provides for a scheme which would allow insolvent companies to pay their tax debt ininstallments in all reorganizationproceedings. The proposal, however, does not shield buyers o f going concerns from past labor liabilities of the insolvent debtor. These hidden liabilities would result inlower sale prices, andtherefore, an inefficient recovery. If appropriate legislative measures are not considered so as to fully solve the so calledprobkma da sucesszo, this problemwould partiallyremain with respect to past labor liabilities. 22. Administrativeexpensesare considered debts of the estate (despesas extraconcursais), which grants themfirst claim in the ranking ofpriorities." Where this refers to debt incurred, withjudicial authorization, inreorganizationproceedings, this may facilitate the ability of a business under reorganization to obtain credit for the maintenance of business operations (Art. 59 5 2"). Under the proposed reform legislation, such creditors can reduce recovery risk because they are guaranteed that the credits obtained duringajudicial reorganization process have priority, should the process be converted into liquidation. 4. The ProposedNew Law Comparisonswith Other Countries - 23. Thefollowing tablesprovide the ratings of the corporateinsolvency legalframework of specific countriesor regions, assessed using the World Bank Principles and Guidelinesfor Effective Insolvency and Creditor Rights Systemsas a benchmark (April 2001)." It compares (i) currentlegislationforcorporateinsolvency(LeideFalZnciasDecreeLaw7661of Brazil's June 21, 1945),as evaluated under the ROSC exercise; with (ii) the present Bi1l,l2; (iii) seven emerging market countries; (iv) 15 EUcountries; and (v) the United States of America. Table 1 encompassesPrinciples related to the legal framework for Insolvency, and Table 2 refers to Principles focused on corporate rehabilitation. lo Art. 11-VI and Art 12. This category of expenses includes all claims outside of the other classes of creditors, namely: [a] judicial expenses for unsuccessfully contested matters; [b] the remuneration costs of the judicial administrator and hidherauxiliaries; [c] taxes and incidental public contributions accrued during the recuperation or liquidation processes; and [d] judicial obligations acquired from the legal processes during recuperation or liquidation. A Principle will be considered observed (1) whenever all essential criteria are generally met without any significant deficiencies. A Principle will be considered largely observed (2) whenever only minor shortcomings are observed, which do not raise any concerns about the authority's ability and intent to achieve full observance with the principle within a prescribed period of time. A Principle will be considered materially non-observed (3) whenever, despite progress, the shortcomings are sufficient to raise doubts about the authority's ability to achieve observance. A Principle will be considered non-observed (4) whenever no substantive progress toward observance has been achieved. l2The Bill has been reviewed solely with respect to whether it observes the World Bank Principles of the Legal Framework. Thus, the ratings do not reflect whether the Bill would be implemented in practice or would be implementable without further changes to the Institutional and Regulatory Frameworks. Consequently, ratings in practice could be lower than indicated. 177 Table 1: Brazil's Corporate Insolvency System -Current andProjected Compared to Other Countries - Overall objectives I 3.00 2.00 2.86 2.00 1.oo 17. Director and officer liabilitv 3.00 1.oo 2.43 1.53 1.oo 18. Balance between liauidation & rehabilitation II 3.00 1.oo 2.57 1.93 1.oo 19A. Scope and application 1 2.00 3.00 1.57 1.80 1.oo 9B&C Ease of access (Insolvency test) 3.00 2.00 2.57 1S O 1.oo 10. Moratorium and suspensionsof rights 3.00 1.oo 2.00 1.60 1.oo 111. Governance and management 3.00 3.00 1.71 1.64 2.00 112. Creditor safeguards & committees II 4.00 1.oo 2.71 2.20 2.00 113. Collection, preservation, disposition of assets I 3.00 2.00 2.71 1.80 1.oo 14. Treatment of contractual obligations 3.00 1.oo 2.29 1.87 1.oo 15. Recovery o f avoidable transactions 3.00 1.oo 2.7 1 1.40 1.oo 116. Treatment of stakeholders rights I 3.00 3.00 2.7 1 1.75 1.oo 1 = Fully Observed 2 =Largely Observed 3 = Materially Non-Observed 4 = Not Observed For the purposes of the study, emerging economiesare: Argentina,CzechRepublic,Lithuania,RussianFederation, Slovak Republik,Turkey andUkraine. Table2: Brazil's Corporate Insolvency System -Current andProjected Compared to Other Countries - 18.Stabilizing and sustaining business operations 4.00 ' 1.oo 2.7 1 2.20 1.oo 19. Informationaccess and disclosure 2.00 1.oo 2.00 2.40 1.oo I 1 1 20. Formulation, consideration and voting of plan 4.00 1.oo 2.29 1.93 1.oo 21. Approval of plan 4.00 2.00 2.57 2.13 1.oo 22. Implementation and amendment of plan 4.00 II 1.00 2.57 2.07 1.oo 23. Discharge and bindingeffects of dan 3.00 j1.00 1.86 1.93 1.00 1= Fully Observed 2 =Largely Observed 3 =Materially Non-Observed 4 = Not Observed For the purposesof the study, emergingeconomiesare: Argentina, CzechRepublic,Lithuania,RussianFederation, Slovak Republik, Turkey andUkraine. 24. It is clearfrom these tablesthat there would be a dramatic improvementin the framework for addressinginsolvency in Brazil, with theproposed new legislation.Progress i s particularly evident inthe area of corporate rehabilitation, where Brazil would move from a regimeof most international principles not beingobserved (five out of seven), to nearly full observation (six out of seven). Brazil's legal framework would compare very favorably to not only the other emerging markets consideredbut also, a selection of EUcountries, and would have a score only below the US. Inthe case of insolvency, Brazil's existing legislation was not as deficient, and the new framework still indicates a number of areas to be addressed. Some of the outstanding issues remaining inthe proposed new framework are discussedfurther below. 178 5. OutstandingIssuesandNext Steps 25. Even though the Billpositively changes the existingpreferential treatmentgranted to tax credits and recognizespriority for financing provided while in restructuringproceedings, it does not limit thepreference granted to labor creditors by the current legislation. Chapter 11, section I1of the Billoffers the following classification of creditors inorder of payment preference: (i) labor credits, includingclaims for industrial accidents, without any limitations (Art. 11-1);(ii) the seconddegreeinequal conditions, andinone to one proportions: (a) sharing tax credits (Art. 11-11, a), and (b) securedcredits (Art. 11-11,b); (iii) credits with special privilege, such as a mechanic's lien (Art. 11-LII); (iv) credits with generalprivilege established by ordinary civil and commercial laws (Art. 11-IV); (v) unsecuredcredits (Art. 11-V);and (vi) subordinated credits (Art. 11-VI). 26. Despite improvementsintroducedby the Bill in the ranking of claims in insolvency, secured credits (mortgages,pledges) are still weaklyprotected vis-a-vis other classes with higher or equalpriority. Securedcredits come below administrative expenses and labor claims, and sharetheir grade with tax claims. Insuch a systemit seems unlikely, incases of insolvency andliquidation, that securedcreditors would recover significant amounts of their claims. Interests of securedcreditors intheir collateral should beprotected to avoid a loss or deterioration inthe economic value of their interest during the proceeding. Where assets are sold, securedcreditors should be paidpromptly. Consideration shouldbe given to removing the priority on tax claims, andtreating these paripassu with general privileged creditors. 27. As regards labor claims, itspriority is not inconsistentwith other leadingjurisdictions. However, it should be noted that in most leadingjurisdictions, these claims are capped by limitingthe periodfor which recovery is allowed andby also limiting the total maximum allowable (for example: three months of remunerations or some amount of money expressed). Consideration might also be given to ways of protecting employee losses outside the bankruptcy process, eg under a social protection fund, as under the German system. Furthermore, although pledges and mortgages should be afforded greater protection, the Project does not restrict the rightsof creditors underleasing, aZiena@ofiducidria andconditional sales arrangements, which inprincipleis correct. 28. Projected provisions on applicability of the Billwould keep the legal framework for insolvency proceedings fragmented. The Billdoes not encompass entities that are currently excluded also from concordata andfaZ2ncia proceedings, suchas cooperative companies (Art. 1- I).Moreover, state ownedenterprises (empresaspliblicas andsociedadesde economia mista) would be out of the scope of the projected ordinary insolvency regime (Art. 1-V). Consideration should be given to the draftingand subsequentenacting of a new law that shall subject state- owned corporations, private-public joint-stock companies and other state-owned enterprises to the same insolvency law as the rest of private corporations. The inclusion of cooperatives inthe ordinary insolvency regimewould be advantageoustoo. Brazilian courts havejurisdiction in bankruptcy matters if theforeign company has its 29. Cross-borderinsolvency issues are not dealt with under the Bill, exceptto state that principal business unit or a branch in Brazil (Art. 3). Inabsence of specific legislationfor dealing with cross-borderinsolvency, as most civil-lawjurisdictions Brazil i s currently 179 employing techniques such as exequatur, enforcement of foreign insolvency orders relying on legislation for enforcement of foreignjudgments, andletters rogatory for transmitting / receiving requests for judicial assistance. These legal approaches frequently result ininadequateand inharmonious consequences,which hamperthe rescue of financially troubled businesses, are not conducive to a fair andefficient administration of cross-border insolvencies, impede the protection of the assets of the insolvent debtor against dissipation and hinder maximizationof the value of those assets. Moreover, the absence of predictability inthe handlingof cross-border insolvency cases may impede capital flow and i s a disincentive to cross-border investment. To the extent that there i s a lack of communication and coordination among courts and administrators from concernedjurisdictions, it i s more likely that assets would be dissipated, fraudulently concealed, or possibly liquidatedwithout reference to other more advantageous solutions. As a result, not only i s the ability of creditors to receive payment diminished,but so is the possibilityof rescuingfinancially viable businessesand savingjobs. B y contrast, mechanismsinnational legislation for coordinated administration of cases of cross-border insolvency make it possible to adopt solutions that are sensible andinthe best interest of the creditors and the debtor; the presenceof such mechanismsinthe law of a State is therefore perceived as advantageousfor foreign investmentand trade inthat State. To achieve the above mentioned objectives, Brazil should give consideration to adopting rules -in the upcoming Insolvency Law or in a separateand specific law- similar to the UNCITRALModelLaw on Cross-Border Insolvency. 30. The Bill does notprovidefor independentand qualifiedjudicial administratorsfor either reorganization or liquidationproceedings, supervised by an independentregulatory body. This key issue deserves high consideration. It will be a new one inBrazil, as its current insolvency systemrelies upon creditors (or lawyers) (and not on independentnor qualified professionals) to act as administrators in concordutu and liquidators infaZe^nciu.The current situation creates an opportunity to adopt a regulatory framework which provides for independent supervisory responsibilities to qualify, train and monitor trustees, and to adopt compensation guidelines with incentives for efficient liquidations / administrations while reasonably adaptedto the system's needs. A structured career should be put inplace, which would form a talent pool of qualifiedregistered administrators. Corrupt or incompetent administrators would be taken out. 180 31. The early stages of implementationwill test the new system inpractice, a challenge that deserves careful considerationof ways to strengtheningregulatory andjudicialframework. Both the Billand the projected amendmentsto the CTNare welcome innovations that would significantly improve Brazilianinsolvency legal framework, providingfor in-court and out-of- court reorganization mechanismsandjudicial liquidationproceeding. As mentioned, however, a shortcoming of the Bill i s that it does not provide for a fully independentand qualifiedcourt- appointed administrator and/or supervisor neither inliquidation nor inreorganization proceedings for insolvency. Inaddition, an independent supervisory and regulatory body i s not created. On thejudicial side, anew legislation will face the risk of misinterpretations that could jeopardize its intended goals. This is a highly likely risk inBrazil due to the large number of state courts that will havejurisdiction over insolvency proceedings. The implementation of the new legislationwill demand a significant effort ineducating the principalusers of the system and the public in general. Capacity buildinginthejudiciary will be an urgent key issue for the success of the upcoming legal regime. A Pilot Court PrograminBrazil largest commercial centers would be a significant first step for the overall improvement ofjudges and courts interms of their competenceon insolvency matters. 181 ANNEX 8 THEFINANCIALSECTOR 1. The following sections provide notes on specific themes inBrazil's financial system. The themes selected are intendedto reflect, first, some of the new areas inthe financial system included inthe present operation, relative to the previous two programmatic adjustment loans for the financial sector.' These themes are, first, the development of the risk capital segment of Brazil's capital markets, and second, the development of the insurance industry. Both these areas are closely associated with the development of an overall growth program. Riskcapital markets provide the financing for new firms and new innovations, while the insurance segment, among other institutional investors, provides a source o f long term finance for the development of the real sector.2 2. Two additional areas reflect the continuity of themes raised inprevious adjustment loans, which remain pertinent for the future. The first of these i s the theme of financial access, recently discussed indepth in a separate World Bank study.3The present note complements this report b y discussing very recent measures adopted inthis areaby Brazil's government, over June to September 2003. Finally the last theme covered i s Brazil's payments system, where a major phase of reform to the large value payments system hasjust been concluded, with significant support from Bank-financed technical assistance, and where a new phase of reformi s now anticipated, for retail payment^.^ 1. Venture CapitalandRisk Capital Markets 1.1 Backgroundand Overall Trends 3. Brazil's history of macroeconomic instability, very highreal interest rates even for government debt, extensive public intervention inthe market for long term capital via directed lending o f up to 40 percent o f bank lending to the private sector, and a taxation regime that has hurtliquidityof manyforms of financial contracts have all contributed to the emasculation of local capital markets. When coupled with world wide economic shocks, the recent technology bubble, and legal uncertainty inthe enforcement o f shareholder rights, it i s apparent why there have been few recent substantial IPOs and why venture capital i s little developed. Inessence these factors have effectively made exit for any private capital investor very uncertain, Brazil - Fist Programmatic Loan, April 2001, Report No. P7448-BR and Second Programmatic Loan, May 2002, Report No. 24067-BR. Brazil's pension funds are the most important segment of its institutional investors, in volume, although the insurance sector i s the more rapidly growing segment today. A discussion of the pension funds sector has been omitted here as it will be covered in substantial detail in a separate operation under preparation for FY04/05 on pensionreform. Brazil - Access to Financial Services. June 2003. Draft. Brazil -Financial Sector Technical Assistance Loan, August 2001, Report No. 22603-BR. 182 enforcement of their rightscomplex, while overall alternative forms of investments (e.g., investing inBrazilian government debt). 4. Moreover, Brazil is characterizedby apronounced segmentation in the access of firms tofinance. Althoughlarger firms inthe tradable sector often find adequate financing solutions through Brazil's development bank, the BNDES, or inmajor offshore markets, SMEs or companies inthe non-tradable sector face limited financing options. Lending by private banks occurs at remarkably highspreads by international standards.Domestic capital markets do not play a major role inthe financing of enterprises either via public or private equity or via debt issues. Besides highinterest rates, micro-enterprises or SMEs also face highcollateral requirements including personal guarantees, reflecting problems with contract enforcement. It i s thus not surprisingthat inBrazilfactoring and leasing are relatively well developed financing techniques while venture capital financing i s virtually non-existent. Figure 1:Recent History of Private Equity and Venture CapitalInvestments:Brazil I I OverallTrends in PrivateEquity Investments VUEdeals and investmentsin Brazil 2000 100 80 1600 + - E 80 60 e g' Q) 1200 5 '0 60 69 2 40 n 40 t 800 .E&8 20 5 400 =5 20 a I 0 0 0 1996 1997 1998 1999 2000 2001 2002 1998 1999 2000 2001 2002 OBrazil Number of deals +Averagelnvestment/deal ( U S M M ) 5. Over theperiod between 1996to 2002 trends in risk capital committed are disappointing.Figure 1indicates that not only have the aggregate value of transactions inthe riskcapital segment of the Brazilian capital markets declined since 1998, the absolute number and average value of deals closed has also substantially declined. Real interest rates of almost 20 percent during 1995-June 1999 and about 10percent betweenJuly 1999 and the present have rendered private risk capital unattractive as an asset class to both local and foreign investors in Brazil. 183 Figure 2: Structural Characteristics of the BrazilianVCPE Market I VUEfunds raisedlallocatedto Brazilvs. FDI Active Rayers in V U E Market in Brazil 3 0 35 e 30 m 40'0 e3 2 0 25 cn 2 2 0 % 5 2 300,0 '0 v) c '0 loL 6 20% L 3 5 0 0 0 1000 I -Oft-snore Rea onaIG ooa Fmas a ocat ons =Off-shore. Local Funds C&ntry-specific Funds(Brazil) IntermtioMJ Local Fund Famly Corporate Others +FDI iForeianDire.9 Investmnt) Funds Managers Groups Venture 6. Particularlyinthe last three years, one critical source of venture capital and private equity inBrazil, foreign direct investment-either via key global private equity funds, or through direct private capital equity investments-has virtually collapsed. There has been a parallel decline in local funds. Internationalfunds still provide 46 percent; however, local company VC funds as well as special funds established inBrazilcan be expected to become more important than at present inthe next few years. Some of the problems are business cycle related, andthere may be a spontaneous revival. However the average time to exit still remains very long inBrazil (around six years and often more) reflecting the relative lack of liquidity and capitalization of local equity. Moreover in the past few years more Brazilian companies have de-listed than listed. Even private equity transactions have often involved investments inpublic companies that are subsequently de-listed as a means of allowing timely exit. Inaddition the tax system with its very strong emphasis on taxation of sales, income and earnings creates large incentives for companies to stay informal. This problem i s magnified for small firms. 7. The authorities recognize that any attempt to address the issues indeveloping this segment of the Brazilian capital markets requires a package o f reinforcing actions. Fiscal credibility and lower interest rates can start to prompt greater liquidity inBrazil's capital market, thereby allowing for more options for exit from private equity investments. More specific efforts have also begun, as discussed below. 1.2 The Program of Reform ActionsAlready Taken 8. Steps have been taken to permit institutional investors to invest inflexible risk capital market segments. These include closedpension funds, corporations with private capital units, foreign private capital funds, local venture capital funds that must invest incompanies o f certain size, etc. This i s especially important because as interest rates fall investments inthis asset class will become more of a natural alternative. Inthe case of the Brazilian closedpension funds which do not permit portability and therefore have more locked inliabilities from an actuarial vantage point; there i s a natural set o f incentives to invest inthis asset class. With assets of duration of about two years and liabilities between 10 and 11years there i s a strong need to undertake better duration matching. Private equity investments are an asset class that can assist 184 pension funds to better manage this asset liability mismatch, although the relative lack of liquidity of this asset class andlack of recognized performance benchmarks are potentialrisks of allowing "imprudent investment" inthis alternative asset class. Thus, it will be critical that such pension funds have a way to assure exit from private equity or venture capital investments and that investment limits be inplace. 9. Introducing More Flexible InvestmentRegulationsfor ClosedPension Funds: Brazilian closedpension funds controlled nearly R$170 billion (nearly 90 percent o f the total of R$191 billion o f total pensionfund investments in 2001.5 Recently new andmore flexible investment regulations have been issued (CMN Resolution no. 3121/03) for closed pension funds, to invest intrue private equity funds (as now definedunder a new complementary instruction issued by Comisszo de VuloresMobilidrios (CVM)for private equity funds, see below). Under this new regulation the closed pension funds will be able to invest up to 50 percent o f the total portfolio inso-called variable return instruments. This will include investments inpublicly traded equity on BOVESPA, investments in standard equity funds (Fundos de Investimento em Titulos e ValoresMobilidrios; FITVM: C V M 302/99); investments inventure capital funds (FundoMu'tuodeInvestimento em EmpresusEmergentes; FIEE: CVM 209/94); and investments inprivate equity funds (Fundo de Investimento em Purticipug6es: FIP: CVM 391/03);and other investments in such instruments as Brazilian Depository Reciepts (BDRs)etc. Within this overall limit on investments invariable return instrumentsthe closed pension fund will be able to invest up to 20 percent of the portfolio in a combination of FIEEand FIPfunds. However, the pensionfundadministrator will have to also meet concentrationlimits by companies, IBXindices, etc. 10. Broadening and Modernizing the Investment Vehiclesin Private Equity: The C V M issued a new complementary regulation (CVM 391/03) governing the development of private equity funds. This regulationi s inline with international standards. This vehicle allows for acquisition o f shares or debt of private companies and securities of public companies. Interestingly the fund can be formed with assets of companies under reorganization (hence could be structured as a vulture fund), only qualified investors can participate (can be highnet worth individuals and institutions with more than R$250,000), fund quotas canbe amortized and traded on the BOVESPA, there are no limits on the size of investments as inthe case of venture capital funds, and perhaps most importantly the regulation allows for the structuring o f funds with different share classes. This last characteristic will partially ameliorate the problems associated with exit as structures can be set up (e.g. mezzanine financings)to accommodate shareholders' diversity of risk preferences and create cash flow characteristics that may imply relatively greater future negotiability of the contract inquestion. 11. Introducing More Effective Enforcement of ShareholderAgreements: Coupled with actions to improve the regulatory framework the authorities have taken actions to improve the means of enforcing shareholder agreements. The Brazilian Supreme Court has declared the Arbitration Law to be constitutional. This will now allow by laws or a written shareholder agreement of a company to be enforceable or amenable to settlement via thirdparty arbitration. This can permit more scope for recourse when a shareholder agreement mustbe exercised. In practice when a company encounters problems inBrazil, ordinary remedies (e.g. put to other Basedon datafromSPC and SUSEP. 185 shareholders, drag along rights to sell to another investor etc.) cannot usually be exercised as the company cannot pay. The combination of the new insolvency law and the existence of a third party arbitration processwill hopefullyimprove this situation. Actions Under Considerationfor the Short Term 12. Allowing OpenPensionFund Investments in Risk Capital: Although open pension funds only presently accountfor about 10percent of total pensionfund assets under management their assets have been accumulating more rapidly and their role can thus be expectedto increase inimportance. As beneficiaries haveportabilitythe stochastic properties of the liabilities argue for a more careful approachinpermittingprivate equity investments. Although at present these types of investments are not allowed, the possibility of allowinglimited investments inprivate andventure capital funds underwell definedprudential guidelines anddisclosures is under examination. 13. Streamlining the IPOprocess and Reducing Costs of Issue: There continue to be excessively hightransactions costs inundertaking an PO. They include: coordinating and underwriting, registration of the issueinthe commercial registry and inCVM, registeringwith associations such as ANBID, legal work, marketing, disclosure, obligatory publication (which alone are almost R$245,000), various continuing costs such as fiduciary agent fees and rating agency fees, and various fees to negotiate the transaction on the relevant exchange or trading and clearing platform (see Table 1, for a typical corporate debt issue). Takento ether these fees account for almost 4.3 percent of issue size for issues around R$40 million. Giventhat many of k these costs are fixed (e.g. publication relatedfees), the cost of issuingdebt i s prohibitive at low issue sizes and i s reduced as issue size grows. Fromthe perspective of investors, small issue sizes are often difficult tojustify as part of aportfolio, given the administrative and other costs of booking very small denomination assets. There are also opportunity costs associatedwith the slow process of registering an issue (andthe need for constant re-registration) due to the lack of a well developed shelf-registration system for debt issues. 14. A new CVMinstruction relating to public offerings is already under final discussion at the C V M commission, which would reducecosts for issuers by increasing competition inthe provision of these services andvia the redesign of regulations for disclosure inways that can engender competition. For example, inthe case of publication, corporate borrowers will be able to disclose information directly over the internet or via a wider choice of newspapers.The new regulation will also permit the use of shelf registration, and other techniques that can reduce overall transactions costs of is~uance.~ ~ By contrast continuing costs of an issue such as fiduciary costs and various forms of recurring fees to distribute the issue over the SND systemetc., only accountfor about 0.23 percent of issues of this size BNDES could also help to aggregate medium and small borrowers in getting better terms from ancillary service providers in underwriting from investment banks, legal firms, registries, and newspaper or media firms. Also the use of technology via an electronic order book building process for distribution of corporate debt deserves thought as a means of forcing greater competition across investment banks inthe distribution of corporate debt. 186 Table 1: Typical Costs InvolvedinIssuingCorporate Debt Placementfee 0.3% 5% of issuedamount - 508200 796250 CVM 0.3% of issuedamountor R$ 82,870 82870 82870 (cap) CommercialRegistry 127 127 SRO ANBID (certification) 0.001% ofissue, R$2OOOmin, 2000 2000 R$30,000 max Rating Agency S&P 0.02% of issue(minUS$25,000; 25000 25000 max US$13O,OOO) LocalAgent R$30,000 30000 30000 15. Reducing BNDES's long term lending and directed credit to create space for more effective public interventions to promote development of private riskcapital. A phase-down o f its programs o f credit to small and medium enterprises and use of this scarce government capital to leverage the use of private resources and injection of risk capital will be considered. This approach will not be independent of the continuum of existing interventions by FINEP, SEBRAE, andthe universitiesinincubationefforts. 16. The authorities could also rationalize tax treatment for risk capital, through the consideration o f measures such as a flat tax across different vehicles, special tax treatment for smaller companies, etc. Clarification of the basis o f calculation for the capital gains tax, for both individual or fund investment by foreigner, i s also needed. Additionally, improved valuation and accounting guidelines inSuperintend&& de Seguros Privudos (SUSEP), CVM, and SPC (supervisors of pension and investment funds, are needed). Special risks are presented by investments inprivate equity duringthe sometimes long period before actual cash flows are 187 realized. There are related issues of valuation and development of benchmarks to permit performance assessment of fund managers. Medium TermMeasures 17. Inthe mediumterm the authorities havedecidedto take severaladditional measuresto foster the financing of innovation. These measuresinclude: simplifying antitrust filing requirements, investigating further actions to reducelegal uncertainty inthe provisionof risk capital, andrevamping the institutional roles of key public agencies inthe life cycle of companies. 18. SimplihingAntitrust Filing Requirements: Antitrust filing requirements inBrazil are administered by ConselhoAdministrativo de Defesa Econdmica (CADE) under the existing Brazilian competition act. (Law 8884/94 article 54 para. 3.). Today this act gives CADE very broad authority to review any acts that may limit or otherwise restrain open competition, or that result inthe control of relevant markets for certain products or services. Therefore if there i s any action that impacts economic concentration, whether via mergeror organization of other companies or funds to control other companieswhen the resulting company or "group" accounts for 20 percent of a relevant market or inwhich any of the participants has posted inits latest balance sheet annual gross revenues equivalent to R$400million. Note that this provision applies to foreign companies inthat "parties" i s definedbroadly to include not only companies participating inthe transaction but also economic groups worldwide. Application of this criteria to private capital transactions i s unclear as definition of an economic group incase of a fund i s not well defined and calculation of turnover i s not clear. Hence the authorities have agreedto consider introductionof a size threshold or conditions under which an exemption will be permitted inthe case of such private equity transactions. 19. ReducingLegal Uncertainty:8Despite improvements and proposed improvements inthe corporate law and the bankruptcy law many forms ofjoint liability exit for shareholders as well as for Directors andManagement. This can complicate the process of raisingrisk capital andcan effectively be priced into these transactions or inthe extreme can compromise their consummation. An effort will be madeto see how to reducethe potential liability to both foreign and local investors inBrazilianjoint stock companies. Suchpotential liability extends to possible civil, labor, social security, tax, and consumer liabilities as well as to proxy liability that are actually imputable to underlyingprivate minority shareholders. Such liability appears to even go beyond the initial value of the investment inthe company. 20. Article 115 of the Brazilian Corporate law (Law 6404/76) allows for this type of liability becauseit establishes that a controlling or minority shareholderwill beliable for any damage causedby abuse of hisright to vote even if his vote does not prevail. Under this article, the right to vote is deemedto have been abusedif it i s exercisedwith the intentionof causing damage to the company or other shareholders or of obtaining advantages for the shareholder or a thirdparty to which neitherof themi s entitled, and which results or may result indamage to the company or its shareholders. In addition controlling shareholderscan be liable for abuse of power (Article * This sectioni s basedon legal briefs provided by major Brazilian law firms; notably the firm of Pinhiero Neto. 188 117) and incertain cases a private equity minority investor that signs a shareholder agreement canbe subject to liabilities imputable to the controlling shareholder group. 21. Beyond these problems there have been times inBraziliancourts where rulings have in essence disregarded the legal entity "the corporation" thereby piercingthe corporate veil so as to allow a harmed party to effectively hold shareholders, directors and officers liable for their personal assets. Under article 50 of the new Civil Code (January 2003) two explicit conditions are laid out under which ajudge can rule that the effects of certain obligations of the legal entity be extended to the personal assets of the senior managers, and shareholders.' Finally similar concerns can arise inthe context of the case of labor, social security, tax and consumer protection disputes. Insome cases (e.g. labor disputes) the `disregard' doctrine i s beingusedif the company i s insolvent and cannot make wage payments. Inother cases minority private capital investors are held liablebeyond their investment as the shareholder agreementi s usedto argue that this shareholder i s part of the control group. 22. Rationalizingthe Government'sRole in Risk Capital:Today inBrazilthe roles and functions of differentagencies inthe process of supporting the `life cycle' of company financing from incubation to a public offering are not adequatelydelineated. I anything there may be too many such agencies involvedwithout any overall framework and structure. Today, these include BNDES-BNDESPAR via its operation inmanaging stocks and venture funds; FINEP, which i s part of the Ministry of Science andtechnology andrunsthe so-called INOVARprogram, SEBRAEwhich is supporting small andmicro-enterprises andvia ANPROTEC representsover 200 incubators throughout Brazil, andfinally, the Universities, which play different roles. The authorities have committed themselves inthe short to medium term to review andrecommend changes inthe exact roles and functions of all these differentagencies. The aim i s to use their interventions to demonstrate the processor cycle of takingfirms from the early incubator stage to apublic offering - a processwhich to date has not occurred inBrazil. Hence, even the demonstration impact could be important. The authorities will prepare an explicit plan of action for rationalizingthe roles of each of these entities to see how they can work together to create greater incentives for technology investing and related productivity growth via development of community clusters, R and Dtie ups of large firms with Universities, etc. 2. The Insurance Sector: Status andProspects 2.1 A Profile of Brazil's Insurance Sector Growth, Ownershipand Products - 23. Brazil's insurance sector i s large in absolute terms but relatively underdeveloped given the size of the economy and compared to regional and international standards. In2001, the Brazilianinsurance markethadtotal premiums of US$10.8 billion compared to a total of US$41.2 billionfor the LatinAmerican andCaribbean region. This makes the market the second largest inthe region andranks it 24th largest inthe world. Incontrast, the premiums as The two specific conditions are departure from purpose (desivio de jinalidade) or asset confusion (confusdo patrimonial). The judge needs to ascertain when these conditions have been met and if there are acts of fraud or abuse of the use of the company by shareholders. Increasingly the same disregard doctrine i s being used in other statutes such as consumer protection, antitrust, labor and tax legislation. 189 a percentage of GDP for Brazil (2001), commonly referred to as "insurance penetration," stood at 2.14 percent well below manyother countries inthe region and 59th inthe ranking of all countries." In2002, the sector showed sharp growth inpremia following initiatives to broaden product range andbetter economic conditions for longer term savings. Total premia are now estimated to bejust over 2.8 percent; an indicationthat the sector is now realizingthe results of several earlier initiatives to enhance its economic role. Table 2: Brazil's Insurance Sector: BusinessSegments and Volumes as a % of GDP 1996 1997 1998 1999 2000 2001 2002' Jan-Sep I 2003l I LifeBusiness 0.38 0.39 0.39 0.35 0.36 0.36 0.80 1.05 NonLifeBusiness 1.63 1.74 1.77 1.66 1.75 1.78 1.90 1.75 Total Business 2.01 2.13 2.16 2.01 2.11 2.14 2.70 2.80 Source:Swiss Re Siama (1996-2001). 1) Data for 2002 and 2003 are from SUSEP. Table 3: Comparisons of InsuranceIndicators Brazil and SelectedCountries - InsurancePremiums Premiumsper Shareof World (% of GDP(2001)) Capita $US2001 Market2001(%) Brazil 2.14 64.0 0.45 Mexico 1.81 112.6 0.46 Source:Swiss Re, Sigma 612002 24. There is scope for the sector to play a larger role inthe development of the economy, through the provisionof a more complete range of services to the community inBrazil and through the provisionof longer term capital for growth. Assets of life insurance companies are subject to ratio basedasset rules which act to limit exposures. The sector, inpart due to its small size and secondly due to limited longer term products, does not contribute as strong a role as long term institutionalinvestors as desirable. Efforts to encourage such developments should be planned and implementedover time. 25. There are over 120companies operating ina diverse market with no player having a dominant market share and only sevenplayers with market shares above five percent. Companies are locally incorporated inBrazil. Ownership varies andincludes participationby foreign insurers and localbanks. Although the market i s dominated by domestic companies, recentjoint ventures and partnerships with companies outside thejurisdiction have introduced competition (Figure 1). lo Re,Sigma6/2002. Swiss 190 Figure1:ParticipationinBrazil'sInsuranceMarket-DomesticandForeignCompanies Participation inthe Market bySource of Capital and Premium Europeand UK 25% NorthAmerica Brazil J&,, LCentrai Americs 64% 3% 0% 26. In termsof products,theBrazilian non life insurancemarket is one of the largestin the region. Iti s characterized by substantialproperty related business lines plus DPVAT (Compulsory ThirdParty Motor Insurance)which i s the only real insurance line inthe non life sector, a relatively limitedexposureto insurednatural catastrophes, and group life insurance (which i s treated as a non life product). Premiumincome for non life insurance totalled R$19.2 billion for the year to August 2003 (an annualized rate of $R28.8 billion compared to R$24.3 billion for the 12 months to December 2001). A steady 21 percent of the non life premiumi s healthinsurance. The largest classes of business are automobile property insurance which represents36 percent of the market. 27. In terms of performance, business lines generally report a loss ratio of under 60 percent with the material exceptions beingthe worse performingDPVAT- thirdparty motor liability insurance (72 percent but much improvedfrom 79 percent in 2001). The bulk of the business i s written inthe two most populous regions of Sao Paulo (51percent) and Rio de Janeiro (13 percent). Total provisions have grown as new and stronger regulatory requirements take effect andstood at R$18.1billions as at August 2003. 2.2 Life InsuranceProducts 28. The life insurancemarket, hitherto dominatedby group life insurances, has recently successfully introduced new products for the pensionplan market.Relativelyrecently, economic stabilization has encouraged longer term saving. A new insurance product has beenbrought to the market (the VGBL, in 2002), to complement an existing product, the PGBL, for open pension schemes. These products target pension plans, each with a slightly different tax treatment. The products have beenvery successful and have transformedthe market." 29. Giventheir success, it will be important for the industry, going forward, to ensure that realistic longterm risks andreturns are reflected inproduct design. The industry i s aware of the ''Open pension schemes (PGBLs) represent a deferred annuity type product that i s available to the public on a tax favored basis. The product involves periodic contributions which are invested, after allowance for administrative charges, in a selected investment vehicle. With economic stabilization, built in tax advantages, and declining employer-managed pension plans, the PGBL product has grown in importance. VGBL schemes alter the timing o f the tax benefit. 191 desirability of providingfor updatesof mortality tables and of the needfor features which allow for appropriate cognizanceof prevailingmarket conditions at the time of payout. 30. A less internationally common product (capitalization) exists inthe market which combines aregular saving facility with a lottery component. The product i s describedby market participants as highly profitable. This i s mainly due to the fact that expense charges on premiums are set to recover the costs of administration and sales plus a cost for the lottery component and returns offered are low. Total provisions heldby companies offering this product as at August 2003 were R$8.0 billions. Contributions are runningat R$5.2 billion per annum indicatingthat the product i s particularly short term innature. While products canbe sold for longer periods, there i s a substantial part of the market which i s representedby contracts with a term ofjust one year and many of the longer termcontracts are terminated early. 31. Although these products are popular, it is clear that the financial benefit is heavily biased infavor of the issuer of the contract andagainstthe customer andbetter product disclosure to consumers would be advisable.A key short term objective for the authorities i s to develop mechanismsto improve transparency with respect to this product, encouraging or even enforcing improvedtransparency as a step toward moderating company profits andallowing the market to impose greater discipline on company expense charges and penalties. 32. While the small life insurancesector is emerging andbecoming more innovative as a result of economic conditions which are more conducive to their product, actuarial and other technical skills are underdeveloped. Company managementtechniques demonstrate a capacity to develop but are not as advancedas is evident inother sectors. Although appropriate for the current level of operations, it i s apparentthat the opportunity that could exist from a more developed andinnovative sector i s substantial. It i s notable that the bank-owned insurers are the best placed and are havingthe strongest success rate inthis sector and canbe expected to continue to do so inthe future. 2.3 Insurance Regulationand Supervision 33. Supervisionof insurance, openpensions, and capitalizationfalls under the minister of Finance and is performed largely by aprivate insurance council (CNSP). Day to day supervision is, infact, carried out by SUSEP, an `autarqia' under the Ministry of Finance. 34. As the recent FSAPfor Brazil noted, SUSEP, as the supervisor for the insurance sector, has made very dramatic and impressive progress over the preceding five years to improve both the quality of the regulation and the veracity of supervision of the insurance sector. Since the FSAP, further improvements have been made inthe supervisory processes and some regulations as a direct result of taking up recommendations made, including, for the new life insurance products, a requirement for actuarial evaluations on a more prudentbasis; a requirement for a solvency margin; moves to develop a mortality table; and a requirementfor businessplans and financial projections. 35. Technicalcapacity within SUSEP is, however,in need of development.The key senior technical staff should be aparticular focus as they present a strong commitment to their tasks but have limited exposure to alternative approachesor mentoring -bothwould be of considerable 192 benefit. Support directed at enhancing policy considerations are now underway, particularly with respectto the ongoing development of supervisory procedures inline with new IAIS principles, the enhancement of the valuation and solvency regime inthe light of emerging new accounting standards for insurance, and the abovementioned enhancement of disclosure are relevant areas of focus. Inaddition, exposure to mechanismsfor the securing of more complex andcontroversial policy changes would be of benefit. 2.4 TheReinsuranceMonopoly 36. One reasonfor limited technicalskills andproduct innovation is the existenceof the reinsurancemonopoly.Fromtime to time, consideration has beengiven to an element of liberalization inthis area, by allowing other entities into the domestic market. Indications have been that a number of the larger global reinsurers would seek to establish operations inBrazil. Ultimately, it i s also possible that some would move regional operations to Brazil. The IRB could also transfer some of its other statutory tasks of a supervisory nature back to the insurance supervisor (SUSEP). 37. The Instituto de Resseguros do Brasil (IRB) itself has been in an improvingfinancial position though still less than optimally capitalized. Uncertainty and a lack of recruitment has meant that the staffing resourceswith relevant expertisehavebeenprogressively eroding. Management at the IRB, together with the Government as shareholder, should take steps to ensurethat the company i s well positioned for the future consistent with the needs and incentives for boththe IRB and the wider insurance sector. 38. Brazil has the potential become the major marketinLatin America as a result of these trends inthe future, transforming it's leadership insize into regional leadership inimportance. 3. RecentMeasuresto ExpandFinancialAccess 39. FromMay, 2003, the government has introduced a series of new measures aimed at supporting financial access to the poorer segments. A number of these measuresfollow creative good practice techniques, already adoptedinmany countries. However, other measureswhich may help to expand access inthe short termmay be less beneficial, or even harmfulto the provision of such services inthe long term, due to their distortive impact on financial markets, especially for microfinance. Details of some of these measuresand their potential impact are discussedbelow. 3.1 Measures to Expand Bank Services 40. The new measures include,first, eased access to the banking system, through: (i) the establishment of simplified accounts for individuals, which offer a basic package of bank 193 services and are free of charge up to certaintransaction limits;12 (ii) simplified conditions for opening a bank account, without the need for proof of income;13 (iii) an expansion inthe scope o f services offered by correspondent banks including the opening o f accounts and credit facilitie~;'~and (iv) payroll 10ans.l~ 41. Such measures for basic or lifeline banking have been commonly adopted in several countries and if well administered can be a good technique to broaden access to financial services for the under-served population. It should be noted however that ensuring that participating institutions' operating costs are covered may make basic accounts more sustainable inthe medium term thanthe provision of free services. Andmeasures to simplify the procedures for opening accounts for low income persons could be extended gradually to encompass a considerably wider group perhaps eventually including all bank clients. 3.2 Banking and Microfinance- A New Interface 42. Other measures introduced to expand the interface of Brazil's banks with its poor deserve closer scrutiny as they constitute an increase indirect credit and introduce potentially price distortive interest rate ceilings on microfinance lending. Brazil's banks provide the bulk of the financial services and remain the mainstay o f all intermediation. As such they can provide a means to expand access on a significant scale. However financial sustainability, andthe containment o f risk, i s critical for sound banking. A key recent measure announced i s the earmarking of two percent o f banks' sight deposits for microfinance credit operations encompassing loans to small businesses andloans to low income individuals, based on the new basic accounts.16 If not used for this purpose, these resources will instead be deposited as unremunerated reserves at the Central Bank. Interest rates on loans made from these resources will be capped at two percent per month. Banks may undertake these microcredit operations directly or through microfinance entities; however inthe latter case the interest rate caps are bindingon the onlender. l2 CMN Resolution3104 of June 25, 2003 and CMN Resolution 3113 of July 31, 2003. The simplified accounts will not offer checking facilities and all withdrawals will be by card only. Balances will be limited to R$1,000. Such accounts can be used for making public payments. N o charges are made unless: the account holder makes more than 4 withdrawals a month; gets more than 4 statements a month, makes more than 4 deposits a month or using a check linked to the accounts' funds. Financial institutions involved will include Multiple Banks, Commercial Banks and Caixa Econ8mica Federal. l3CMN Resolution3104 of June 25, 2003 and CMN Resolution3113 of July 31, 2003. Opening a simplified account will however still require a taxpayer identification number and an Identification card, along with other basic personal information. l4C M N Resolution 3110of July 31,2003. l5 Provisional Measure No 130 of September 17, 2003. Employees can authorize the automatic payment of loans, financings and leasings direct from their payroll. Authorized payments will be limited to thirty percent of the total amount. l6Law No. 10735 of September 11, 2003 (formerly ProvisionalMeasure No 122 of June 25, 2003) and CMN Resolution 3109 of July 24,2003. Such operations are destinedfor low income earners, holders of simplified accounts and small businesses. Loans will be limited to R$500 for individuals (raised to R$600 on October 30- C M N Resolution No. 3128) and R$1,000 for small businessmen. Terms will be no less than 120 days (terms can be smaller as long as rates are adjusted accordingly). Credit service charges are not to exceed 2 percent for individuals and 4 percent for small business. 194 43. The reservation of a certain proportion of sight depositsfor microfinance lendingimposes a de facto tax on the banking system, inthe form of additional reserves, if microcredit loans are not expanded, and apotential increase incredit risk if they are undertaken.Additionally, the interest rate ceilings imposed on such loans can distort the microfinance market, discouraging loans at normal interest rates. Banks can protect themselves somewhat against expandedcredit riskbychanneling the credit through other entities, suchas SCMs; however, theseentities are then obligedto adhereto the conditions of the interest rate ceilings, as they could presumably receive the funds at low costs (given the zero opportunity cost to the bank).The offering of loans (and near automatic access to loans through revolving schemes), with such accounts increases possibilities of risk. 44. Inparallel, Brazil's largefederal bankshave all expandedtheir microfinance operations undera series of individuallydesignedschemes. At the BNDESbank, anew microcredit program was introduced inSeptember 2003 which restricts onlending rates for microcredit financed by BNDES credit lines to two percent or five percent per month, depending on loan size.17At the Caixa Econ8mica Federal, holders of its new special accounts, the Caixa Aqui, will have access to pre-approved rotating credit lines, also at the two percent rate.'* At the Banco do Brasil, a new subsidiary has been established, - the 'Banco Popular', which has been established as an independent subsidiary of the Banco do Brasil, to work specifically with microcredit 10ans.l~With credit operations funded by the two percent sight deposits of the parent bank, this wholly owned subsidiary will focus primarily on Brazil's large informal market with simplified accounts. The Banco Popular will use only corres ondent banks to provide its services, which will be contracted on a fee-per-transaction basis?'In keeping with other federal banks, the CrediAmigo program at the Banco do Nordeste do Brasil also plans to adopt the new interest rate ceilings, The government has also approved new regulations allocating R$ 1.1billionfrom FAT to Banco do Brad and CaixaEconbmica Federal to expand working capital credit for small and l7Two percentfor loansupto R$1,000 and 5 percent for loans from R$1,000 to R$10,000. It also staggers the rate at which funds are offered to the onlending entity, by loan size. Funds financed under the new microcredit program will be divided into three size categories: Up to R$1,000; Up to R$5,000; and from R$5,000 up to R$10,000. The cost of funding for onlenders will continue at the TJLP (Long Term Interest Rate) for loans up to R$1,000, and at TJLP +2% and TJLP+5% for larger loan sizes. A minimum of 30 percent of onlending must be used in the smallest size category. l8Of R$200, with interest rates capped at 2 percent per month. Account holders can also receive social benefits, make payments, receiveFGTS and PIS income, as well as deposits and withdrawals. Caixa had already accumulated 750,000 new clients in October 2003 and expectsto reach one millionby the end of the year. Caixa Aqui has so far reachedmore than 2,000 small municipalities thus makingCaixapresent inall 5,561 municipalities inBrazil. l9Law No. 10738of September 17,2003 (formerly ProvisionalMeasureNo 121of June 25,2003) 2oA pilot program is expectedto begin December 11" with 350 correspondentbanks in five cities. The plan is to have 4,500 correspondent banks and one million clients by end December 2004. The initial business plan will involve US$22 million in total investments and will utilize US$lOO million of zero cost funds on-lent by Banco do B r a d (as part of the banks' 2 percentof demand deposits). The Banco Popular expects to break even inits 31dyear. 195 mediumcompanies,21andhas also approvedmeasures to expand subsidized credit to the poor for the acquisition of construction material.22 3.3 Additional Measures - Credit Cooperatives and Investment Funds 45. Inthe cooperative sector, recentmeasures include the easingof membership restrictions on new cooperatives to permit `open' structures, with easier conversion to such structures in certain regions.23Efforts have also beenmadeto put credit cooperatives and banks on the same regulatory footing interms of comparable structuresfor capital requirements, and to limit the preferential terms for use of special government programs such as the PRONAF. Moves to harmonize the regulatory requirementsand to limit preferentialterms are welcome. The decision to ease the formation of `open admission' credit cooperatives in small or remote municipalities, thus allowinglocation, as well as by activity or profession, to beabasis for association, is clearly intendedto stimulate the cooperative sector andhelp provide financial servicesinremote areas. However there may be attendant risks. Restrictions of membership are usual even inadvanced countries and provide a form of "reputational collateral." Enhanced supervision would be needed to contain such risks. 46. New measureshave also been createdto ease project fundingin "special interest sectors" through funds constituted as special purpose vehicles or venture capital funds.24According to the text of the new measure, two types of mutualfunds have been conceived; the RealEstate Investment Fundand the Credit Rights Investment Fund.Projects would have public participation. Charges cannot be less than SELIC rate; however subsidies will be offered to equalize the cost of financing and the rate of returnon receivables from each project. Paper i s to beheldby financial institutions, basedon acontract between the government andthe financial institution. Paper will be issued via public offerings or by electronic auction. These new proposalshave yet to be implemented andtheir final form i s unclear. The proposed `equalization' payments, and obligation to financial institutions to holdpaper, couldbe causes for concern. "CODEFAT (ConselhoDeliberativo doFundodeAmparodo Trabalhador - Deliberative Councilof the Worker ProtectionFunds)ResolutionNos. 331 and332 of July 10,2003 allocatingR$800million for Banco do BradandR$300million ''forCODEFAT CaixaEconBmicaFederal. Resolution No. 327 of June 25, 2003, establishes arrangements for the provision of loans for construction materials,up to alimit of R$17,500per loan, anda maximumterm of 8 years (only for individuals). 23CMNResolution3106 of June 25, 2003. For new cooperatives,the eased entry applies to municipalitieswith up to 100,000 inhabitants. Existing credit cooperatives, operating for more than three years, can transform into `open admission' credit cooperatives, but only in municipalities (or contiguous municipalities) with up to 750,000 inhabitants. Minimum capital requirements for the transformation is R$6 million for entities located in municipalities in metropolitan regions with more than 100,000 inhabitants and R$3 million for the rest. In the North and Northeast, this requirement is reduced by 50percent. 24 Medida Provis6ria - Provisional Measure No. 122 of June 25,2003. I t authorizes the government to launch Incentive Programs for the Implementation of Special Interest Projects (PIPS), through paper held by designated mutual funds. Two funds, the Real Estate Investment Fund(FII) (Fundosde Investimento Zmobilidrio); and the Credit Rights Investment Fund(Fundosde Znvestimento em Direitos Creditbrios) (FIDC), will finance the projects, usingreceivables originating from contracted commitments towards purchases, sales, rents and service fees, with public and private participation. PIPS' objectives will focus on housing and infrastructure development. The government can add further projects as needed. Resources will be destined for: financing up to 30 percent o f the total value of each project, with a maximum term of 5 years. 196 3.4 Additional Commentson theNew Measures 47. The most debatable inthe series of new measuresi s the reservation of sight deposits for the new microloans, andthe interest rate ceiling imposed on these loans. Apart from the implicit tax on banks, additional costs are the crowding out of market-basedintermediation, which i s no longer remunerative comparedto such subsidized credit. Often such low-interest rate programs fail to reach intended beneficiaries. The cost of such programs lies not only inthe volumes of funds intendedto be madeavailable butalso inthe interest ratedifferentials between these funds, and market rates, eventually borne by society. Moreover, considerable international experience has demonstrated that interest rate caps are unnecessary and may lead to an inefficient use of such funds. 48. While it is true that Brazil's microfinance institutions have enjoyedprivileged access to BNDES fundingat the TJLP rate, aphasedandgradual increaseto marketlevels acrossthe board may have beenmore desirable. To understandthe impact of the new measures on the role of the BNDESbank, it must berememberedthat hitherto, BNDEShas played a central role in providingfunding for microfinance. The proposed three tier rate structure (of TJLP, TJLP plus two percent and TJLP plus eight percent) basedon loan size thresholds could encourageefforts to circumvent these thresholds by breaking up loans to classify them in smaller size categories. 49. Giventhe low size of the proposednew threshold, even inthe largest loan size category, these measures adversely affect the microfinance sector by what amounts to a sudden significant increaseinfundingcosts by eight percent. Coupled with the ceiling on lendingrates, this could have a negative impact on their ability to survive. Given that a number of MFIs are still deemed to be nonprofit or civil society organizations, such atransition will be difficult to sustain and could reversethe gains of recent years. Convergence of interest rates combined with gradual transition and guidance on the incorporation of good lendingpractice, would be desirable, without the introductionof size thresholds. The combination of interest rate caps and increased fundingcosts of the presentproposalscouldbe a significant setbackto the development of Brazil's microfinance sector. 50. There appears to be every intention of maintaining the Banco Popular, this on a sound economic footing, but care will be neededto ensure it i s well capitalized and realistically funded, andgenuinely separatedfrom its parentbank. Clearly efforts hadbeen madeto study the CrediAmigo experiment and the new venture proposes a different approachto the expansion of access. Insteadof the loan-officer intensive, andbranch-office intensive approach of CrediAmigo the new institutionproposesto use largely electronic and card-driven banking, with outlets incommercial establishmentswhich will provide staff and with a skeletal staff of its own. Through this it hopes to keep costs below levels experienced by CrediAmigo andby its independent legal character and use of non-Bank employees, to avoid the labor disputes with which CrediAmigo has recently been confronted. Nevertheless, the reliance of the Banco Popular on funding at a near zero cost, basedon the earmarked reserves of the Banco do Brasil, i s disquieting. The degree to which the operations of the new institution will genuinely be separatedfrom the parentbank will also be a challenge. 5 1. Thegovernmentpoints out that these measureswerepart of a widerpackagefor the banking system, which reduced implicit taxes.The new requirementto direct two percent of 197 sight depositstowards microloans (or to keep them as unremuneratedreserves at the Central Bank) was introduced inparallel with a recent overall reduction of 15 percent inreserve requirements. Hence intotal there i s a substantial net reduction. Inaddition, at the time of their introduction, credit conditions were at their tightest inaperiod of several years, which was impactingparticularlyon small business. 52. It is also arguedthat the two percent interest rate caps, as well as low-cost funding, is only applied to the smallest size loans and a distinction i s thus madebetween "social" microcredit, and "normal" microcredit. There i s an expectation that the bulk of microcredit would continue at market determinedterms and that "social" microcredit would only account for a small part of the market.Thus it was consideredthat Brazil's microcredit sector overallwould not be distorted by the new measures. 53. Going forward it will clearly beimportant to see how significant, in terms of scale, the new "social" schemes will be andwhether they do significantly affect the overall microcredit market. The Ministry of Finance i s preparedto take the budgetary implications seriously and supports proposals for monitoring and assessment. Monitoring by the Central Bank, as financial system supervisor, i s also suggestedSuch programs need to beclosely scrutinized interms of cost, impact and outreach, as well as impact on the financial condition of participating financial institutions -banks as well as microfinance entities, and on the segments of the financial system concerned; especially the microfinance sector. 4. Brazil's Payments and Securities Settlement System Reforms -An Update 4.1 Introduction 54. The following paragraphsprovide an update on projects under implementation to improve safety andefficiency inthe Brazilianpayment and securities settlement systems in 2003. It follows earlier Bank descriptions of the launch of the comprehensive project of reform of the Brazilian payment system(known as Reforma do Sistema de Pagamento Brasileiro, SPB).25 4.2 Developmentsin Large Value Payment Systems 55. The BrazilianReal Time Gross Settlement System (Sistemade Transferencia de Resewas,STR) was launched successfully inApril 2002. The STR system designis basedon international principles and standards.The personnel of the Banco Central do Brasil (BCB) have acquired substantialknowledge on RTGS systems designandimplementation throughout the world. There is full understanding of the major policy implications of such a system, as well as technical design and operational options. The primary needto achieve an appropriate balance between risk mitigation and systemefficiency i s respectedinthe designof the STR. 25Brazil - First ProgrammaticFinancial Sector Adjustment Loan, Report No P7448-BR, April 26, 2001; and Brazil SecondProgrammaticFinancial SectorAdjustment Loan 24067-BR; May 20,2002 198 56. Participants maketransfers using standardizedmessages inthe RSFN(Rededo Sistema Financeiro Nacional) network. Since all participants have to be connectedto the network, they can send or receive messages on a real-time basis. The Systemhas beendevelopedto foster application of Straight-Through Processingamong participants (see Annex 1for additional informationon the RFSN). The STR technological platform (the mainframe and the processing capacity) was upgradedin 2003, with World Bank funding. The system currently has adequate capacity andpayment flows can be monitored inreal time by the BCB. 57. Since its launch the STR systemhas processeda great numberof transactions. Table 3 shows that inOctober 2003, a volume of 1,355,419 payment orders were channeled into the STR, for avalue of 5,686.6 billionreais. The systemreacheda peak of over 1.7 million operations for a value of over 8.7 trillion reais inJanuary 2003, but these numbershave decreaseddue to a change inthe management of open market operationsthat are now executed on abi-weekly basis. The STR i s now being auditedby a leading consulting firm, with World Bankfunding. As partof the same project, the SELIC systemwill also be auditedin2004. Table 3 Brazil's New PaymentsSystem(STR) Volume - - andValue of Transactions Apr-02 119,981 1,147,240 May-02 397,122 4,288,545 Jun-02 386,977 4,161,113 Jul-02 473,538 5,290,250 Aug-02 793,816 5,757,179 Sep-02 854,957 6,669,67 1 Oct-02 1,031,595 8,029,418 NOV-02 1,429,072 7,643,72 1 Dec-02 1,787,703 8,549,016 Jan-03 1,759,879 8,765,394 Feb-03 1,461,901 5,144,614 Ma-03 1,328,376 4,441,884 Apr-03 1,353,257 4,875,338 May-03 1,338,4 18 4,846,275 Jun-03 1,249,047 4,44 1,601 JuI-03 1,347,148 5,236,887 Aug-03 1,263,744 4,787,409 Sep-03 1,370,245 5,3 12,286 Oct-03 1,355,419 5,686,558 Source: Banco Centraldo Brasil 199 58. As for Brazil's other large value systems, Table 4 shows that the volume and value of payments inthe COMPE have decreasedas aresult of the proactive policy of the BCB to move large value items out of aclearinghouse that operates ina deferred net mode. Yet the aggregate value of payments processedinthe COMPE is still relatively high. InOctober 2003, the BCB and the banks agreedto impose a upperthreshold of 5,000 reais on the DOC26.Also, DOCs will be removed from the COMPE andprocessedinthe other private clearinghouse (Camara Znterbancaria de Pagamentos,CIP). COMPE Aug 2003 335,115 24 Source: Banco Central do Brasil 59. Brazil's commercial banks and the central bank are currently studying olicies for a safer and more efficient clearing processfor checks and the Bloqueto de Cobranp! All actions in this field will be coordinated inthe project knownas SPB-2 (see below). Table 4 also shows that the volume and value of paymentsprocessedby the CIP i s relatively low. It i s expected that moving DOCs from the COMPE to the CIP will increasethe volumes and makethe CIP commercially viable. On the other hand, the CIP will processbothlarge value and low value items. The BCB might have to monitor whether this change innature of the CIP has any implications for the payments system as a whole. 26DOC is mainly used for making interbank credit payments. Like "bloqueto de cobranca" (see note below) a client can issue a DOC from an ATM, home-banking or internet-banking station. It i s worth mentioning that DOCs are seldom used for funds transfers between accounts within the same bank which are largely made inreal-time through banks' own internal electronic systems. It is cleared and settled electronically through the COMPE. In 2002, "bloquetos de cobranca" comprised about 3.1% of clearinghouse turnover by volume and 35.6% by value. It i s the second most important instrument in COMPE after checks. As opposed to Bloquetos de CobranGa, DOCs usually involve large value payments. 27 Bloqueto de Cobranca is a bar-coded document used to pay bills. A customer receiving a "bloqueto de cobranca" takes it to a bank and pays in cash, through a debit card or writes a check to authorize payment through his account. Alternatively, the customer can input the bar-coded numbers at an ATM, home-banking or internet-banking station. Banks charge the payee an interbank fee to use them. They are cleared and settled electronically and when it i s the case the physical item i s truncated at the collecting bank. Typically Bloqueto de Cobranca is a retail instrument as 97.6% of the documents are R$5,000 or less and its average value in 2002 was R$920. 200 4.3 Developments in Retail Systems 60. There i s considerable room for improvement inthe efficiency o f retail payment instruments and systems, which still lack interoperability. After approval from its Board of Directors, the BCB i s currently working on what has been called the SPB-2 (Sistemade Pagamento Brasileiro-2), a second generation reform aiming at the modernization of payment instruments, especially those intendedfor low value payments, inorder to promote cheaper and more efficient substitutes for checks and for cash itself. Paper instruments, such as checks and currency, demand hightransportation and processing costs, a burden to both financial and non- financial system. Fraud and counterfeiting are also more likely to be associated with such instruments. 61. There are social costs associated with idle capacity inretail payment systems infrastructure derived from the low level of interoperability betweenbanks and clearinghouses, among Automatic Teller Machine networks and among deposit terminals at sales outlets networks and the lack of standardization insystems communication protocols. These obstacles prevent all participants, direct and indirect, from benefiting from scale economies. According to Central Bank's preliminary documents on SPB-2, the project should comply with at least the following actions: 0 evaluation of inefficiencies; 0 incentives to cooperation; adjustment of the legal and regulatory basis; 0 standardization of communicationprotocols to be usedby systems that convey payment transactions; integration of networks; 0 truncation o f checks; and 0 promoting a more intensive use of electronic instruments. 62. The stocktaking analysis i s expected to be completed by the end of 2003. The year 2004 will be devoted to the development of a vision for the retail system inBrazil, which will include the definition of the role of the BCB. The successful implementation of the SPB-2 project i s fundamental for the completion of the reform of the payments system as a whole inBrazil. 4.4 Developments in Securities Settlement Systems Bolsa de Mercadorias & Futuros (BM&F) Assets Clearinghouse 63. The BM&FAssets Clearinghouse, which will settle transactions for government bonds andfixed-income securities issuedby financial institutions, is currently testing messaging capabilities and internal procedures. As part of BM&F, the clearinghouse i s subject to the same governance arrangements as BM&Fand access i s granted to those that fulfill requirements stated 201 inBrazilianlaw, the rules andresolutions enacted bythe National Monetary Council, Central Bank directives and the BM&F's bylaws. 64. The clearinghouse will settle transactions executed inits electronic trading platform, the SISBEX system. This system allows for anonymous trading as well as for the registration of transactions performed inthe OTC market, thus providing great transparency and improvement inthe price formation process. Eligible transactions include spot transactions, forward transactions, repurchasing agreements andsecurities lending. Given the existence of a structured, T+O lending market which considerably reduces the risk of settlement failure, short selling is one possibility under discussion. 65. The Assets Clearinghouse will operate within risk management mechanisms designed b y BM&F's internal RiskCommittee, which is responsible for decisions regardingrisk management systems, stress scenarios for margincalculation purposes, concentration andleverage limits and other related subjects. The whole risk management framework should be approvedby the Central Bank. 66. The settlement process will be based on a delivery-versus-payment (DVP) model where securities andfunds are settled on a net basis and finality i s achieved during the settlement window that occurs at the end of every trading day (lending transactions are the only exception to this rule, being settled inreal time). One of the main advantages o f this model i s that it eliminates principal risk, thus reducing the level o f required margin. 67. As far as other risks are concerned, credit risk management tools will include leverage limits, credit scoring and admission criteria for Clearing Members and other direct settlement participants. The internal Risk Committee will also set up a forum where participants' creditworthiness and overall leverage can be conveniently assessed. The market risk of each participant (Le., the replacement loss the clearinghouse would face should this participant become a defaulter) i s calculated on a real time basis by the clearinghouse's risk management system. This system calculates the market value o f each participant's joint portfolio of transactions and collateral under current market conditions (mark-to-market) and under a set of stress scenarios defined by the internal Risk Committee. A negative market value in any o f the stress scenarios results inmargincalls to make up for the additional market risk inthe worst-case scenario. 68. Liquidityrisk management will also play a key role inthe clearinghouse's risk management process, due to the DVP mechanism. Thus, concentrationlimits and previously committed liquidity facilities are set to avoid liquidity problems due to settlement failures. The clearinghouse's legal risk management policy is based mainly on BM&F's legal framework. This legal framework i s supported by Law 10.214, which established the Brazilian Payments System, and the rules and resolutions enactedby the National Monetary Council and the Brazilian Central Bank, as well as BM&F's bylaws. Finally, operational risk management policies include a comprehensive set o f controls and procedures aimed to minimize the probability of human error. All computational systems are replicated ina contingency site and updated inreal time in order to avoid disruptions in the settlement process. Moreover, all vital systems, including the risk management system, were internally developed. 202 69. The clearinghouse i s testing its applications and its linkages with SELIC to assess for assessingthe implications for custodial arrangements for the new system. The BM&Fhas submitted the proposal to the central bank for their authorization. The system i s expected to go `live' inthe first semester of 2004. Thenew SELIC 70. The BCB i s currently implementing a reform of the SELIC system, which i s the central securities depository of government securities. Aspects of the reform include an upgrade of the technical platform and the implementation of securities lending facilities. At the end of the process the new SELIC i s expected to be compliant with all international standards for securities settlement systems. The project i s expected to take place for the entire year 2004. 4.5 Developmentin the OversightFunction of the Central Bank 71. Several actions to strengthen the oversight function of the Central Bank o f Brazilhave taken place inthe year 2003. 72. First,at the beginningof 2003 the BCB started to report regularly on payment system issues inthe new Financial Stability Report (Relutorio de Estubilidude Finuncieru). The report presents a chapter on payment systems together with other sessions on macroeconomic issues, bankingsupervisionandsystemic risk.Thethree issues publishedto date have extensively addressed some important aspects o f the SPB such as the reform of the large value systems, the project for retail systems and the tests of risk management procedures of the several clearinghouses. 73. Second, the BCB now maintains contacts with several other central banks, inparticular inEurope andinLatinAmerica, with particular regardto issues related to the project for retail systems (SPB-2). 74. Finally, the BCB i s constantly involved inthe control of risk management mechanisms of the clearinghouse and, as mentioned above i s currently involved inthe evaluation of the proposal for the new securities settlement system of the BM&F. 75. The Department of banking operations and payment systems i s carrying out payment system oversight at the BCB. For the future, the BCB might have to formalize in a more organic manner its organizational and cooperative aspects related to the oversight function. 5. The NationalFinancial SystemNetwork 76. Inthe past, exchange of information relatedto payment systems betweenthe Central Bank and other participants (including clearinghouses) were mostly made through file transfers (FTP -File Transfer Protocol). Financialtransactions derivedfrom reserve requirements management, rediscount operations, open market transactions and Treasury account entries were processed through the SISBACEN (The Central Bank Information System). Participants had to type in all the information required by these systems to a remote SISBACEN terminal located on the banks' premises, though completely isolated from their own internal systems. Therefore, 203 there was no technical feasibility for the implementation of straight-through processing between the Central Bank andparticipants. 77. Some of the principles envisaged for the reform of the Brazilian payment systems, such as an RTGS fund transfer within the CentralBank and intraday liquidity management, were not consistent with the then existing communication infrastructure. The Central Bank decided to create from scratch a network that would allow participants to safely exchange messages pertaining to all activities throughout the Brazilian payment system - the National Financial System Network (Rede do SistemaFinanceiro Nacional - RSFN). Thus allowing participants' computer systems to interact and exchange information inreal-time with minimummanual intervention. Chart 1. RSFN NetworkArchitecture 'Bacen / B r a s i l i a Bacen 0 1 Bacen 02 ASBAC RSFN dedicated routers RSFNdedicatedrouters Source: Banco C e h l do Bmsil 78. Brazilian Payment System Network Group (GTRede SPB)-with representatives from To pursue the endeavor, a working group chaired by the Central Bank was formed -the clearinghouses, banking associations andthe Treasury. The Network Group had the following mandate: to specify the new network's architecture, topology and physical structure; to define rules and standards for Ipconnections betweenthe networking services providers (NSP) and participants; 204 to proposethe best network solution regarding technology, scalability, security, contingency and cost-benefit ratio; to specify the technical requirementsto be usedinthe procurement processto chooseNSPs; to negotiate prices andconditions with NSPs; to confirm the two NSPs selectedinthe procurement processto set up the network; to follow ,audit and assess the implementation of the network. 79. The network architecture hadto support the real-time feature of most of the financial transactions envisaged inthe new Brazilianpayment system. Thus, it hadto achieve stringent requirements on availability, reliability, performance, security and contingency. Basedon those requirements, the Network Group has defined stringent specifications with which any NSP must comply, including redundancy in all segments of the network: the backbone, physical interconnections, equipments andlast mile. Inaddition a service level agreement between the NSPandparticipants was enforced ina master contract (see Box 1). 80. Security aspects of the network were assignedto other special working groups -The Security Group -, whose members representedthe same entities present inthe Network Group. These two groups cooperatedvery closely for two years. The outcome was anetwork basedon the TCP-IP protocol, fully compatible with internet concepts, tools and applications (for instance: client-server applications, web interface and electronic mail). The network i s also ready to convey new services inthe future such as "voice over IP" (phone calls among participants using the network), direct interconnection between financial institutions etc. 81. As far as information security i s concerned, all contents on the network (except public information) are protected with asymmetric cryptography2*and their origination can be certified by using digital signature2' (even public nature). The RSFNoperates as an extranet3' for the entire financial system; therefore outside users have no logical or physical channels through which may gain non-authorized access. 82. Message Group -was constituted with representativesfrom the financial sector to assess all The messagingprotocol was equally built from scratch. A third working group -The informationflows necessary to performday-to-day operations throughout the payment system and subsidiary systemswithin the Central Bank (reserve requirements, rediscount etc.) andthe 28According to the CPSS Glossary, asymmetric cryptography i s "a set of cryptographic techniques in which two different keys (private and public keys) are used for encrypting and decrypting data. The private key i s kept secret by its holder while the public key is made available to communicating entities. Also called public key cryptography." 29According to the CPSS Glossary, "digital signature is a string of data generated by a cryptographic method that is attached to a messageto ensure its authenticity as well as to protect the recipient against repudiation by the sender." 30Extranets are internet like networks which connects different authorized entities. 205 Treasury. The Group also had the mandate to choose the messaging protocol to be implemented and the technicaljustification for this. 83. According to the Central Bank, the decision to depart from reliable, well established messaging protocols readily available inthe market and, instead, create a proprietary protocol was taken on the grounds of providing the system with a set of messages to carry not only payment-related information but broader transaction-related information as well. For instance, a clearing member can use messages not only to pay for his net debt position within the clearinghouse but also to check his current operational limit or to pledge additional collateral. Messages can also be used inthe Central Bank / banks relationship as intraday rediscount operations and reserve requirement maintenance are automatically managedon a straight- through processing basis. The Central Bank also claims that a proprietary messaging system gives them more flexibility and discretion when it comes to future changes to the message catalog. 84. The Security Group and the Messaging Group -were eventually formally recognized by the The three worlung groups established duringthe reform process -The Network Group, Central Bank as permanent consultative bodies for the Brazilian payment system in their respective areas. Further governance arrangements for the RSFNare still lacking. So far, there i s no permanent staff formally in charge of the monitoring of the service level agreement. This service has been outsourced for some time with satisfactory results but a permanent governance structure would serve better for such a sensitive network. 206 ANNEX 9 THEINNOVATION SYSTEM 1. Roughly half of cross-country differences inper capita income and growth are drivenby differences intotal factor productivity (TFP), generally associatedwith technological progress. Further, mucho widening gap between rich an poor countries i s due, not to differences incapital investment, but intechnological progress. Despite a recent increaseinprivate sector investment innew equipment, Brazil's "technology gap" is still large.2For 10years (1983-1993), Brazil's TFP gap has widened systematically, incontrast with the previous decades. Since 1994, the technological gap has stoppedwidening but has not beenreduced (see Figure 1). Figure 1:Brazil and U.S. Evolutionof De-trended TFP in 1950-2000 (US1950=100) D e t r e n d e d T F P.Br a z l l a n d U S A I i 1 0- i 2 0 - 0 . . . . . . . . . . . 2. Over the last decades, however, Brazil has shown the disposition, the commitment and vision to become a leading force ininnovation and technology. The country has pioneeredLAC a science andtechnology program and has a highly entrepreneurial economy andhas excelled in selected scientific programs3 However, for Brazil to capture all the benefits associatedwith an knowledge economy that country has to be able to transform knowledge into productivity gains. Inthis Annex, we will discuss the mainissuesassociatedwith Brazil's poor capacity to See Office of Chief Economist for LatinAmerica and the Caribbean, "Country Innovation Brief-Brazil". 'The "technology gap" is measured by the difference between Brazil's and US de-trendedTFP growth rates. De- trended values correspond to the difference between the original TFP growth rates and the rates of change in the world's technological frontier, which were assumed to grow at 1.8 percent a year. See Gomes, V. ;M.B. Lisboa and SA. Pessoa(2002): "Estudo da EvoluGiio da Produtividade Total dos Fatoresda Economia Brasileira: 1950-2000". Relat6rio Final. MF: Brasilia, DF. Guasch, L.(2002) : Innovation and Technology in Brazil. Brazil Transition Note. World Bank: Washington, DC. 207 transform knowledge into productivity gains, as well as recent achievements of the government inthis areaand the future challenges that Brazilmightface. 1. BackgroundandIssues 3. Varying accordingto the overall economicdevelopmentstrategy, Brazil has been a pioneer in LAC in developingand implementingScienceand Technologypolicies. An explicit science andtechnology (S&T) policy at the federal level was defined for the first time by the 1968-69development plan. The plan proposed the creation of a National Systemof Scientific andTechnological Development (SNDCT) further detailedin sub-proposals andof a National Fundfor Scientific andTechnological Development (FNDCT)to finance the SNDCT. The 1970s and 1980s saw a strong emphasis on local technology development and a bigrole for the state. S&T policies duringthe 1990's reflected the frequent shifts inthe federal government and inthe overall development strategy, as well as the increasing fiscal constraints. Inthe early 1990's, two programs sought to boost technology absorption and diffusion inthe manufacturing sector - PACT1and PBQP-but lacked the appropriate stimulus mechanisms. B y mid 1990's, R&D tax incentives were reinstated for the agricultural (PDTA) andindustrial (PDTI) sectors, for specific industries, such as the informatics. Other measures were aimed at buildingresearch infrastructure and training o f scientific personnel, such as those inRHAE and Omega projects, were also adopted. A series of more technology-oriented measures were also put inplace with the support of the World Bank - the PADCT Iand 11,which invested a total of US$470million in4,500 projects. Overall, federal S&T policy inthe 1990's lacked o f stability and coherence. 4. Early investments in S&Tpolicy generatedresults in terms of building institutions and instrumentsto support S&T objectives.Brazil has its own Ministry of Science and Technology and aNational Council on Sience andTechnology (CCT), aimed at defining S&T strategies and coordinating inter-government initiatives. It has established two strong federal institutions CNPq (ConselhoNacional de Pesquisas) and Finep (Financiadora de Estudos e Projetos) for promoting basic research, including post-graduate studies, and financing technological technology investments by the private ~ e c t o rCNPq directly administers several research . ~ institutes with international reputation among which CBPF (Centro Brasileiro de Pesquisas Fisicas) and IMPA (ZnstitutoNacional de Matemdtica Pura e Aplicada). Sucessfull research centers are attached to other ministries, such as Embrapa (EmpresaBrasileira de Pesquisa Agropecurdria) and Inmetro (ZnstitutoNacional de Metrologia), a basic industrial technology institute maintained by the MDIC.' State-owned companies also ran their own research centers such as Petrobra's Cenpes, while SENAI (ServiCoNacional da Zndhstria) has been supporting technology centers. CAPES (Coordena@io de Ape$eiGoamento de Pessoal de Ni'vel Superior), attached to the Mistry of Education, i s also responsible for improving the qualifications - mostly supporting post-graduate studies - of university professors. Besides federal institutions, Brazil has several state-level institutions, such as the IPT (Znstituto de Pesquisa TecnoMgico)and Fapesp in the state of SLio Paulo. 208 5. As a result, Brazil has been able to generate selective evidence of scientific and technological success. The number of active scientists andresearchers grew from 15 to 77.8 thousandbetween 1992-2000. The share of publications of Brazilianresearchersincreasedfrom 0.64 to 1.4 percent of world total between 1990-2000,with outstanding results inmicrobiology (2.08 percent) and agricultural sciences (3.08 percent).6 Brazilian scientists were the first to crack the genetic code of the Xylella bacteriathat attacks orange trees and vines. A group of Brazilianscientists i s beingfundedby Brazil andthe UnitedStates to unravel the genome of the bacterium spreading Pierce's disease. World-class technology programs have been developed in aeronautics (Embraer), satellites (CBERS), biotechnology (Genoma), tropical agriculture (Embrapa) and deep-water exploration (Petrobras). Petrobris, for example, held55 patents inthe U S in2001 while Embrapa accountedfor one half of the total agricultural researchspending throughout LatinAmerica in 1996.7 6. Nevertheless, overall technologicalperformance of the Brazilian economy seems to be relatively poor. Aggregate measuresof technology performance indicates that Brazili s in an intermediate position: the technology index of Sachs andVial (2002) ranks Brazil 49thin a group of 75 countries in 2001, sli htly better than China (52th) and India (66`h) but worse than Chile (42`h) and Singapore (18th). The innovative performance of Brazilianfirms (measuredby patents i grantedinthe US) was outpacedby that of Indiaand Singapore, countries with muchfewer patentsgranted than Brazil 15 years ago (Figure 2).' Brazilperforms relativelybetter interms of technology absorption: the technology transfer index of World Economic Forum (2003) ranks Brazilthe 3rdamong 56 non-core innovator countries, better than Chile and China but worse than Malaysia and India. There i s still scope, however, for improvement. Acquisition of embodied technology through the import of capital goods i s low according to international standards, even when controlled for the volume of imports (Figure 3). Technology transfer as indicated by the payment of royalties and license fees has improvedsince mid90s but i s still far below countries such as Korea (Figure 4). The improvements on licensing agreements should not be overemphasized:a recent World Bank study indicates that only 2.2 percent of the Brazilianfirms would consider licensing or turnkey operations from international sources one of its 3 most important source of technology acquisition, against 23.7 inChina." Access to information and communication technologies i s also low inrelation to other country in similar factor endowments: in2000,4.4 percent of the Brazilianpopulation had personal computers, against 5.0 inMexico andArgentina; 8.2 inChile; 23.7 inKorea and 58.5 inthe UnitedStates. Brazil performs poorly also interms of internet hostsbut relativelybetter inaccess to telephone services. 'Ministe`rioda Cigncia e da Tecnologia(2002): "Indicadores de CiCncia e Tecnologia". MCT: Brasilia, DF. Beintema, N.M.et al. (2001): Agricultural R&D in Brazil - Policy, Investments and Institutional Profile. Washington,DC: IFPRI-Embrapa-Fontago. The same relative position o f Brazil i s indicated by the technology index reported by the Global Competitiveness Report of the World Economic Forum (2002). Interestingly, both countries presented a turning point in the rate of patenting in the mid go's, while Brazil showed no significant change. loData from the preliminary results of the Brazil Investment Climate Assessment. During the ~ O ' S ,the Brazilian performance interms of licensing (US$ 8 per capita) was inferior to Argentina, India, Korea, Spain and the US. 209 Figure 2: Number of Patents Granted inthe U.S. 200 - Singapore 150 - I 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: USPTO Figure 3: Total Imports and Imports of Capital Goods in L A C and Selected countries (1999) 0 10 20 30 40 50 60 70 80 90 Import of Goods & Services (%GDP) Source: Based on data from De Ferranti et al. (2003) and WDI Figure 4: Royalty and Payments of License Fees in Brazil, India and Korea- 1990- 2002 (% GDP) I i 0.80% - 0.7090 - 0.60% - ! 0.50% Korea 0.40% - !I 0.309'0 - Brass 1I 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 ~ Source: IMF 210 7. Althoughfederal resourcesfor R&D have declined,poor technologyperformance of theprivate sector is caused more by the low effectiveness of R&D expenditures than by a shortage of inputs. Total federal disbursement on R&D has declined by an annual average of 3.14 percent between 1996-2002, while MCT expenditures on R&D have reduced 4.11percent (Table 1). R&D expenditure as a share of GDPinBrazil in 1998 was the largest inLatin America while expenditures per researcher i s also commensurate to its development level." The number of scientists and engineers i s still low for the size of the population but i s consistent with patents obtained inthe U.S. and R&D expenditures -- Brazil i s outperformed by several its level of development.12 However, interms of R&D effectiveness -- measured by the ratio of developed anddeveloping countries. l3In some cases, countries with lower stocks o f capital per researcher - such as Chile and Mexico --present an output per unit of resources almost two times higher than Brazil (Table 2). Table 1:Brazilian FederalDisbursement on R&D: 1996-2002" MCT Federal Government (RS$l,OOO) (RS$ 1,000) 1998 879 -17.0% 2 198 -9.6% 2002 820 -21.0% 2,050 -13.1% 1996-2002 -4.11% -3.14% *1999 values Source: SIAFI 11Informationprovided by MCT indicatesthe share of R&D expenditures inthe GDP to be 1.05 percent. Depending on the methodology of calculation, the value may be closer to 0.7 percent. Both values are however lower than fast- growing EastAsian countries (suchas Korea, Hong Kong and Singapore). l2 See De Ferranti et a1 (2003): "Closing the Gap in Education and Technology". World Bank: Washington, DC. WDI data indicates that the share of scientists and engineers in Brazil was roughly ?Athat of Argentina, % of Chile and %I of Mexico. This is partly the result of low average schooling years and low enrollment rates in tertiary education. l3For a similar conclusion extended to the Brazil National Innovation System see also Office of Chief Economist for LatinAmerica and the Caribbean, "Country InnovationBrief-Brazil", pp.5. 211 Table 2: R&D expenditures and efficiency in Brazil and Selected countries R&D R&D Expendituresby R&D Expenditures Universities Effectiveness (Patentsper million (per of R&D (% GDP) researcher) (%total R&D) expenditure) Brazil 1.05 122,100 43.61 0.018 Chile 0.54 56,454 43.82 0.033 Mexico 0.40 98,955 26.18 0.035 China 0.83 70,823 n.a. 0.016 Korea 2.47 185,041 n.a 0.277 Singapore 3.85 n.a. n.a 0.181 Canada 1.94 177,235 32.65 0.166 Spain 0.90 103,546 30.92 0.044 U.S. 2.76 191,220 14.24 0.313 Source: Based on WDI data. 8. comparativelylarge (see Table2).International evidence has shown that if not submitted to The share of the universities' expendituresin the total R&D expendituresin Brazil is the appropriate incentive-regime, universityperformed R&D may present a negative impact on R&D effectiveness ratios. Public research institutes may also raise the same type of concern. Both universities and government research centers correspond to more than 55 percent of total R&D expenditures inBrazil in2000.14The incentive-regime for public R&D execution i s essentially misalignedinBrazil for two reasons mainly: (i)i s not conducive for cost-effective it out-put oriented research; (ii) it does not encourage transferring public-generatedknowledge to the private sector for commercial application andby which productivity gains may be materialized). The higher education sector and public research centers have less incentives to address the private sector knowledge needs to the extent their research budgets are publicly- fundedtroughearmarked resources. Infact, having a significant part of its research budget obtained through competitive biddingshas been argued to be one important reason for Embrapa's effectiveness inR&D.I5Also, 75 percent of the Brazilian R&D efforts are aimed at "general knowledge improvement" as opposed to any specific activity, an emphasis on basic researcMibera1 arts much higher than that found inMexico (four percent) Spain (seven percent) or Portugal (25 percent), countries with a cultural heritage similar to that of Brazil. l4RedIberoamericana de Ciencia y Tecnologia (RICyT) database. Available at www.ricyt.org/Indicators. l5See Beintema, N.M.et al. (2001): "Agricultural R&D in Brazil - Policy, Investments and Institutional Profile". IFPRI-Embrapa-Fontagro :Washington, DC. 212 9. Brazil's innovationperformance is also affected by low private R&D investments due to unnecessarily low expected netprivate returns. Conditions governing application of IPRlaws inBrazil are still inadequatedespite recentimprovements, especially onlicensing processes which has been simplified since 1993. INPIstill lack appropriate humanandfinancial resources and duration for authorizations is still an issue, reducing the appropriability of the investment. Brazil offers tax incentives to R&D similar to those indeveloped countries (accelerating R&D depreciation, carry-forwardprovision etc) as well as tax-breaks. Tax-breaks to private R&D are providedby at least five different laws, amounting to RS$ 1.8 billion in2003, a three times increase from 1995 figures, of which roughly 80 percent (RS$1,5 billion) are applied to the informatics industriesby law 8,248/91 (Table 3). Sector concentration anddesignissues makeit unclear the overall impact of tax-breaks on the overall cost of R&D.16Since 2000, 14 sector funds were created, amounting RS$846 million (RS$ 1,101 ifFuntel is included) in2002. Sector funds were createdwith the objective of providingfor astable sourceof public funds for R&D (Table 4). Sector funds are disbursedby Finepthrough differentmechanisms, mainly grants, aimingat multipleobjectives and economic agents, with different duration periodand normally with strict limits for the amount disbursedper project.17Although these mechanismsand instruments are recent andFinephasbeen permanently adjusting them accordingly, sector funds disbursementshave beenunstable, lengthy, excessively fragmented and not always incentive- compatible. The laws creating the sector funds sometimes introduce obstacles to rationalization and better governance. '*TheFundo at better defined objectives -- improving cooperation betweenthe private-sector andthe Verde-Amarelo and the Fundo de Infra-Estrutura, targeted university andto support modernization of R&D infrastructure respectively -- and freed from sector constraints for the sector allocation of resources and with better instruments(subsidized loans, risk-sharing instruments)are reasonably designed even though its governance structure still needs improvement. Not surprisingly, limitation of funds was the mainobstacle for investments inR&D for 67 percent of the firms, according to a recent survey. According to the same survey, only 26 percent of the Brazilianinnovative firms would engage in cooperation with third parties of which only 24 percent would have cooperation agreements with univer~ities.'~ l6Onthe other hand, "ex-Turijidrios" for the import of capital goods reduce the costs of investments. l7 For example, through Curtu-Convite Finep publicly invites firms to submit there projects together with universities or research centers. Funds goes to the public institutions and requires matching by the private sector which can be financed by Finep under its normal credit-lines. The Editulde Inovqao aims at supporting the spill- over of firms and incubation activities by means of typical grants. Projects can last from 6 months to 4 years. '*Most sector fund laws require the application of resources on the industries they were collected, an unnecessary rigidity. These laws also usually establish regional targets for the allocation of resources 30-40% in N,NE and CO regions, that might not be consistent with economies of scale and agglomeration inherent to R&D activities nor even feasible (as for instance in the case of the Aeronautics Sector Fund). Each sector fund has its own executive committee (comiti?gestor) composed by persons from the government, private sector and university. l9According to information obtain through interviews with CNI's personnel. Another instrument was the support to technology-oriented companies through the Contec-Condiminum risk-sharing program of BNDESPAR (a subsidiary of the BrazilianNational Development Bank (BNDES). 213 Table 3: Tax-Breaks for Private R&D inconstant 1999 Reais ( thousand )* Law Number 8248191 8661193 year 8010190 8032190 10176101 9532197 8387191 Total 1991 72,529 6,742 _- -- -_ 79.271 1992 56,372 5,632 _ _ -_ _- 62,004 1993 71,623 11,437 339,767 _ _ _ _ 422,827 1994 89,455 7,676 420,888 2,103 _- 97,131 1995 82,048 12,783 354,650 13,429 _ _ 462,910 1996 71,982 10,059 506,180 14,335 77,158 82,041 1997 70,926 3,943 627,503 26,414 110,431 839,217 1998 69,097 4,788 835,191 46,650 105,323 73,885 1999 78,956 4,400 1,054,609 33,700 381,413 1,553,078 2000 60,323 10,522 1,178,000 22,289 13,374 70,845 2001 118,418 6,342** 1,230,000 22,447** 62,401** 1,439,608 2002** 138,600 13,090 1,450,000 47,100 65,152 151,690 2003** 154.000 6.160 1.530.000 . , 78.100 61.506 1.829.766 *Current I _ values for 2000-2003. **Estimated Source: MCT 10. Weak enforcement of IPRs, poorly designed tax-incentivesand subsidies- in sum, a poorly designed innovationpolicy -- seem to be the one important cause of low private expendituresin R&D. Comparing these variables with the quality of researchinstitutes, as determinants of private expenditures inR&D reinforces this hypothesis: Brazil performs relativelyworse than average interms of the use of tax-credits and subsidies while it i s about averageinterms of the quality of its researchinstitutes (Figures 5 to 7 )Considering the typical public-goods problem associatedwith the lack of perfect appropriability of R&D expenditures, returnsof R&D inBrazil andthe low private expenditures. the lack of a properly designedinnovationpolicy explain in2 art the discrepancy between social 9 11. To reduce the gap between social andprivate returns to R&D, Brazil needs a clear technologyand innovationpolicy. A coherent andcomprehensive set of measures focused at a few well definedobjectives against which effectiveness could be measuredand policy couldbe evaluated, i s essential. A common vision i s necessaryon how to translate public investment in knowledge into productivity gains andthereby economic growth. There have been some recent attempts inthis direction but Brazil still needs to strengthenthe appropriate institutions necessary to propose and implement such policy. It i s also necessary to better define attributions and roles Lederman and Maloney (2003) estimate that the economic return to R&D in countries of Brazil level of income are high around 65%, indicating that Brazil should be investing between 2 and 8 times more in R&D than it currently happened during the 1990s. See Lederman, D. and W. Maloney (2003): "R&D and Development". Mimeo. Office of Chief Economist for LCR. World Bank: Washington, DC. 214 among different institutions, as well as better coordinate with non-federal initiatives. One interesting example has beenthe experienceof Embrapa, as the coordinator of the "Brazilian Agricultural System of Innovation," which involves state levelpublic agricultural extension companies, university institutes, other public researchcenters and the private sector.*l Until recently, however, the roles of Centro de Gestiioe Estudos Estratkgicos (CGEE),the Conselho Nacional de Ci2ncia e Tecnologia (CCT), among other institutions was unclear. The establishment of one executive committee for each sector fund, composedby government, industry and universityrepresentativeswith the attribution of definingthe sector funds strategies andpolicies for resource allocation mayjeopardize the capacity of the government to implement a coherent and comprehensive innovation policy. Finally, the role of Finep-currently working as an execution body for the funds and as financial institution-must be clarified to avoid possible conflictingobjectives as well as typical agency problems. Figure 5: Private R&Dvs. Subsidies(2001) 0 1 2 3 4 5 6 Subsidiesfor Finn-LevelResearchandDevelopment Source: WEF (2002) 21See Beintema, N.M.et al. (2001): "Agricultural R&D in Brazil - Policy, Investments and Institutional Profile". IFPRI-Embrapa-Fontago :Washington,DC. 215 Figure 6: Private R&D vs. Tax Credits (2001) 0 1 2 3 4 5 6 Tax Creditsfor Firm-LevelResearch andDevelopment I Source: WEF (2002) Figure 7: Private R&Dvs. Quality of Research Institutes (2001) 0 1 2 3 4 5 6 7 8 Quality of ScientificResearchInstitutions Source: WEF (2003) 2. Recent Achievements andFuture Challenges 12. In order tofacilitate technologyabsorption,the Braziliangovernment has taken initiativesinthe fields of the licensing agreements and acquisition of capital goods. The process of deregulating the transferenceof technology startedin 1991 and further steps were taken in 1993. Essentially the term for INPIto register contracts was shortened and several administrative procedures were waived, which partly explains the boominroyalty payments. This process has continued untilrecently although at a slower pace. Yet several unnecessaryrequirements cause 216 further delays and further simplificationi s much needed.22Import tariffs and PIeffectively applied to capital goods have reducedfrom 65 percent to 55 percent of its total value between 2001 and 2003 and the tax reforminCongressi s likely to reducetax impact on the acquisition of capital goods. More than nominaltariff rates, which might still behigh, access to credit, specially by MSME,i s an constraint to the acquisition of importedcapital goods. 13. To improve effectiveness ofpublic R&D expenditures,the government sent to Congress a draft "Innovation Law" inDecember 2002, after one year of discussion. Although modest in scope and depth, the draft law clearly improves the incentive-regime for both amore results- oriented public research and results transfer for the private sector. The new administration interruptedthe legislative processof approval, realized a new round of consultations with the civil society and the private sector, and i s working towards improving the existing draft, aiming at reassumingthe legislative processinthe next months. 14. To improvethe incentiveregimeforprivate R&D, two sector funds -the Verde-Amarelo and the Infrastructure funds -provided for the creation of better targeted and more private sector oriented instrument for the reduction of the cost of R&D, namely a risk-sharing mechanism (PortariaMinisterial 5992002 of the MCT, a matching-grant mechanism (PortariaMinisterial 596/2002 of the MCT) and a subsidized-interest rate mechanism Portaria Ministerial 597/2002 of the MCT). In2002, two Venture Forum (inthe cities of Sa"oPaulo and Fortaleza) were realized, leading to few private venture operations. 15. Generalprinciples and objectivesfor theBrazilian science and technology strategy were establishedin July 2002. After a long discussion, the government issued the "Livro Branco: CiCnciaTecnologia e Znovapio", with. The document however i s not yet to be downsized into an executable strategyto transform knowledge into productivity gains. In December 2002 was sent to Congress an assessment of the impacts of tax-breaks on R&D, showing its commitment to improvingmonitoring evaluation of innovationpolicy inBrazil. The new administration started to revitalized the CCT and also better definedthe role of the CGEE. 16. Futurechallengesmay be summarized infour mainheadings: 0 Facilitate technology absorption by: strengthening the diffusion of technical standards and norms; facilitating acquisition of importedand local capital goods; facilitating acquisition of computers andinternet access; simplifying government licenses and authorizations for technology transfer agreements and supporting technology extension services (as for example SENAITECS), among other means; 0 Increase the effectiveness of public R&Dby: improvingincentives for productivity improvement inpublic researchinstitutes and public universities; encouraging transfer of technology from the public to the private sector by licensing regimeby university and publicresearchcentersto the private sector or facilitating entrepreneurship; and establishing incentive regimes for partnershipsbetween public research institutes and the private sector, among other means; 22See FIAS (2001): Brazil-Legal, Policy and Administrative Barriers to Investment in Brazil. Volume I. FIAS- IFCNorldBank:WashingtonDC. 217 0 Foster private sector participation (funding and expenditure) by: strengthening IPR enforcement, reducing the time to register a patent; reviewingtax incentives and policies for reducing the cost of R&D; rationalizing management structure (governance) of the sector funds; emphasizing matching grants; supporting private researchcenters; reviewingpublic incentives for private funding of tertiary enrollment andlabor training; facilitatingjoint-venture for R&D and supporting venture capital funds, among other means; and 0 Define and implement a coherentfederal technology and innovation policy by: defining acoherent federal innovation policy (as a sub-set of the NationalS&T po1icy)strengthening policy-makingand coordination capacities, possibly by enhancing governance and the role of the CCT as well as creating an "Technology and Innovation" sub-committee within CCT; improving monitoring and evaluation; andbetter defining the role of Finep, among other means. 218 219 220 ANNEX10 IMFRELATIONSNOTE SUMMING UPOFTHECHAIRMANOFTHEBOARDOFTHEINTERNATIONAL MONETARY FUNDFOLLOWING FIFTHREVIEW UNDER THE BRAZIL'S STAND- BYARRANGEMENTONDECEMBER 15,2003 IMFApproves15-MonthExtension,andUS$6.6 BillionAugmentationofBrazil's Stand-ByCredit* The ExecutiveBoardof the International Monetary Fund(IMF) has approved an extension for 15 months and an augmentation by SDR 4.5 billion (about US$6.6 billion) of Brazil's stand-by credit, originally approved on September 6,2002 (see Press Release No. 02/40). The Board also approvedthe authorities' request for a shift of repurchases expectations inthe credit tranches of an amount SDR 4 billion (about US$5.8 billion) into an obligations basis ineach 2005 and 2006. The Board's decision was taken simultaneously with the completion of the fifth andlast scheduledreview of the original program, which made SDR 5.6 billion (about US$8.2 billion) immediately available to Brazil.However, inlight of improvements inBrazil's balance of payments, the authorities have indicated that they do not intend to make further drawings. Followingthe Executive Board's discussion of Brazil on December 12,2003, Horst Kohler, ManagingDirector andChairman of the Board, stated: "Brazil's performance under the Stand-By Arrangement approved on September 6,2002 remains exemplary. All performance criteria and structural benchmarks associatedwith the fifth review were met. "Supported by the commitment of significant Fundresources, Brazilhas come a long way since last year's financial market volatility. The responseof the new administration to financial pressures has beenboth ambitious andcourageous, balancing fiscal and monetary policy discipline with the resolute pursuit of key social goals to relieve poverty andstrengthenthe social safety net. To allay concernsover debt sustainability, the government increasedthe primary surplus target. The central bank respondedproactively to guide inflation back to the government's targets. Moreover, early inits tenure, the administration took the difficult political step of seeking approval of key structural measures-including pension and tax reform-that will deepenthe foundations for sustainableand equitable growth of output andemployment. "The successfulimplementation of these policies has resulted in a rapidrestoration of confidence, which i s beingclearly reflected inthe performance of financial market variables. Improvedmarket sentiment, inpartreflected inthose variables, i s driving an emergingrecovery of economic activity, anddemandgrowth should continue to * Press Release No. 031217. December 15,2003. 221 accelerate inthe coming year. Ensuring that all members of Brazilian society participate inthe country's vast potential will bethe government'skey challenge for the coming years. "To support the government's efforts to put Brazil firmly on a path to sustainedgrowth with improvedequity, the Fund'sExecutive Boardhas approved an extension and augmentation of the Stand-By Arrangement. The Fundregards this step as an important component of the government's strategy for a smooth exit from Fundfinancial support. The Fundwill also assist Brazil insmoothing its scheduleof external commitments by shiftingsomeFundrepurchasesfrom an expectationsto an obligations basis in2005 and 2006. The authorities' statedintentionto treat the arrangement as precautionary, given the absence of a balance of payments need, i s welcome. "Prudentmonetary and fiscal policies will remain at the core of the Fundarrangement. At the same time, the program also provides support for essential spendingto help achieve the government's social objectives. The maintenanceof a strong primary fiscal position, along with continued further improvements inBrazil'sdebt structure, will be key to ensuringmedium-term sustainability andpromotingfavorable investment decisions. The program also features important structural measuresthat will both support and sustain dynamic growth inBrazil inwhich the private sector will continue to play the major role. These include steps to reducebankingspreads, increasefinancial intermediation, and improve the businessenvironment, while also undertakingthe preparatory work towards increasing the flexibility of the budget. These policies will help nurturethe recovery now underway inBrazil and sustaininvestment andeconomic growth into the mediumterm," Mr.Kohler stated. Recent Economic Developments Brazil's monetary and fiscal policies have remaineddisciplined, actual and expected inflation have declined steadily, and market forecastsput end-2004 inflation solidly within the official target range. Inaddition, the external adjustment remains impressive, with recordtrade surpluses and the current account movinginto surplus. Both the public and private sectors have regained access to international capital markets, and country risk has dropped to levels not seen since 1998.The real has appreciated by 30 percent innominalterms from its weakest point during the crisis, and, inrealterms, is now close to its January 2002 level. Important progresshas also been made inmoving forward the government's structural reform agenda, and this has been a key driver of market sentiment. This strong performance has laidthe foundation for aresumption of growth. Following disappointing performance earlier this year, there are now clear signs that domestic demandhasbegun to recover. Due to the slow start this year, output i s unlikely to rise by more than 0.6 percent, but growth i s forecasted at 3.5 percent in 2004, with consumption and investment bothrisingsolidly. 222 Programsummary Despite the recent successes, Brazilremains vulnerable to negative shifts in market sentiment. The authorities have therefore committed to apolicy program for 2004 that will continue makingprogress in addressingcore vulnerabilities, such as the large external borrowingrequirement, andrelatively low net reserves, currently at about US$17 billion. The extension for 15 months of the current Stand-By credit, and the shiftingof somerepaymentsto the Fund,are also part of the authorities' strategy to reduce vulnerabilities and to exit from Fundassistance. The program calls for a continued healthy public sector primary surplus in 2004. The budget for 2004 i s consistent with a primary surplus target of 4.25 percent of GDP. The authorities planto continue to buildon recent progress inimprovingthe composition of the domestic debt, further reducing another important vulnerability. Details of their public debt managementplanfor 2004 are still being finalized ,and will be publishedin January. The authorities' overall goals will be identical to those in 2003: to further reduce the share of debt that is indexed to the exchangerate or is at floating rates, while increasingthe share of fixed rate and inflation-linkeddebt. The central bank's proactive conduct of monetary policy has ensuredthe credibility of the inflation targeting regime over the past year. As a result, the central bank has been able to ease policy steadily over the last several months as inflation expectations have continued converging to the government's targets. The authorities' structural reform agenda for 2004 is anotherelement inthe effort to address vulnerabilities and stimulate growth. Key priorities include increasing financial intermediation, reducing bank lendingspreads, and improvingthe business environment. Inaddition, the authorities will work to implementthe tax andpensionreforms currently before congress. Significant reforms are also under way to reduce bureaucratic barriers to international trade. Enhancementsto the regulatory framework are an important element of the authorities' strategyto improve the environment for private investment. They include a new regulatory modelfor the energy sector andthe removal of tax andregulatory inefficiencies, including the conversion of the COFINS contributionto a value-added- type basis, to reducethe distortions arising from its current cascading format. Following the recent experience with streamlining export regulations, the government will undertakea study to identify measuresto simplify, integrate, andreduceregistration requirements for businesses. The authorities are also continuing to introduce reforms to improve the delivery of social services, which they see as central to their policy platform. Inaddition to the creation of the Fome Zero (Zero Hunger)program, the government has consolidated existing social assistanceunderthe umbrella Bolsa Familia (Family Stipend) program. The authorities believe that improvements ininfrastructure spending inthis areahave the potential for largesocial returns. 223 Brazil i s an original member of the IMF; its quotaLis SDR 3.04 billion (about US$4.4 billion). Brazil's outstandinguse of IMFcredit currently totals SDR 23.19 billion (about US$33.86 billion). 224 Brazil: SelectedEconomic Indicators 2000 2001 2002 2003 (inpercent) Domestic economy Change inreal GDP 4.4 1.3 1.9 0.6 Unemployment rate 11 7.1 10.6 10.5 12.0 Inflation (IPCA, end-year) 6.0 7.7 12.5 9.5 (inbillions of U.S. dollars) External economy Exports, f.0.b. 55.1 58.2 60.4 72.5 Imports, f.0.b. 55.8 55.6 47.2 50.0 Current account balance -24.2 -23.2 7.7 2.0 Capital account balance 19.3 27.1 8.8 7.9 o/w Foreign direct investment 32.8 22.5 16.6 8.0 Gross official reserves 33.0 35.9 37.8 47.7 Current account balance (inpercent of GDP) -4.0 -4.5 -1.7 0.4 (inpercent of GDP) Financial variables Public sector borrowing requirement 21 3.6 3.6 4.7 5.3 Public sector primary balance 3.5 3.6 4.0 4.3 Gross external public debt 15.4 18.1 24.0 23.6 Change inbroad money (inpercent) 3.3 13.3 23.6 19.0 Average overnight interest rate (in percent) 17.4 17.3 19.1 23.2 Source: Brazilian authorities and IMFstaff estimates. 11Statistical methodology and definition changed in 2001. 21Harmonized public sector borrowing requirement (excluding the impact on the debt stock of exchange rate movements occurred during the reference period that will not be paid untilthe bond matures). I A member's quota in the IMF determines, in particular, the amount of its subscription, its voting weight, its access to IMFfinancing ,and its allocation of SDRs. 225 M z 226 r ; P 36 m 227 ANNEX 12 STATEMENTOFIFCHELDAND DISBURSEDPORTFOLIO CAS Annex B8 (IFC) for Brazil Brazil Statementof IFC's Held andDisbursedPortfolio As of 913012003 (InUS DollarsMillions) Held Disbursed FYApproval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1997198 Guilman-Amorim 0 0 0 0 0 0 0 0 1998 IcatuEquity 0 19.6 0 0 0 12.48 0 0 1999 InnovaSA 16.25 5 0 45 16.25 5 0 45 198018;Ipiranga 0 0 0 0 0 0 0 0 1999 Itaberaba 0 5.34 0 0 0 5.34 0 0 OlOO/( Itau-BBA 40 0 0 0 30 0 0 0 1999 JOSAPAR 1.57 0 7 0 2.57 0 7 0 1995 LojasAmericana 8 0 5 0 8 0 5 0 1987192196199 MBR 20 0 0 0 20 0 0 0 2002 Macae 68.61 0 0 0 68.61 0 0 0 0 Macedo Nordeste 1.58 0 5 0 1.58 0 5 0 2002 Microinvest 0 1.25 0 0 0 0 0 0 0102 Net Servicos 0 5 0 0 0 4.65 0 0 1975196 OxitenoNE 2.5 5 0 0 2.5 0 0 0 1994 ParaPigmentos 15.05 0 9 0 15.05 0 9 0 1987196 Perdigao 8.75 0 0 0 8.75 0 0 0 1989195 PolitenoInd. 1.46 0 0 0 1.46 0 0 0 1994100102 Portobello 0 1.15 0 0 0 1.15 0 0 2000 Puras 3.67 0 0 0 3.67 0 0 0 2003 Queiroz Galvao 40 0 0 0 10 0 0 0 1998 Randon 5.13 0 3 0 5.13 0 3 0 1990 Ripasa 0 5 0 0 0 5 0 0 1997 Rodovia 0 0 0 0 0 0 0 0 1983 SOCOCO 0 0 0 0 0 0 0 0 1987197103 SP Alpargatas 30 0 0 0 5 0 0 0 1994195197 Sadia 8.23 0 5.17 89.93 8.23 0 5.17 89.93 1997 Samarco 8.1 0 0 1.33 8.1 0 0 1.33 1998 Saraiva 6.92 3 0 0 6.92 3 0 0 2003 Satipel 25 0 0 0 25 0 0 0 0 SearaAlimentos 0 3.88 0 0 0 3.88 0 0 2000 Sepetiba 27 0 5 8 12 0 5 8 1997 Suconico 3 0 0 0 3 0 0 0 1999 Sudamerica 0 15 0 0 0 15 0 0 0 Suzano 0 1.27 0 0 0 1.27 0 0 228 2001 Synteko 18 0 0 0 18 0 0 0 1996 TIGRE 7.69 0 5 0 7.69 0 5 0 0192 TRIKEM 0 0 0 0 0 0 0 0 1998 Tecon Rio Grande 5.41 0 5.5 9.89 5.41 0 5.5 9.89 2001103 Tecon Salvador 0 0.56 0 0 0 0.55 0 0 2002 UPOffshore 11.6 10 0 30 0 0 0 0 0188/02/03 Unibanco 0 0 0 0 0 0 0 0 1999 Vulcabras 11.67 0 0 0 11.67 0 0 0 1999 Wiest 0 0 8 0 0 0 8 0 2001 AG Concession 0 15 15 0 0 4.29 0 0 1996197 Alga Telecom 0 8.17 0 0 0 8.17 0 0 2002 Amaggi 30 0 0 0 30 0 0 0 2002 Andrade G. SA . 40 0 0 20 40 0 0 20 2001 Apolo 8 0 0 0 5.5 0 0 0 1998 Arteb 20 7 0 18.33 20 7 0 18.33 1999 AutoBAn 27.6 0 0 23.72 27.6 0 0 23.72 1993194196 BACELL 0 0 0 0 0 0 0 0 1998 BSC 6.59 0 0 3.53 6.59 0 0 3.53 1993196 BUNGECEVAL 0 8.06 0 0 0 8.06 0 0 1990191192 BahiaSul 0 0 0 0 0 0 0 0 1996103 BancoBradesco 10 0 0 60 10 0 0 60 1988103 BancoItau 25 0 0 175 25 0 0 175 1997 Bompreco 10.42 0 5 0 10.42 0 5 0 0 Bradesco-Hering 7.5 0 0 0 7.5 0 0 0 0 Bradesco-Petrofl 7.5 0 0 0 7.5 0 0 0 1994196 CHAPECO 17.85 0 0 5.26 17.85 0 0 5.26 2002 CN Odebrecht 51.78 0 20 113.57 51.78 0 20 113.57 1973178183 CODEMIN 0 0.4 0 0 0 0.4 0 0 2003 CPFLEnergia 40 0 0 0 0 0 0 0 1992 CRP-Caderi 0 0.51 0 0 0 0.51 0 0 1995 CambuhyMC 1.88 0 0 0 1.88 0 0 0 1997 Copesul 0 0 0 0 0 0 0 0 0197100 Coteminas 0 0.53 0 0 0 0.53 0 0 1980192193 DENPASA 0 0 0 0 0 0 0 0 1995196/98/02 Distel Holding 0 0 0 0 0 0 0 0 1998 DixieToga 0 15 0 0 0 15 0 0 1987196197 Duratex 8.33 0 0 25.67 8.33 0 0 25.67 1999 Eliane 25.6 0 13 0 25.6 0 13 0 1998 Empesca 5 0 10 0 5 0 10 0 2001102 Escola 0 0.28 0 0 0 0.25 0 0 2000 Fleury 7.71 0 6 0 7.71 0 6 0 1998 Fosfertil 6.82 0 0 30.68 6.82 0 0 30.68 1998 Fras-le 8 0 10 0 8 0 6.7 0 1994 GAVEA 3.75 0 5.5 0 3.75 0 5.5 0 0 GPCptl Rstrctd 0 9.67 0 0 0 9.51 0 0 2001 GPC 9 0 0 0 9 0 0 0 Total Portfolio: 779.52 145.67 142.17 659.91 640.42 111.04 123.87 629.91 229 ApprovalsPendingCommitment Loan Equity Quasi Partic 2003 Amazonas Water 15 0 0 0 2002 Andrade 0 0 0 100 2000 BBA 10 0 0 0 2002 Banco Itau-BBA 0 0 0 100 2001 Brazil CGFund 0 20 0 0 1999 Cibrasec 0 1.5 0 0 2003 DuratexIV 0 0 0 5 2002 Macae 0 0 0 275 2002 Net Servicos 2 50 0 0 0 2002 Suape ICT 6 0 0 0 2004 TermoFortaleza 55.5 0 7 112.5 2004 UBB Swap Gte 20 0 0 0 2002 Unibanco-CL 0 0 0 150 Total PendingCommitment: 156.5 21.5 1 142.5 230 ANNEX 13 Brazil at a glance 9/3/03 Latin Lower- POVERTY and SOCIAL America middle- Brazil &Carib. income Developmentdiamond` 2002 Population, mid-year(millions) 174.5 527 2,411 GNI per capita (Atlas method, US$) Life expectancy 2,830 3,280 1,390 GNI (Atlasmethod, US$b/lllons) 494.5 1,727 3,352 - Average annual growth, 1996-02 Population(%) 1.3 1.5 1.o Labor force (`A) 1.7 2.2 1.2 GNI Gross per ' --I primary Most recent estimate (latest year available, 1996-02) capita enrollment Poverty ("A of populationbelow nationalpoverty line) 22 Urbanpopulation(% of totalpopulaf/on) 82 76 49 Life expectancyat birth (years) 69 71 69 I Infant mortality (per 7,000livebirths) 30 27 30 Child malnutrition(% of childrenunder5) 6 9 11 Access to imDroved water source Access to an improved water source (% ofpopulation) 87 86 81 Illiteracy(% ofpopulation age 754 12 11 13 Gross primary enrollment (% of school-age population) 162 130 111 -Brazil Male 166 131 111 Lower-middle-incomegroup Female 159 128 110 KEY ECONOMIC RATIOSand LONG-TERMTRENDS 1982 1992 2001 2002 Economicratios* GDP (US$ &//lions) 281.7 390.6 509.0 452.4 Grossdomestic investmenffGDP 21.1 18.9 21.2 19.3 Exports of goods and services/GDP 7.6 10.9 13.2 15.8 Trade Grossdomestic savings/GDP 20.4 21.4 20.2 21.5 Gross national savingdGDP 15.3 20.1 16.6 18.0 Currentaccount balance/GDP -5.8 1.6 -4.6 -1.7 InterestpaymentdGDP 3.4 0.7 3.0 3.0 Domestic Investment Total debffGDP 33.3 33.0 48.3 51.3 savings Total debt service/exports 81.9 21.1 76.4 70.2 Presentvalue of debffGDP 52.6 58.4 Presentvalue of debffexpotts 334.2 Indebtedness 1982-92 1992-02 2001 2002 2002-06 (average annualgrowth) GDP 2.6 2.7 1.4 1.5 3.4 -Brazil GDP per capita 0.7 1.4 0.1 0.2 2.2 Lower-middle-incomearow Exports of goods and setvices 6.9 6.5 11.2 7.8 5.4 STRUCTURE of the ECONOMY 1982 1992 2001 2002 Growth of investmentand GDP (YO) (% OfGDP) I Agriculture 9.0 7.7 6.1 6.1 `5T I Industry 45.6 38.7 22.3 Manufacturing 34.6 24.7 14.0 Services 45.4 53.6 71.6 Privateconsumption Generalgovernment consumption 10.0 17.1 19.2 19.3 Importsof goods and sewices w*w.mGDI -GDP 1982-92 1992-02 2001 2o02 1 (average annualgrowth) Growth of exports and imports (%) I Agriculture 2.5 3.5 5.7 5.8 2o Industry 1.6 2.3 -0.7 1.5 IO Manufacturing 0.5 1.8 1.4 1.4 Sewices 3.2 2.8 1.9 1.5 Privateconsumption 0.7 3.9 0.8 0.4 -10 Generalgovernment consumption Grossdomestic investment 4.1 2.1 -1.1 -5.2 -bports -Imports Importsof goods and services Note: 2002 data are preliminaryestimates. The diamonds show four key indicatorsin the country (in bold) comparedwith its income-groupaverage. If data are missing,the diamond will be incomplete. 231 Brazil PRICES and GOVERNMENT FINANCE 1982 1992 2001 2002 Domesticprices Inflation(%) (% change) T I Consumer prices 100.5 951.6 7.7 7.7 15 Implicit GDP deflator 104.8 968.5 7.5 8.5 10 Government finance 5 (X of GDP, includes currentgrants) 0 Current revenue 22.7 24.1 07 08 00 00 01 02 Current budget balance 3.0 3.1 I Overall sulpius/deficit 3.8 "GDP deflator -CPI 1 TRADE 1982 1992 2001 2002 (US$ millions) Exportand import levels(US$ mill.) Total exports (fob) 35,793 58,223 60,362 75,000T Coffee 2,534 2,932 3,049 Soybeans 2,696 2,726 2,199 Manufactures 23,787 32,901 33,001 50 000 Total imports (cif) 20,554 55,572 47,219 Food 850 1,169 1,085 25 000 Fueland energy 3,069 6,276 6,281 Capital goods 6,335 14,808 11,593 0 Export price index (79953700) 73 92 94 95 06 07 08 09 00 01 Importprice index (1995=100) 65 63 114 115 Exports W Imports Terms of trade (7995=700) 112 147 82 82 BALANCEof PAYMENTS 1982 1992 2001 2002 (US$ millions) 1Currentaccount balanceto GDP (%) I Exportsof goods and services 21,967 38,999 67,545 69,968 Importsof goods and services 24,761 25,717 72,653 61,863 Resourcebalance -2,794 13,282 -5,108 8,105 Net income -13,510 -9,382 -19,743 -18,191 Net currenttransfers 2 2,243 1,638 2,390 Current account balance -16,302 6,143 -23,213 -7,696 Financingitems (net) 11,101 8,926 19,795 -3,570 Changes in net reserves ' 5,201 -15,069 3,418 11,266 Memo: Reselves includinggold (US$millions) 3,994 23,754 35,866 37,823 Conversion rate (DEC,locaL/US$) 6.52E-11 1.ME73 2.4 2.9 EXTERNAL DEBT and RESOURCE FLOWS 1982 1992 2001 2002 (US$millions) Compositionof 2002 debt (US0 mill.) Total debt outstandingand disbursed 93,932 129,060 245,844 232,075 IBRD 2,694 7,238 7,963 7,710 A 7.710 IDA 0 0 0 0 Total debt service 19,215 8,647 54,322 51,636 IBRD 411 1,913 1,362 1,518 IDA 0 0 0 0 Compositionof net resourceflows Official grants 24 38 81 0 Official creditors 966 -936 2,742 916 Privatecreditors 7,580 5,888 -1,781 -9,541 Foreigndirect investment 2,910 2,061 22,636 0 Portfolioequity 0 1,704 2,482 0 F: 152.327 World Bank program Commitments 1,090 1,344 1,624 1,276 A IBRD Disbursements 623 581 1,639 1,384 E. Bilateral B IDA -- D Other multilateral - F. Private Principalrepayments 215 1,266 828 1,063 C IMF G Short-term - ~ Net flows 408 -685 810 322 Interestpayments 196 647 533 456 Net transfers 212 -1,332 277 -134 DevelopmentEconomics 9/3/03 232